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Canada's house of cards?

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After holding its benchmark interest rate at one percent, the Bank of Canada this week took a decidedly dovish view in its quarterly forecast, saying the country's export-dependent economy is moving from what was a soft patch to a year of sluggish growth. But that dovish view -- backed by low interest rates -- is helping to fuel a decade-long housing boom that many analysts say is unsustainable.

Bank of America Merrill Lynch economist Sheryl King says an increasing number of Canadians are opting for variable rate mortgages and ignoring warnings from policymakers about household debt levels.

"Homeowner's continue to hear a chorus of admonishments from the Department of Finance, the Bank of Canada and OSFI that these low interest rates will not be around forever," King said in a recent note to clients. "However, we think the stronger signal households are receiving is from policy rates, which have held steady at 1.0 percent for 13-months now."

King says roughly two out of three mortgages underwritten this year have been for a variable rate term, compared to a typical 25 to 30 percent share. She says this is part of a larger trend of homeowners opting for variable rate mortgages.

"Over the past decade or more, rolling a variable rate mortgage from month-to-month has consistently been less expensive than a fixed mortgage rate. In essence, a generation of homeowners has experienced nothing but declining rates and lower monthly interest payments," she says.

"This expectation will be hard to change."

As evidence of the damage a low-interest rate policy causes, King says we only need to look at the U.S. real estate bubble.

"The U.S. homeowner was lured down a very similar path by the Federal Reserve at the turn of the century. Indeed, in late 2000 the spread between a 1-year ARM [adjustable rate mortgage] and a 30-year conventional mortgage was as narrow as 30bps…households did not start to sour on ARMs until 2004 when the Fed finally started to raise the funds rate. By that time longer term mortgage rates were also on the rise and moving out of the affordability reach of many U.S. homeowners."

As for Canada, King believes a 2-percent rise in interest rates will push a fixed rate mortgage beyond the reach of the average home owner.

GDP FORECASTS BOUYED BY FROTHY REAL ESTATE

A booming housing market is also underpinning GDP forecasts by both private sector economists and government forecasters. The latest survey by private sector economists forecasts that GDP growth will average around 2.6 percent -- close to Canada's pre-financial crisis average -- over the medium term.

But Capital Economics believes these forecasts are misguided.

"Canada's recent economic performance has benefited greatly from a booming housing market, which has driven house prices, residential investment and construction employment to elevated levels, from which we see little hope of it rising much further."

"There is the strong likelihood of a housing market correction at some point in the not-too-distant future, which we believe would involve an outright decline in housing investment."

Capital Economics also says policy makers are not considering the fallout from financial crisis, which has been shown in the past to produce weak economic growth for several years.

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