PERSPECTIVE | March 14, 2024

Canada’s financial conditions remain underwater for now, signalling slow growth in the first and second quarters of the year after a contraction last year in the third and fourth quarters.

As the Bank of Canada said in its December policy statement, higher interest rates are restraining spending. Consumption growth in the last two quarters was close to zero, and business investment has been volatile but essentially flat over the past year.

The markets appear to support our expectation of Canada moving toward its potential growth later this year and into next year. But that will only happen after monetary authorities begin to take their foot off the brakes. We think that will occur in the spring.

The RSM Canada Financial Conditions Index, which measures risk priced into financial assets, remains negative only because of increased risk and volatility in the bond market and the decline in commodity prices.

Canada’s money market shows normal levels of risk, while the increased returns in the equity markets and reduced volatility suggest a bull market.

But first, a pause

Just as monetary policy tends to tighten slowly after a bout of inflation, you would expect interest rates to hold steady as the economy recovers before easing toward normal. But this hasn’t always happened.

The last three business cycles suggest that events can get in the way of gradualism. The Bank of Canada’s pause in 2000 ended quickly as economic growth decelerated. The pause in 2006 ended with the financial crisis. The pause in 2018 ended as the U.S. trade war took hold.

This time could be different. Absent another shock, the current pause in monetary policy is occurring under less severe conditions, which will allow the Bank of Canada to gradually moderate rates.

But that will only occur if the central bank is sure that the post-pandemic demand surge has cooled and inflation has receded enough to maintain price stability.

Even though the Bank of Canada will most likely cut its policy rate in June, we think that the central bank should act sooner, given the deteriorating economic and financial conditions. In our view, a rate cut in April followed by three 25 basis-point rate cuts by the end of the year would be appropriate.

Quantitative tightening

The Bank of Canada has said that it intends to continue to allow the gradual drawdown of its bond holdings, a process known as quantitative tightening. We do not expect those holdings to have a substantial effect on the supply of bonds or the demand for those securities.

If anything, gradualism should only have a marginal effect on the downward pressure on bond yields and support expectations of a normalized yield curve.

The yield curve

The front end of the yield curve shows that investors are anticipating a moderation in the Bank of Canada’s monetary policy.

Two-year Treasury yields, which are directly related to expectations of monetary policy, were priced around 4.1  per cent in early February. That was 90 basis points lower than the Bank of Canada’s overnight rate of 5 per cent and was further confirmation of the direction of monetary policy.

We would expect the prospect of the central bank’s easing to gradually affect the middle of the curve, helping to push five-year yields below 10-year yields. That would set the stage for a normal, positively sloped yield curve.

10-year yields

Though the monetary policies of Canada and the U.S. do not move in lockstep, they have followed similar paths and have resulted in similar movements in 10-year government yields.

At present, 10-year U.S. Treasury bonds are trading more than 60 basis points higher than Canadian government bonds. With nearly identical levels and trends in price stability, the strength of the U.S. labour market and a robust U.S. fiscal policy imply an economy better able to support higher interest rates than Canada.

Commodity prices

The Canadian economy has been highly dependent on its resource sector, which puts its exchange rate vulnerable to changes in commodity prices.

The most striking example is the effect of the collapse of commodity prices from 2014 to 2016 and the concurrent drop in the Canadian dollar’s value.

Commodity prices have collapsed similarly over the past year and a half, but its effect on the Canadian dollar has been more subdued.

This time around, we attribute the Canadian dollar’s recent decline more to the global strength of the U.S. dollar than to the drop in oil prices and other resources.

Business lending conditions

The Bank of Canada’s Senior Loan Officer Survey for the third quarter confirms the excess risk priced into financial assets seen in the RSM Canada Financial Conditions Index.

As of the third quarter of last year, lending conditions at financial institutions had been tight for five consecutive quarters.

These conditions followed two years of higher lending costs as the central bank raised interest rates to cool inflation, and the threat of a recession loomed.

In the coming loan officer survey for the fourth quarter, we expect positive economic growth and a gradual rescinding of some of the perceived risk in financial assets as the economy continues to grow and financial institutions become more willing to lend.

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