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The Higher the Rate, the Bigger the Fall


Mortgage rates have been on the rise as central bankers aggressively hike policy rates in an attempt to rein in inflation from historically high levels. This has, as expected, dampened demand for housing, as higher borrowing costs reduce affordability, and, in turn, are leading to price declines in many of the nation’s housing markets. The speed of this response has been faster than expected—bigger mortgage loans and higher indebtedness may have led to increased sensitivity to rate hikes, amongst other factors. As rates continue to rise, will home prices continue to decline as a result, and by how much?


This note attempts to isolate the contribution of interest rates to the future path of house prices from other factors, such as the fall in purchasing power caused by high inflation, war uncertainty, deteriorating confidence, and the fall in stock markets. All else being equal, it explores different house price outcomes based on different paths for mortgage rates and their impact on housing activity, the latter measured by residential investment. Residential investment, a major component in our economic growth and output gap forecasts, captures demand and supply via its components of residential construction, renovations, and owner transfer costs.


The conventional fixed five-year mortgage rate is closely tied to government bond yields—the latter having been on the rise since the second half of 2021, when the Bank of Canada turned more hawkish in the face of rising inflationary pressures that proved more persistent than previously expected. Canada 5-year government bond yields, a benchmark for fixed mortgage rates, increased by over 200 bps between August 2021 and June 2022. During that same period, the rate on the most common five-year fixed-rate mortgage increased by 185 bps, from a trough of 3.2 in August 2021. The rate on variable-rate mortgages, which generally moves in tandem with the prime rate, has increased by 200 bps between August 2021 and July 2022.


Throughout the pandemic, an increasing share of new mortgages has been taken up by variable-rate mortgages, owing to the lower rate offered on these mortgages relative to fixed-rate mortgages. Today, half of newly originated mortgages are variable-rate mortgages, with their share of total outstanding mortgages reaching 32%. There are signs that the originations of these mortgages have peaked however, as the share of originations has been steadily declining since reaching the 56% share recorded in January. In our estimation, we use the conventional fixed-mortgage rate as a proxy for broader movements in the full range of mortgage rates. We believe this still takes into account the impact of increases in variable rates, as fixed and variable rates have generally moved in tandem, just at different levels. Our dependent variable, average house prices, captures the entire housing market, regardless of mortgage type. The results are therefore best interpreted as the change in house prices given the increase in rates, rather than given a certain level of rates. The conventional fixed mortgage rate that we use in this estimation is a general benchmark that is the simple average of the posted, closed, 5-year interest rates for mortgages issued by banks, trust companies, credit unions, savings and loan and life insurance companies.


In this note, we consider 5 different scenarios for the conventional fixed five-year mortgage rate and corresponding outcomes for residential investment and home prices:


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