A "frothy" market exists when the value of an asset becomes inflated or overvalued.

This condition could lead to a bubble that eventually bursts, bringing the house down.

Robert Kavcic, a senior economist with BMO, says the Canadian housing market has been “frothy”.

However, with interest rates on the rise, Kavcic sees some of the fizz starting to disappear.

“Froth is coming out of home prices, just as it is across a number of other asset classes that were boosted by excessively stimulative policy,” Kavcic wrote in a post on May 20.

He explained that home prices in the country have historically grown at about three percent per year going back to the early 1980s.

The growth “roughly” reflects inflation, wage growth, and falling interest rates.

“In the current episode,” Kavcic stated, “even as inflation has accelerated to multi-decade highs, real home prices have surged by more than a third in the span of two years, clearly stretching beyond that long-run baseline growth trend.”

As of the first quarter of 2022, the BMO economist suggested that the market “peaked”, with prices at 38 percent “above trend, the widest deviation in the past 40 years”.

In particular, “most froth has accumulated in the suburbs and exurbs of Toronto”.

“Other markets, such as Vancouver, Montreal and Atlantic Canada are frothy, but not to the extent of Southern Ontario,” Kavcic stated.

And then something happened.

The Bank of Canada dealt back-to-back increases in its interest-setting rate in March and April this year.

The cumulative 0.75 percent hike brought the central bank rate to one percent.

As a result, the “market is softening sharply in some areas”, Kavcic noted.

“So, when we speak of a housing correction it’s not a question of if, but where, how much and for how long?” the BMO economist wrote.

On May 16, the Canadian Real Estate Association (CREA) reported that home sales declined on a month-over-month basis in April 2022.

National home sales dropped by 12.6 percent in April compared to March 2022.

CREA reported that the slowdown in sales “placed monthly activity at the lowest level since the summer of 2020”.

The home price index dipped 0.6 percent month-over-month in April, but was still up 23.8 percent year-over-year.

CREA stated that the drop was the “first month-over-month decline since April 2020”.

In his May 20 post, Kavcic noted that the market’s “psychology and affordability have already been tested by just” the 0.75 percent “tightening” of rates by the Bank of Canada.

Kavcic expects “another 125 bps by year-end” or an additional 1.25 percent hike.

He explained that such measure will mean current mortgage rates of about 1.5 percent will increase in the range of 3.75 percent to 4.5 percent.

“The difficulty is that home prices were already stretched versus income and interest rate levels at those ultra-low rates, so the upward move will be that much tougher to swallow,” Kavcic stated.

The BMO economist went on to suggest that a 10 percent to 20 percent “decline in prices would be needed, all else equal, just to maintain current (stretched) affordability”.

However, “mileage will vary by market and region”.

Is a crash coming?

“We believe underlying fundamentals remain in place to eventually support the market,” Kavcic wrote.

For one, “demographics are a legitimate source of demand”.

He was referring to millennials and new immigrants to Canada.

“There will be buyers waiting; but prices need to make sense in a higher-rate world,” Kavcic wrote.

Also, high building costs will “put a floor under resale prices at some point, perhaps sooner than later”.

As well, the policy stress testing borrowers has “insulated the financial system from higher interest rates, at least from a capacity-to-pay perspective”.

To illustrate, Kavcic said that mortgages at 1.5 percent would need to meet a payment threshold of 4.75 percent to 5.25 percent.

“This won’t save house prices from falling (they are driven more by the rate you actually pay than a backroom calculation), but it provides good insurance that payments will keep being made, especially with the labour market so tight,” the economist explained.

Kavcic does not believe that “what is now an asset-price correction could evolve into more prolonged economy-driven weakness”.

“While a much cooler housing market will weigh on economic growth, we believe that this will be largely an asset-price phenomenon, with underlying fundamentals eventually setting a floor, and the financial system well protected,” the BMO economist wrote.