The Bank of Canada says households can weather higher borrowing costs, but flagged rising asset valuations and financial stress among renters as risks to the outlook.

Canadians are “proactively” adjusting to higher interest rates, and the financial system “remains resilient,” the central bank said in its annual review of the system published Thursday. And while payments have risen for about half of the country’s mortgages, households have higher wages and savings, officials said, and they’re adjusting their spending patterns.

“Overall, the evidence suggest that households have the flexibility to continue servicing their debt at higher rates,” Senior Deputy Governor Carolyn Rogers said at a news conference.

Many households and businesses built up liquid assets during the pandemic, the bank said, and a “growing number” of mortgage borrowers with fixed-payment flexible rate mortgages are making lump sum payments ahead of renewal.

The lack of widespread financial stress gives policymakers room to focus their attention on inflation as they weigh when to start lowering borrowing costs. There’s less urgency for immediate or deep interest rate cuts if Canadian households can handle a higher-for-longer interest rate environment, especially amid reduced recession risks.

Still, non-mortgage borrowers with credit card and auto loan debt are struggling, the central bank said, and the proportion behind on payments has returned to or surpassed pre-pandemic levels. Just over one in 10 Canadians has a credit card balance of 80 per cent or more of their limit, the bank said, from a low of just under eight per cent in 2021.

Policymakers also flagged “stretched” financial asset valuations in U.S. and Canadian equities and corporate bonds, saying they “may not properly reflect risks to the economic outlook and therefore increase the likelihood of a disorderly price correction.”

The bank said business insolvencies, which have grown sharply in recent months as generous pandemic-era loans expire, are “mainly the result of a catch-up effect,” though higher rates and slower demand are contributors to the increase.

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Officials said small and medium-sized banks are most exposed to risks around commercial real estate at around 20 per cent of loans, but noted those risks aren’t concentrated in a single area of the financial system.

In the news conference, Governor Tiff Macklem expressed concern about hedge funds doing cash-futures basis trades in the government bond market. It’s a popular trade in the U.S. that has grown in Canada, where traders capitalize on price differences between bonds and bond futures.

“In order to make this worthwhile, you need to do a lot of it, and to do a lot of it, you need to borrow,” Macklem said. If bonds suddenly repriced, margin calls or the need to unwind those trades could “really amplify the market swing,” he warned.

Hedge funds and pension funds have “significantly” raised their leverage in repo markets, up 75 per cent and 14 per cent respectively in the last year, the bank said in its report.

Canadians are among the most indebted people in advanced countries, and elevated home prices and high borrowing costs have pushed housing affordability to the worst levels in decades. At the end of 2023, over a third of new mortgages had debt-service ratios greater than 25 per cent, the bank said, up from less than one-fifth before the pandemic.

Macklem and his officials will next set rates on June 5, and the majority of economists in a Bloomberg survey see policymakers cutting the benchmark overnight rate to 4.75 per cent at that meeting. Markets put the odds of a cut at about two-thirds.

Underlying price pressures eased in the first three months of the year, but the central bank has said it wants to see further progress on disinflation before cutting rates. April’s CPI data, scheduled for release on May 21, will be an important determining factor for the governing council’s decision.