Financial conditions continue to improve both in Canada and in the United States, signaling stability in markets and setting the groundwork for economic growth.
RSM’s proprietary financial conditions indexes are based on the level of risk or accommodation in four asset markets: stocks, money markets, bonds and commodities.
Financial conditions index values of zero indicate normal, or neutral, levels of risk in the security markets. Positive values signal lower, or accommodative, levels of risk than would ordinarily be expected.
Read more of RSM Canada’s insights on the Canadian economy and the middle market.
Negative values indicate more risk than would normally be expected. Canada’s financial conditions have recently been neutral, having recovered from the inflation shock of the past two years.
The equity market is currently 1.2 standard deviations above normal, enough to push the composite financial conditions index above zero, while the fixed income and the commodity markets retain an insignificant level of excess risk.
There is a similar situation in American financial markets, with equity markets reacting to the prospect of continued economic growth and improved corporate earnings, while the fixed income markets react to the gradual easing of monetary policy.
The propensity to borrow or lend
In periods of economic stress, investors will require higher rates of return to compensate for the higher risk and banks will tighten their lending requirements.
As of the end of October, Canada’s financial conditions have continued to improve in terms of return and stability. That implies that bank lending conditions will become less restrictive compared with the past two years of geopolitical upheaval and the inflation shock.
The next Bank of Canada’s Senior Loan Officer Survey will be released on Nov. 15.
An upward sloping yield curve
We expect Canada’s yield curve to continue to normalize as the Bank of Canada pushes its policy rate lower.
Inflation has dropped to the midpoint of the central bank’s 1 per cent to 3 per cent target, which implies a real (inflation-adjusted) interest rate of only 1.39 per cent for a five-year Treasury bond (plus the normal spread for a corporate bond). These low real interest rates should invite business investment in productivity.
Yields at the front end of the curve are determined as present values of the Bank of Canada’s policy rate. The two-year Treasury bond yield of 3.09 per cent at the end of October suggests a terminal rate policy rate of less than 3 per cent, confirming the forward market’s implied rate of 2.8 per cent by the third quarter next year.
Business loans and mortgages
Five-year Treasury yields also respond to expectations of the policy rate. Because of the conventions of Canada’s housing market, that means that Canadian five-year mortgage rates will react more to Bank of Canada policy than 30-year mortgages in the United States react to rate changes by the Federal Reserve.
Quantitative tightening
We expect the Bank of Canada to reduce its holdings of Treasury bonds by attrition and not replace bonds that have matured.
Those assets were purchased during the pandemic to ensure liquidity in the bond markets and to pressure long-term yields lower.
A policy of gradual attrition of central bank holdings should be more or less neutral for bond yields, with the market for longer-term securities reacting to expectations for growth.
Long-term bond yields
Because we expect the collaboration between Canada and the United States to continue, though with a more accommodative monetary policy in Canada and slower growth, we would expect long-term rates in Canada to trade lower than in the U.S.
The consensus projection for U.S. 10-year bond yields is 3.75% next year. The consensus expectation for the Canadian 10-year note is 2.85%, with a slightly lower yield spread of roughly 90 basis points.
Commodity prices and the Canadian dollar
The CRB commodity price index has dropped by 20 per cent since peaking in April 2022. That includes a 31% drop in crude oil.
Over that same period, the trade-weighted Canadian dollar has lost roughly 8 per cent of its value, accounting for a substantial drop in the value of Canada’s nominal gross domestic product.
And with slower immigration, reduced consumer spending and falling interest rates, the Canadian dollar is likely to drift lower.
