Policy hat trick

16 mars 2020

Kurt and Daniel weigh in with their perspectives on a strong coordinated policy response during a highly volatile week and what it means for Canadian financial markets.

Fiscal, monetary and regulatory authorities are coming to the rescue with aggressive and coordinated stimulus measures:

  1. The Bank of Canada delivered an unscheduled 50 basis point rate cut to just 0.75% – the second in as many weeks – which had been fully priced in by the rates markets. The BoC also committed to purchasing short-term bankers’ acceptances in the secondary market to promote functioning financial markets.
  2. The Ministry of Finance offered C$10 billion in immediate credit support to small and medium-sized businesses to be disbursed by the Business Development Bank of Canada and the Export Development Bank, as well as a potentially multi-billion dollar package to assist businesses impaired by the sharp drop in crude oil prices and weakening demand due to a wide array of social distancing measures.
  3. The Superintendent of OSFI lowered capital requirements by 1.25 percentage points (from 2.25% to 1.0%) to spur credit to the real economy.

In addition to the stimulus proposed by Minister Morneau, Prime Minister Trudeau indicated the government would be working to create financial support for households that are economically disadvantaged by the outbreak while he himself was under self-isolation. This follows C$1 billion in targeted assistance announced Thursday to aid healthcare workers and to build federal medical supplies.

In our August 2019 paper, Dealing with the next downturn, we argued that legislatures and monetary policy officials would need to work more closely together to minimize the economic shock given the low level of policy rates; this coordinated response has the greatest potential chance to cushion the downside. Ultimately, the true litmus test for arresting the declines in Canadian stocks and other risk assets will likely have to come from growing confidence in global policymakers to deliver what is needed to both contain the spread of the virus and the associated economic damage. Canada is a shining example, alongside the Bank of England’s similar moves last week.

A torrid week for returns

Canadian equities took a steep hit last week and underperformed their U.S. counterparts. A double punch from coronavirus and the oil price shock are putting heavy downward pressure on the domestic market. In a volatile week, the S&P/TSX Composite Index suffered its worst single-day decline on Thursday, then experienced its second best single-day increase on Friday, based on price return data from 1971. The TSX currently sits almost 24% below its February 20th record high. It only took 20 trading days for the index to reach bear-market territory from its latest peak, marking the fastest decline in the past nearly 50 years (see chart of the week).

Perhaps a surprise to many, even gold prices took a hit last week, a sign that investors may be looking to bolster liquidity in an environment where portfolio insurance no longer appears cheap. However, elevated macro uncertainty and near-zero real interest rates should continue to provide support for precious metals.

A more challenging outlook for Canadian banks is being priced in. The recent sell off pushed the average dividend yield of Canada’s big six lenders to 6.6%, a level unseen in nearly three decades except for during the global financial crisis. Canadian banks appear well-capitalized and have limited direct exposure to the oil and gas sector, however a broader economic slowdown could lead to higher credit losses, especially in an environment where household debt loads remain elevated.

Overall, we maintain a balanced view on equities, with preference for the minimum volatility and quality style factors, which tend to be more resilient during growth slowdowns.

Loonie crushed amid heightened risk aversion, falling oil

The Canadian dollar fell to its lowest level since the 2015/16 mini-recession on crude oil declines, shrinking cross-border interest rate differentials and heightened risk aversion, only to recoup some of its losses on Friday as risk appetites reemerged at already beaten down levels. For the week, the Loonie depreciated 3.7%, registering a more than 3 standard deviation move using data since the mid-1980s from Refinitiv Datastream.

Canadian investors may want to consider unhedged F/X positions in global stocks to potentially reduce volatility played out last week amid the economic and financial market stress, as most G7 currencies strengthened versus the loonie. Given our outlook for extended sub-$30/barrel crude oil prices and continued BoC rate cuts, we think the loonie could experience further weakness despite being at already weak levels on a fair value measure.

Curve shifts amid long-end illiquidity and repricing for sharper rate cuts

The Canadian government bond yield curve twisted in an unusual way last week, with short-term yields declining more than 20 basis points at the 6-month maturity point while 30-year bond yields rose 37 basis points. This has had the effect of steepening the yield curve. The 2s/10s curve spread now stands at 30 basis points.

We would highlight the ballast properties of Canadian government bonds. While questions have emerged about the long-term diversification benefits of government bonds at historically low interest rate levels, they have so far proven to be strong portfolio stabilizers during the crisis.

Bond markets exhibited signs of significant stress this week. Investors are finding it difficult and expensive to execute large trades in U.S. Treasuries, Canadian federal and provincial, corporate, and emerging market bonds. Our Capital Markets desk observed some execution in long-term Canadian federals and provincials at spreads 8x wider than normal. Trading in high yield bonds, especially energy bonds has seized up, with virtually no activity and several issues showing no bids.