Canada's financial conditions improve along with those in U.S., setting stage for growth

Financial conditions continue to improve in Canada and the United States, signalling market stability and setting the groundwork for economic growth.

The RSM Canada Financial Conditions Index is based on the level of risk or accommodation in four asset markets: stocks, the money market, bonds and commodities.

Financial conditions index values of zero indicate normal, or neutral, levels of risk in the security markets. Positive values signal lower, or accommodative, levels of risk than would ordinarily be expected.

Negative values indicate more risk than would normally be expected. Canada’s financial conditions have recently been neutral, having recovered from the inflation shock of the past two years.

The equity market is currently 1.1 standard deviations above normal, enough to push the composite financial conditions index above zero, while the fixed income and the commodity markets retain an insignificant level of excess risk.

There is a similar situation in American financial markets, with equity markets reacting to the prospect of continued economic growth and improved corporate earnings, while the fixed income markets react to the gradual easing of monetary policy. 

The propensity to borrow or lend

In periods of economic stress, investors will require higher rates of return to compensate for the higher risk, and banks will tighten their lending requirements.

As of mid-November, Canada’s financial conditions have improved in terms of return and stability. At the same time, bank lending conditions are becoming less restrictive compared with the past two years of geopolitical upheaval and the inflation shock.

An upward-sloping yield curve

We expect Canada’s yield curve to continue to normalize as the Bank of Canada pushes its policy rate lower.

The inflation rate has dropped to 1.6 per cent, below the midpoint of the central bank’s target of one per cent to three per cent, which implies a real (inflation-adjusted) interest rate of only 1.5 per cent for a five-year Treasury bond (plus the normal spread for a corporate bond). These low real interest rates should invite business investment in productivity.

Yields at the front end of the curve are determined as present values of the Bank of Canada’s policy rate. The two-year Treasury bond yield of 3.15 per cent at the end of October suggests a terminal rate policy rate of less than three per cent, confirming the forward market’s implied rate of 2.8 per cent by the third quarter of next year. 

Business loans and mortgages

Five-year Treasury yields also respond to expectations of the policy rate. Because of the conventions of Canada’s housing market, Canadian five-year mortgage rates, currently at 5.5 per cent, will react more to Bank of Canada policy than 30-year mortgages in the United States react to rate changes by the Federal Reserve. 

Quantitative tightening

We expect the Bank of Canada to reduce its holdings of Treasury bonds by attrition and not replace bonds that have matured.

Those assets were purchased during the pandemic to ensure liquidity in the bond markets and pressure long-term yields lower.

A policy of gradual attrition of central bank holdings should be more or less neutral for bond yields, with the market for longer-term securities reacting to expectations for growth.

Forecasts for long-term bond yields

Because we would expect the collaboration between Canada and the United States to continue, including with a more accommodative Canadian monetary policy and slower growth, we expect long-term rates in Canada to trade lower than in the U.S.

Currently, the Canadian 10-year yield is 115 basis points below the U.S. yield.

The consensus projection for U.S. 10-year bond yields is 3.75% next year. The consensus expectation for the Canadian 10-year note is 2.85%, with a slightly lower yield spread of roughly 90 basis points.