(Corrects second byline)
By Saeed Azhar and Sinéad Carew
NEW YORK (Reuters) -Bank of Canada's surprise full percentage point interest rate hike on Wednesday could put the brakes on the country's once-frothy housing market and weigh on banks' profits after strong mortgage growth emerged as the main growth engine during the pandemic.
The Canadian housing market was on fire earlier this year, fueled by ultra-low borrowing costs and pandemic-related demand shifts, with prices surging more than 50% over two years.
But sales have dropped dramatically in recent months and May's average selling price was down 12.9% from February's peak.
"Higher mortgage rates are definitely going to be headwinds for real estate and for the banks," said Paul Gardner, portfolio manager and partner at Avenue Investment Management.
Mortgages accounted for about 50% of Canadian banks' loans book, analysts estimate.
But Gardner said unemployment is low in Canada, which means people can still pay their mortgages even though there's going to be less discretionary spending for them.
"You're most vulnerable when unemployment goes through 10% and we're facing the other side, so it's kind of things that there are extreme events that are neutralizing each other," Gardner said.
He said bond markets are already pricing in a recession with an inverted yield curve, which is generally not great for the banks.
The Canadian central bank raised its policy rate to 2.5% from 1.5%, its biggest rate increase in 24 years, and said more hikes would be needed. Economists and money markets had been expecting a 75-basis point increase.
The gap between the 2- and 10-year Canadian bond yields widened by 11 basis points to about 15 basis points in favor of the shorter-dated bond.
Shares of the Royal Bank of Canada fell as much as 2.3% to a session low of C$124.71 ($96.29) on the Toronto Stock Exchange after the rate decision. Toronto-Dominion Bank shares dropped as much as 2.8% to C$78.55 but were last trading down 1.7% at C$79.50, while Bank of Nova Scotia shares dropped as much as 2.1% to C$73.40, but last traded down 1.2%.
The benchmark Canadian stock index fell to its lowest since March 2021 after the rate decision, but recovered to trade flat by late afternoon.
Sohrab Movahedi, banking analyst at BMO Capital markets, said the housing market has held up and part of this is how the product works: banks pre-approve or provide a commitment to consumers on housing loans.
They have an assumption of what would translate into real loans and banks hedge themselves, he said.
"In all likelihood with the rates moving higher, the proportion of those commitments that ends up in a loan will be lower than usual. More people will choose to either buy smaller houses or defer the purchase," Movahedi said.
"If the economy is going to slow down from here, then earnings growth prospects for the banks will also slow."
(Reporting by Saeed Azhar and Sinead Carew; additional reporting by Julie Gordon and Fergal Smith in Ottawa; editing by Jonathan Oatis)