The Bank of Canada, in its latest annual Financial Stability Report, has identified the ongoing trade tensions with the United States as a significant threat to the Canadian economy, posing potential risks to overall financial stability, according to Reuters. The report highlights vulnerabilities within the Canadian financial system that could be exacerbated by a prolonged trade dispute.
Key takeaways
“In extreme circumstances, market volatility could turn into market dysfunction,” the report warns, emphasizing the potential for rapid and destabilizing shifts in market behavior.
“Canada’s financial system is resilient; banks are well positioned to cope with a period of stress,” the report assures, noting the strength of Canadian financial institutions to withstand economic pressures. However, the report also cautions that this resilience could be tested under severe conditions.
“Main near-term concern is the risk of a disorderly market sell-off; in extreme crisis, authorities might have to provide liquidity,” the report states, highlighting the immediate danger of panic selling and the potential need for central bank intervention to stabilize markets. This could involve measures such as injecting cash into the financial system to ensure its smooth functioning.
“Severe and long-lasting global trade war could push rate of mortgage arrears beyond levels seen in 2008-09,” the report cautions, suggesting that a protracted trade conflict could lead to widespread mortgage defaults exceeding those experienced during the global financial crisis. This scenario would place significant strain on the Canadian housing market and the broader economy.
“If household and business credit defaults were to occur on a large scale, banks could see greater losses than they have provisioned for,” the report indicates, warning that widespread defaults on loans could deplete bank reserves and potentially threaten their solvency. This could lead to a credit crunch, further hindering economic activity.
“In a period of stress, hedge funds could find it harder to maintain their presence in government of Canada markets,” the report observes, pointing to the potential for hedge funds to reduce their activity in Canadian government bond markets during times of economic uncertainty, potentially impacting market liquidity.
“BoC is less concerned about impact of high borrowing costs on debt serviceability than it was a year ago,” the report notes, suggesting that the central bank is currently less worried about the ability of borrowers to manage their debt payments compared to the previous year, likely due to improvements in the labor market and overall economic conditions.
“More than 90% of mortgage holders with 5-year fixed rate mortgages should be able to make higher payments,” the report estimates, indicating that the vast majority of homeowners with fixed-rate mortgages are financially capable of handling increased mortgage payments, providing some stability to the housing market.
“Credit losses could lead banks to reduce lending and this could exacerbate an economic downturn,” the report warns, highlighting the potential for a vicious cycle where rising loan losses prompt banks to curtail lending, further weakening economic growth.
“Also watching availability of credit and conditions for funding and market liquidity,” the report states, emphasizing the Bank of Canada’s ongoing monitoring of credit availability, funding conditions, and market liquidity to ensure the smooth functioning of the financial system.
“Will closely watch indicators of financial stress and evidence of precautionary behavior by financial system participants,” the report concludes, indicating the Bank of Canada’s commitment to closely monitor key indicators of financial stress and any signs of risk aversion among financial institutions to proactively address potential threats to financial stability.
Market reaction
USD/CAD exhibited no immediate discernible reaction following the release of the report. The currency pair was last observed trading with a gain of 0.25% on the day, positioned at 1.3872. Market participants may have already priced in some of the concerns outlined in the report, or are awaiting further developments before making significant adjustments to their positions.
Bank of Canada FAQs
The Bank of Canada (BoC), headquartered in Ottawa, serves as the nation’s central bank, responsible for setting benchmark interest rates and implementing monetary policy. These decisions are typically made during eight scheduled meetings each year, with the possibility of ad hoc emergency meetings as circumstances warrant. The BoC’s primary objective is to maintain price stability, targeting an inflation rate between 1% and 3%. The primary tool used to achieve this target is adjusting interest rates. Generally, relatively higher interest rates tend to strengthen the Canadian Dollar (CAD), while lower rates can weaken it. Other tools at the BoC’s disposal include quantitative easing and quantitative tightening.
In situations of extreme economic distress, the Bank of Canada may employ a policy tool known as Quantitative Easing (QE). QE involves the BoC creating new Canadian Dollars to purchase assets, typically government or corporate bonds, from financial institutions. This process generally leads to a depreciation of the CAD. QE is typically considered a last resort, implemented when simply lowering interest rates is deemed insufficient to achieve the desired level of price stability. The Bank of Canada utilized QE during the Great Financial Crisis of 2009-11 in response to the credit freeze that occurred after banks lost confidence in each other’s ability to repay debts.
Quantitative tightening (QT) represents the opposite of QE. It is implemented following a period of QE, typically when an economic recovery is underway and inflation begins to rise. During QE, the Bank of Canada purchases government and corporate bonds from financial institutions to provide them with liquidity. In contrast, during QT, the BoC ceases purchasing additional assets and stops reinvesting the principal payments received as the bonds it already holds mature. This policy is generally considered positive, or bullish, for the Canadian Dollar.
