Canada’s financial conditions have deteriorated, following the lead of asset markets in the U.S., as tariff-induced uncertainty continues to inflict economic damage.
RSM Canada’s financial conditions index turned negative in the first week of April and is now 0.8 standard deviations below zero. This indicates an excess amount of risk priced into financial assets, with the prospect of slower economic growth in coming quarters.
RSM Canada’s index is comprised of prices and volatility in four asset markets:
- The money market for short-term lending used for commercial activity.
- The bond market for longer-term investment.
- The equity market.
- The commodity market (which affects the Canadian dollar and the value of Canada’s gross domestic product).
Of late, the drop in the equity market has absorbed most of the public’s attention of late—but the potential threat of a drop in U.S. demand could cause the most damage to Canada’s economic growth.
Equity market
While the equity market is not the economy, the seamlessness of the North American economy might best be illustrated by the co-movement of the major Canadian and U.S. stock indices.
The Canadian stock market was the first to respond to the tariffs, with the TSX losing nearly 12 per cent of its value from its January high. It took a few weeks longer until mid-February for the S&P 500 to begin losing money. At its lowest point, the S&P lost nearly 19 per cent of its value before recently recovering.
Recent history could offer a precedent for stock market performance. Before the 2008-09 crash, there was a series of peaks and troughs before the final crash as investors progressively lost confidence in the ability of stock prices to recover—like they always do.
What it will take to push the joint economies into recession this time is as oblique as the scattershot imposition of tariffs. The TSX remains 12.5 per cent higher than it was a year ago, but the sudden loss of value and the loss of income this year is likely to cause households to spend less. This would inevitably hurt the earnings of corporations listed on the exchange as well as the smaller businesses not listed.
Canada’s stock market performance this recent session was 2.1 standard deviations below normal in mid-April before recovering to 1.8 standard deviations below normal at the end of April.
Money market
The money markets at the front-end of the bond market yield curve are determined by the Bank of Canada’s setting of its overnight policy rate and the compensation demanded by lenders for the risk of default.
Since monetary policy has little say in the setting of tariffs, and because of the threat of higher inflation and slower growth resulting from those tariffs, the Bank of Canada maintained its setting of the policy rate at 2.75 per cent.
As with the U.S., and perhaps because of the minimum duration of holding a money market security, Canada’s money markets have yet to price in an economic collapse.
At the moment, the futures market is pricing in two rates cuts by the end of the year, bringing the overnight rate down to 2.25 per cent. This seems to imply increased chances of a slowing economy.
One thing that might help commercial activity and investment is a near-zero real (inflation-adjusted) money market rate. Over the past six months, inflation has averaged 2.2 per cent, which subtracts all but 50 basis points from the nominal cost of borrowing out to five years.
The money market component of the financial conditions index is currently neutral at positive 0.6 standard deviations above zero.
Bond market
While U.S. yields are climbing as investors sell U.S. Treasury bonds, it appears Canada’s 10-year Treasury bond yields are trending lower. This drop in Canada’s yields suggests the increased probability of an economic slowdown amid strained ties between the U.S. and Canada.
The bond market component of the financial conditions index is currently negative at 1.0 standard deviations due to the increase in commercial credit spreads and the increased volatility in the yields of Canadian government bonds.
This implies increased levels of risk for long-term borrowing and lending and, therefore, the increased probability of slower economic growth.
Commodity market
Since Canada remains dependent on resource extraction, commodity prices are incorporated into RSM Canada’s financial conditions index. In particular, the role of trade between Canada and the U.S. is a key consideration as currently 95 per cent of Canada’s oil exports are sent to the U.S.
This suggests co-movement of the Commodity Research Bureau Index, which includes the price of crude oil, and the growth of Canada’s real GDP. Co-movement between crude oil prices and the Canadian dollar is also implied.
If there is to be a recession in the U.S., its effect on Canada will be determined by the length of time it takes for Canada to expand existing markets to find other markets able to absorb resource exports.
The drop in prices has pushed the commodity component of the financial conditions index to neutral. A further drop in demand would have negative impact on the value of Canada’s resource exports and financial health.
The takeaway
There has been an extraordinary increase in uncertainty caused by the unpredictable imposition, delay and subsequent expansion of U.S. tariffs—which in turn disrupted the seamlessness of the North American economy and global supply chains.
Uncertainty suggests a decrease in the willingness to invest, a decrease in spending, an increase in corporate default and an increase in risk priced into financial assets from foreign exchange to credit spreads to equity share prices. This artificial tightening of financial conditions leads to slower economic growth.
It is still too early to assess this new phase of the North American economy. But Canada’s equity and bond markets currently suffer from increased volatility while commodity prices and the Canadian dollar suffer from the prospect of a drop in demand.
Read RSM Canada’s latest analysis in The Real Economy Canada and subscribe for more updates.
