Risk is being reintroduced into Canada’s financial markets as investment decisions and monetary policy begin to pivot from interest rates at the zero bound.
Though the rates are still far lower than in normal times, three-month Treasury bills have moved off recent lows, with the forward market now pricing in four to five rate increases by the Bank of Canada this year. And 10-year Canadian government bonds have moved 25 basis points above their mid-December low point.
Our RSM Canada Financial Conditions Index, which has been drifting lower since September, turned slightly negative in December before recovering in early January. We see this as the market’s immediate reaction to the Bank of Canada’s tapering of its asset-purchase program and the implications for more risk being priced into financial assets.
Positive values of our index signify an accommodative climate for investment, with reduced risk and lower volatility being priced into financial assets.
Index values around zero define normal levels of risk—every financial asset includes some degree of risk. Negative values of our index indicate levels of risk that exceed normal conditions, with investors requiring higher compensation for taking on that risk.
At some point, the pandemic’s grip will recede enough to allow for a return to normal economic activity and asset pricing. But the economy is not there yet, and we expect the monetary authorities to err on the side of prudence for as long as the health crisis remains a threat to everyday behavior.
We regard this recent downtrend in financial accommodation as a return to normal rather than an impediment to the investment community’s willingness to borrow and lend at still extremely low costs.
The uneven financial trends in December and early January suggest that the markets are adapting to changes in policy and the business cycle.
The uneven financial trends in December and early January suggest that the markets are adapting to changes in policy and the business cycle. So while the equity and commodity markets lost a bit of their luster, it was the bond market that dragged overall financial accommodation down.
The jobs report in November and December far exceeded expectations. Even if the spread of the omicron variant dampens those numbers, a healthy job market that may soon approach maximum sustainable employment gives the Bank of Canada room to increase rates.
The equity market reached its peak last year in mid-November with a return of nearly 24%. It then retraced about 3% of those gains in the last six weeks of the year.
Because of the shift in direction, equity market volatility more than doubled compared to the summer. And considering that last year’s returns were multiples of the Toronto Stock Exchange average returns of the past decade, those levels are less likely once interest rates become a more attractive investment alternative.
Money market spreads have come down from their mid-December highs because of the increase in three-month T-bill rates. That’s a reassuring step in the right direction. And long-term interest rates in Canada, as well as in the United States, look to be forming an upward trend after bottoming out during the summer of 2020.
Though still nascent, if the six-month trading pattern of higher highs followed by higher lows proves sustainable, this would be an important step in the recovery from the pandemic. It would underlie a return to normal monetary policy and would indicate confidence in the recovery’s ability to support higher returns on investment.
Treasury market volatility has of course increased. But as the recovery progresses, we would think this is more indicative of the wider range of trading as interest rates move away from the constraints of the zero lower bound and less of the risk of default.
The Canadian dollar
Finally, interest rate differentials between Canada and the United States should have an impact on the value of the Canadian dollar, with the Bank of Canada more hawkish compared to the Federal Reserve.
With the forward markets assuming the four to five hikes in overnight rates and only three hikes in the federal funds rate this year, that suggests a stronger Canadian dollar in the year ahead, at least at the margin.
But the Canadian dollar remains a commodity currency. That implies additional exogenous factors in determining the currency’s value, with foreign demand for Canada’s natural resources playing the dominant role.
First and foremost, there is the controlled supply of crude oil butting up against the increased global demand for energy.
Canada has not been shy about tightening COVID-19 restrictions to kick off the year. The country’s more conservative response to the pandemic might delay growth into the second quarter.
But because we think the pandemic’s grip on the developed economies will lessen over time, we would think the demand for crude oil and Canada’s other natural resources will sustain upward pressure on the value of the Canadian dollar.
