ECONOMIC & FIXED INCOME COMMENT: "Bridging to Normalcy"
Throughout the first quarter capital markets around the world have experienced heightened levels of volatility due to the uncertainty surrounding the COVID-19 pandemic. What was once thought to be a short, sharp decline and “V” shape recovery is now turning into a more severe economic fallout due to the ongoing lockdowns, closures and social distancing measures. In Canada, not only do we have a COIVD-19 health crisis but also a shock to oil prices. To date, GDP forecasts have been a moving target and will continue to change as data presents itself. The average GDP consensus among the top 6 Canadian banks in 2020 is -3.6%. Lower oil prices will dampen business investments, supply-chain disruptions will hurt the industrial sector and social distancing will negatively impact the services sector. Furthermore, unemployment has climbed from 5.6% to 7.8%. It is expected that the first and second quarter GDP will be negative (-5.2% and -24.4% respectively). The third and fourth quarter will depend on the evolution of the COVID-19 virus. At this point projections are 18.2% for Q3 and 8.5% for Q4. The bright light during this unprecedented time is that both the Government of Canada and the Bank of Canada (BoC) continue to provide support through fiscal and monetary measures to help bridge the economy to normalcy.
The Government of Canada has created an Economic Response Plan that is designed to help individuals and businesses stay afloat during these tough economic times. The program is designed to be scalable and will likely change as needs arise. A few of the programs include: Canada Emergency Wage Subsidy- aimed to prevent further job losses and encourage employers to re-hire workers and Canada Emergency Response Benefit which will provide temporary income support to workers who have been impacted by COVID-19.
During the month of March, the BoC has been quite active shoring up confidence and providing support to the Canadian financial system. The BoC has lowered its overnight rate by 150 basis points to 0.25%, the effective lower bound. Furthermore, the BoC has launched for the first time a Quantitative Easing (QE--bond buying) Program. The BoC will adjust the program as conditions warrant until an economic recovery is well underway. Below are a few highlights of the monetary tools the BoC is employing: Commercial Paper Purchase Program- to help provide liquidity and keep short term credit flowing and Government of Canada Debt Purchasing Program in the secondary market with $5 billion weekly to start. This should address the strains in the Government of Canada debt market.
With the Bank overnight rate at record low levels, conversations have sparked regarding negative interest rates. At the most recent press conference on March 27th, BoC Governor Stephen Poloz reiterated additional monetary stimulus will not be in the form of negative interest rates even though in theory the BoC could lower its overnight rate to -0.5%. Negative interest rates create challenges for the financial system and would be counterproductive to the BoC’s current goal of ensuring a smooth functioning financial system which is a key component to recovery. Furthermore, those countries that currently have negative interest rates have not gone further into negative territory (most notably European Central Bank and Bank of Japan,) during the COVID-19 health crisis.
What are negative interest rates?
When central banks impose negative interest rates, the impact is on commercial banks, not individuals. Specifically, individuals are not paying banks to hold their money, rather commercial banks are paying central banks to hold their excess cash reserves. In theory, it is supposed to motivate commercial banks to not hold large cash reserves with the central bank, but instead lend money to businesses and consumers. As a result, if lending and spending are encouraged, they will likely boost economic activity leading to faster economic growth. The Jury is still out on the effectiveness of this policy.
How does it impact financial markets?
Negative interest rates push financial institutions to find an alternative solution to central bank deposits. To avoid paying interest on their cash reserves, institutions can increase their capacity of loans or turn to other assets such as government bonds. This results in a higher demand for these securities and pushes up the price and lowers the yield. Furthermore, this is trickled across all fixed income areas as they are linked to government bonds. Bottom line: negative interest rates lead to lower bond yields.
What are the BoC next steps if further stimulus is needed?
The current measures that the BoC has enacted thus far are scalable. Therefore, the next step could be to increase the size of asset purchases, or to expand the scope. This could be done by purchasing more Government of Canada securities or by increasing Canada Mortgage Bond purchases. Furthermore, the BoC could expand its QE program to include provincial and corporate securities to help address the wider than normal spreads.
The bond market was mixed in the first quarter. Government of Canada bonds returned 5.13% with Government of Canadas 10-years bonds dropping to record lows (0.53% in mid March) while provincial and corporate bonds returned 1.28% and -2.15% respectively. The difference in performance has been primarily driven by a lack of liquidity. There has been a massive demand for cash thus creating an imbalance between buyers and seller and impacting bond prices. With an overwhelming number of sellers compared to buyers in the bond market, hefty compensation is required to give up cash. The extra compensation has little to do with credit risk of default but rather liquidity premium. As mentioned in previous writing, credit spreads have widened and most of the widening can be attributed to the liquidity premium. Central Banks around the world are helping to address this liquidity issue through QE programs. However, it will take time for the cash to work its way through the system. As a result, we should see liquidity premiums narrow as well as improved performance in high-quality corporate and provincial bonds. Finally, the outlook for bond yields in the second half of this year will be dependent upon the progress of COVID-19. At this time, we see Government of Canada bond yields increasing modestly from their current levels while corporate and provincial bond yields remaining stable in the second half of 2020.