The shock to Canada’s system – unsettling financial conditions and unprecedented monetary response
Stress in Canada’s financial system amid the spread of the coronavirus pandemic has risen to levels unseen since the days prior to the September 2008 meltdown of the global financial system.
Canada’s system, as measured by the RSM Canada Financial Conditions Index, experienced a blow of more than four standard deviations below normal conditions during this week. The Bank of Canada has been responding to the crisis — with an unprecedented two consecutive 50-basis-point rate cuts, on March 4 and March 13.
The RSM Canada Financial Conditions Index is a composite measure of the risk being priced into financial assets. We estimate the overall stress in the financial market by observing the level and volatility of asset prices in the equity market, money market, bond market, and commodity market relative to non-crisis norms.
You would expect risk in the system to fall within two standard deviations above or below normal levels of stress. So a four-standard-deviation move below normal conditions suggests disturbing circumstances, requiring extraordinary responses by both the monetary and fiscal authorities as we’ve seen during the Great Depression of the 1930s and Great Recession of 2008-09.
Recognition of the spread of the coronavirus and the threats to the well-being of households and the shutdown of normal life did not become apparent in the asset markets until the last week of February. By then it was too late; not only did the equity market collapse in the first week of March, but the money market and bond market showed significant signs of the lack of liquidity necessary for short-term transactions and longer-term investment. As of this writing, the equity market is 7.0 standard deviations below normal levels of non-crisis stress, the money market is 2.4 standard deviations below normal, and the bond market is 1.8 standard deviations below normal.
Commodities more stable — for now
The performance of the commodity market is also negative, but not significantly so. That’s because we measure the performance relative to the past five years, which now includes prices from the 2014-15 commodity price collapse. We expect that to change in the weeks ahead, as consumer demand for durable goods and energy shrinks in response to the health crisis and business begins cutting back on energy use and production in response to the lack of demand.
All this paints a bleak picture for the economic outlook. Shocks to the financial system are transmitted to the real economy through a decline in investment. The propensity to borrow and lend collapses, with lenders demanding higher compensation for increased credit risk, and borrowers unwilling to take on the risk, reducing demand.
In turn, policies by the monetary authorities to counter supply and demand shocks — such as the coronavirus outbreak – are transmitted through the financial sector. For example, the Bank of Canada’s lowering of short-term interest rates facilitates investment and increases the ability to meet transaction demand for liquidity.
As the figure below suggests, the degree of accommodation in the financial sector — as measured by financial conditions — tends to coincide with bank lending conditions. Positive levels of the Financial Conditions Index suggest a more accommodative environment for lending. Conversely, negative levels imply a restrictive environment for lending.
And as the figure below suggests, that degree of financial accommodation tends to lead the trend in overall economic growth by six months. The current shock to the financial system could be catastrophic if events were to follow the 2008 freeze up of the financial system.
