Tightening financial conditions are hurting the Canadian economy to the point where the rising risk of a recession and a housing contraction much larger than anticipated cannot be discounted.
Although we expect the Bank of Canada to raise its policy rate to a peak of 4.75 per cent by the middle of the year, after that the central bank will most likely use a lift-and-hold policy that will keep financial conditions tight.
The trend and level of equity market returns of the major Canadian and U.S. stock exchanges are synonymous, suggesting the co-dependence of corporate profitability.
Over the past year, the Bank of Canada has increased its policy rate from 0.25 per cent to 4.25 per cent to tame the highest inflation rate since the oil crises of the 1980s. These tightened financial conditions are expected to crimp consumer and business investment, cooling the economy.
We offer some insights into what to expect in Canadian financial conditions.
The Bank of Canada followed other central banks during the pandemic when it purchased long-term government securities to maintain bond market liquidity and to pressure long-term interest rates lower. It’s a strategy known as quantitative easing.
As the recovery from the pandemic took hold in 2021, the Bank of Canada began reducing its holdings of those securities.
It’s debatable if the increase in bond purchases during the pandemic dampened Canada’s long-term interest rates during the pandemic.
After all, there wasn’t much room for interest rates to fall. Long-term rates had already declined to 1.5 per cent before the pandemic, only to fall below 1 per cent in 2020.
In 2022, though, the Bank of Canada shifted gears and began reducing its holding of government bonds. Ten-year yields over this time have increased upward of 195 basis points.
So while quantitative easing may not have had a significant impact on interest rates, recall the dual purpose of central bank purchases. The injection of liquidity kept the financial sector flush, prevented a bond-market freeze up and reduced the chance of an economic collapse—no small feat during a pandemic.
More recently, there has been a sell-off in the Canadian bond market. Why?
We can start with the like-mindedness of the monetary authorities in the advanced economies, especially the Bank of Canada and the U.S. Federal Reserve.
Although their monetary policies were not in lockstep, the Bank of Canada and the Fed quickly pushed overnight rates last year from virtually zero to 4.25 per cent and 4.5 per cent, respectively, with expectations for further rate hikes if inflation remains persistent.
Long-term interest rates are determined by expectations of the policy rate and investor compensation for the risk of holding a security over its maturity. We should expect 10-year government bond yields to move together if the monetary policies and risk assessments of two interconnected economies are in sync.
It’s not just the bond market. The trend and level of equity market returns of the major Canadian and U.S. stock exchanges are synonymous, suggesting the co-dependence of corporate profitability.
If there is a difference between U.S. and Canadian financial markets, it is in the currency market.
The Canadian dollar often fluctuates along with swings in the commodity markets. Recent examples include the 2014–16 crash in commodity prices that coincided with the depreciation of the Canadian dollar, the 2020 commodity price hike and appreciation of the Canadian dollar, and finally, the subsequent decline of commodity prices pressuring the Canadian dollar down again in 2022.
Since 2008, commodity prices have coincided with real GDP growth. We attribute this to the value of the Canadian dollar becoming dependent on commodity pricing. At higher prices of commodities and at a higher value of the Canadian dollar, exports of Canadian commodities add that much more to the value of Canadian economic output.
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