National Bank of Canada worries that the impact of rising interest rates on the residential housing sector “could be dire” in Canada.

According to economists Matthieu Arseneau and Yanick Desnoyers,

“Though the Bank of Canada has done well to set its rate normalization process in motion, the fact remains that the stakes at play are high, with home prices and household debt at record levels relative to income, … The residential real estate sector, which is extremely sensitive to interest rate fluctuations, could have the wind knocked out of its sails if interest rates do nothing more than normalize.”

The two economists studied previous periods of rising rates, given that the Bank of Canada last week began hiking its benchmark overnight rate from the emergency low it used to fight the recession. The fall in rates increased the borrowing capacity of Canadian families, they said, in turn helping to drive home prices to levels that, as a percentage of personal disposable income, have never been higher.

“Whereas a 100-basis-points increase would have meant an extra $101 in 1994, the same hike would amount instead to $177 today,” they said, looking at the impact on a three-year mortgage. “… In order to take into account the fact that household ability to pay has changed over time, we represented this amount as a [percentage] of the income of a two-parent double-income with children family. Accordingly, the impact of a 100-basis-points increase in the three-year rate on monthly mortgage payments is 18 per cent higher today than it would have been in 2004 and 14 per cent higher than it would have been in 1994.”

Meanwhile the Canadian Real Estate Association is now saying that 2010 sales will not be as strong as previously forecast. Nonetheless CREA expects 490,600 sales through the Multiple Listing Service in 2010, a 5.5% jump from a year earlier and the second-best year on record.

“With interest rates soon expected to rise, Canada is widely believed to be entering a typical demand-driven downturn due to recent prices increases and rising interest rates,” said Gregory Klump, chief economist with CREA. “A downward trend in national sales activity combined with an increase in listings will result in a more balanced market. In keeping with the return of a balanced housing market and typical demand-driven housing market cycle dynamics, prices will remain stable.”

Mr. Klump emphasized that Canada’s mortgage market remains “solid,” and that conservative lending practices mean the country will not experience the same type of correction the United States has had where prices have fallen as much as 50% in some markets.

Last month, CREA issued a report debunking the theory put forward by a number of commentators that the Canadian housing market was headed for a major correction. The report came on the heels of an analysis from Canadian Imperial Bank of Commerce senior economist Benjamin Tal that housing prices in Canada were 14% overvalued.

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Tags: Bank of Canada, CREA, interest rates, real estate