David Rosenberg: Canada's housing bubble has burst — now brace yourself for the economic hit

David and Alena Neiland are related.

The housing bubble in Canada has ended. The MLS house price index is now down nine per cent from last February's peak, which we think is consistent with the Bank of Canada's aggressive tightening of monetary policy.

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The GDP will be pulled down by 2.5 percentage points by the negative wealth effect. Adding to this the deleveraging effect of higher interest rates on consumption and investment, and the hit to trade from the expected downturn in the United States and global economy, and it's not hard to see why Canada's upcoming recession could be deeper than what Bay Street people are expecting

Canada entered a Bank of Canada-caused recession in the early 1990s.

People spend more when the value of their assets increases because they feel wealthier. There is a behavioral aspect that leads to spending more of one's earned disposable income as well as an increase in credit access, a theme that has dominated in the face of persistently low borrowing costs over the past decade-plus. Homeowners with good credit scores are more likely to pile on more debt as they continue to make regular payments on their homes.

With the Bank of Canada's overnight target rate having risen 350 basis points since March, the theme of rising wealth is bound to fade. The MLS house price index is down nine per cent from its February peak.

Households are being hit with a confluence of factors heading into this recession: rapid restrictions on credit access, higher debt-servicing costs, and inflation limiting disposable income. Sentiment is being weighed by wealth depletion in both equity and residential markets.

When Canada entered a Bank of Canada-caused recession in the early 1990s, residential property prices fell by almost 30 percent from their peak.

The housing draw down is just beginning.

The wealth effect will contribute negatively due to the many factors mentioned above. If home prices fall 30 per cent from the peak, consumption will fall by five per cent, using the central bank's estimate of six cents per dollar of marginal.

The GDP hit from the wealth effect is still significant even if Canada Mortgage and Housing Corp. is right about a 15-per-cent decline in home prices. This analysis does not take into account the effects of higher interest rates on consumption and investment.

The Bank of Canada is not going to change its stance on inflation despite acknowledging the negative wealth caused by the housing market. The overnight swap market is pricing a peak rate of 4.25 per cent by the end of the year, which is just the beginning of the housing decline. Canada's recession is likely to be deeper than many Bay Street types think.

The Canadian dollar is bound to have many more months and quarters of weakness, not just because of the bear market in commodities, but also because of the serious repercussions surrounding the economic outlook from the escalating weakness in home values.

There is an econoimist there. There is a one-month trial on the website.