Your Business News
Canada financial conditions update: Stabilization and recovery
February 8, 2024
Authored by RSM Canada LLP
Kelsey Dupuis CPA shared this article
REAL ECONOMY BLOG | February 08, 2024
Canada’s financial conditions remain underwater for now, signaling slow growth in the first and second quarters of the year after a contraction last year in the third and fourth quarters.
Canada’s financial conditions remain underwater for now, signaling slow growth in the first and second 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.
A fuller picture of commercial lending will be available on Friday, with the release of the Bank of Canada’s Senior Loan Officer Survey for the fourth quarter.
The markets appear to support our expectation of Canada moving toward its potential growth later this year and into next year. But that will happen only 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 levels of risk and volatility that remain in the bond market and the decline in commodity prices.
Canada’s money market is showing 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 then hold steady as the economy recovers before they ease 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 occur only if the central bank is sure that the post-pandemic surge in demand has cooled and if inflation has receded enough to maintain price stability.
Even though 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 have only a marginal effect on the downward pressure on bond yields and supporting 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% in early February. That was 90 basis points lower than the Bank of Canada’s overnight rate of 5% and was a further confirmation of the direction of monetary policy
We would expect the prospect of the central bank’s easing to gradually have an effect on 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.
Ten-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. labor 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.
There has been a similar collapse of commodity prices 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 that are being seen in the RSM Canada Financial Conditions Index.
As of the third quarter last year, lending conditions at financial institutions had been tight for five consecutive quarters.
This followed two years of higher lending costs as the central bank raised interest rates to cool inflation as the threat of recession loomed.
In the coming loan officer survey for the fourth quarter, we are expecting positive economic growth and a gradual rescinding of some of the perceived risk in financial assets as the economy continues to grow and as financial institutions become more willing to lend.
Let's Talk!
Call us at 1 855 363 3526 or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Tu Nguyen and originally appeared on 2024-02-08 RSM Canada, and is available online at https://realeconomy.rsmus.com/canada-financial-conditions-update-stabilization-and-recovery/.
RSM Canada Alliance provides its members with access to resources of RSM Canada Operations ULC, RSM Canada LLP and certain of their affiliates (“RSM Canada”). RSM Canada Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM Canada. RSM Canada LLP is the Canadian member firm of RSM International, a global network of independent audit, tax and consulting firms. Members of RSM Canada Alliance have access to RSM International resources through RSM Canada but are not member firms of RSM International. Visit rsmcanada.com/aboutus for more information regarding RSM Canada and RSM International. The RSM trademark is used under license by RSM Canada. RSM Canada Alliance products and services are proprietary to RSM Canada.
FCR a proud member of RSM Canada Alliance, a premier affiliation of independent accounting and consulting firms across North America. RSM Canada Alliance provides our firm with access to resources of RSM, the leading provider of audit, tax and consulting services focused on the middle market. RSM Canada LLP is a licensed CPA firm and the Canadian member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM Canada Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise, and technical resources.
For more information on how FCR can assist you, please call us at 1 855 363 3526