Financial markets around the world are reacting to the rising risk of inflation and the prospect of policy responses by central banks, all of which have led to a modest easing in our RSM Canada Financial Conditions Index.
We anticipate further natural easing in financial conditions as bond prices fall and yields rise.
The Bank of Canada has already halted its bond purchase plan, the Reserve Bank of Australia is removing the cap on three-year bond yields and the Federal Reserve on Wednesday is expected to discuss its plans to start unwinding its monthly asset purchases.
While central bankers set the predicate for the normalization of post-pandemic monetary policy, we anticipate further natural easing in overall financial conditions as bond prices fall and yields rise.
The yield on Canadian government 10-year bonds has increased by 200 basis points since the shutdown of commerce last year at the depths of the pandemic.
This should be a welcome sign of a recovering economy and the restoration of balance in the financial markets. But the 60-basis-point increase since the end of August appears to be in response to lingering levels of price increases.
The spillover of those concerns appears to be affecting all markets to some degree, either through diminished rates of return or increased volatility.
The RSM Canada index
Our composite RSM Canada Financial Conditions Index measures the level of risk being priced into financial securities in the fixed income, equity and commodity markets.
The Bank of Canada is likely to maintain its accommodative stance for quite some time.
Though still at accommodative levels, the index has continued to slip from 1.50 standard deviations above normal at its post-pandemic peak to less than 0.60 standard deviations in recent trading. Although that indicates reduced levels of risk being priced into financial assets, the trend deserves attention.
There is reason to think that the fixed-income markets could be getting ahead of themselves. Recall that Canadian and U.S. 10-year bond yields are both reacting to the same set of circumstances and have been in sync for decades.
In fact, Canada’s bond market reacted to the infamous 2013 taper tantrum in the United States when market perceptions of the eventual end of Federal Reserve bond purchases were out of line with policy and economic growth.
Consider that the Bank of Canada is likely to maintain its accommodative stance for quite some time, pursuing a gradualist approach to normalization of interest rates as it stays reluctant to insert any sense of panic that might affect the economic recovery. For this reason, short-term interest rates that are near zero will remain extraordinarily low even after a few rate hikes.
And the central bank is holding C$400 billion worth of government bonds, limiting the supply of bonds available to the market. That is likely to exert downward pressure on longer-term bond yields to some degree in the years ahead, with the unwinding of those holdings likely to occur through maturation rather than a fire sale.