Strains in the commercial paper and government securities markets triggered today’s action to engage in quantitative easing. The Governing Council has been meeting every day during the pandemic crisis. Market illiquidity is a significant problem and one the Bank considers foundational. These large-scale purchases of financial assets are intended to improve the functioning of financial markets.

Credit risk spreads have widened sharply in recent days. People are moving to cash. Liquidity has dried up in all financial markets, even government-guaranteed markets such as Canadian Mortgage-Backed securities (CMBs) and GoC bills and bonds. The commercial paper market–used by businesses for short-term financing–has become nonfunctional. The Bank is making large-scale purchases of financial assets in illiquid markets to improve market functioning across the yield curve. They are not attempting to change the shape of the curve for now but might do so in the future.

These large-scale purchases will create the liquidity that the financial system is demanding so that financial intermediation can function. Risk has risen, which creates the need for more significant cash injections.

At the press conference today, Senior Deputy Governor Wilkins refrained from speculating what other measures the Bank might take in the future. When asked, “Where is the bottom?” She responded, “That depends on the resolution of the Covid-19 health issues.”

The Bank will discuss the economic outlook in its Monetary Policy Report at their regularly scheduled meeting on April 15. In response to questions, Governor Poloz said it is challenging to assess what the impact of the shutdown of the economy will be. A negative cycle of pessimism is clearly in place. The Bank’s rate cuts help to reduce monthly payments on floating rate debt. He is hoping to maintain consumer confidence and expectations of a return to normalcy.

The oil price cut alone would have been sufficient reason for the Bank of Canada to lower interest rates. The Covid-19 medical emergency and the shutdown dramatically exacerbates the situation. All that monetary policy can do is to cushion the blow and avoid structural problems to the economy. The overnight rate of 0.25% is consistent with market rates along the yield curve.

High household debt levels have historically been a concern. Monetary policy easing helps to bridge the gap until the health concerns are resolved. The housing market, according to Wilkins, is no longer a concern for excessive borrowing by cash-strapped households.

At this point, the Bank is not contemplating negative interest rates. Monetary policy has little further room to maneuver, given interest rates are already very low. With businesses closed, lower interest rates do not encourage consumers to go out and spend money.

Large-scale debt purchases by the Bank will continue for an extended period to provide liquidity. The Bank can do this in virtually unlimited quantities as needed. The policymakers are also focussing on the period after the crisis. They want the economy to have an excellent foundation for growth when the economy resumes its normal functioning.

Fiscal stimulus is crucial at this time. The newly introduced income support for people who are not covered by the Employment Insurance system is a particularly important safety net for the economy. There are many other elements of the fiscal stimulus, and the government stands ready to do more as needed.

The Canadian dollar has moved down on the Bank’s latest emergency action. The loonie has also been battered by the dramatic decline in oil prices. Canada is getting a double whammy from the pandemic and the oil price war between Saudi Arabia and Russia. The loonie’s decline feeds through to rising prices of imports. However, the pandemic has disrupted trade and imports have fallen.

The Bank of Canada suggested as well that they are meeting twice a week with the leadership of the Big-Six Banks. The cost of funds for the banks has risen sharply. CMHC is buying large volumes of mortgages from the banks, which, along with CMB purchases by the central bank, will shore up liquidity. The banks are well-capitalized and robust. The level of collaboration between the Bank of Canada and the Big Six is very high.

Fed Cuts Overnight Rate One Percentage Point But Markets Plummet

The Treasury and US MBS markets are usually the deepest, most liquid markets in the world. But over the past two weeks, liquidity has dried up. Financial instability has risen sharply with the high level of volatility. Banks have experienced significant withdrawals as consumers are hoarding cash like everything else. The cost of funds to banks has risen sharply because of the enhanced perception of risk. With the collapse in oil prices, banks exposed to the oil sector are building up reserves for nonperforming loans. As businesses everywhere in nearly every sector shutdown, the risk of delinquencies rises further. Consumers who are housebound spend less money, and those who are freelancers or hourly wage earners might not get paid. Moreover, the shuttering of schools puts an added burden on parents who have no other daycare options for their kids.

All of this disruption, which according to the Center for Disease Control, could last months–the CDC recommended yesterday the shutdown of meetings of more than 50 people for eight weeks–has led to rising concern about the riskiness of banks. Bank shares have plummeted, and the yields on bank bonds have surged. Besides, banks and other mortgage lenders are fearful of being inundated with requests for refinancings, especially in the US, where penalties for breaking a mortgage are much lower than in Canada. Because of the refinancing surge in the US, the price of MBSs has fallen sharply, raising their yields and making the market highly illiquid.

The rising risk premiums, likely recession and illiquidity are causing banks in Canada and the US to raise some mortgage rates. Lenders are tightening the discount off the prime rate on variable-rate mortgage loans. Some fixed rates have edged higher as well. Such spread widening between mortgage rates and government yields happened during the financial crisis. Bank balance sheets will expand as troubled businesses and consumers extend their borrowings on their open lines of credit. Many will be unable to make timely interest payments. Loan loss reserves, already climbing, will rise further. Liquid deposits will be depleted as many are forced to live off of savings while shying away from selling stocks at markedly depressed prices.

These are not normal times. The Fed’s actions did nothing to calm markets. Indeed, stocks and bond yields plummeted in overnight trade, and the stock markets opened sharply lower in North America. The S&P 500 opened down over 8% while the TSX opened down 11%, triggering a circuit-breaker time out. This is the third time in a week the circuit breaker has hit. The TSX is down roughly 35% from its recent high (see chart below). The S&P 500 is down over 20%. The relative underperfomance of the Canadian stock market reflects our out-sized representation of the energy sector. The two weakest sectors in the TSX are the energy and financial sectors.

The world knows that the Fed and other central banks are running out of ammunition. Governor Powell said yesterday that he would not take the key fed funds rate into negative territory but instead would use “forward guidance” and asset purchases (quantitative easing) going forward.

The good news is that the banks are highly capitalized and much more resilient than during the financial crisis. Central banks since that time have put in place measures to monitor financial stability. Last Friday, the Canadian Office of the Superintendent of Financial Institutions (OSFI) reduced the capital requirements for Canadian banks to free up $300 billion for banks to support troubled borrowers. OSFI warned against the use of these funds to buy back stocks or raise dividends.

OSFI also suspended the proposed revision in the qualifying mortgage rate slated to begin April 6. The posted mortgage rate, published weekly by the Bank of Canada, will remain the qualifying mortgage rate. It is currently 5.19%, but it is expected to fall this week to around 4.95%.

But in these extraordinary times, there is a loss of confidence in the financial system. Some are calling for a full shutdown of the stock markets–but imagine the panic if no one could sell assets. There would truly be a run on the banks. Now is not a time to panic.

The Canadian Housing Market

The Canadian Real Estate Association announced this morning that home sales recorded over the Canadian MLS Systems rose 5.9% in February, marking one of the more substantial month-over-month gains of the past decade. Actual (not seasonally adjusted) sales activity stood 26.9% above year-ago levels–keeping in mind that activity was quite weak one year ago. February 2019 marked a decade-low for the month, so a good part of the significant y-o-y gain reflects low levels of activity recorded at the time. February 2020 also benefited from an additional day due to the leap year.

The CREA President, Jason Stephen, said, “Home prices are accelerating in markets where listings are in increasingly short supply, specifically in Ontario, Quebec and the Maritimes which together account for about two-thirds of national sales activity. Meanwhile, ample supply across the Prairies and in Newfoundland and Labrador means increased competition among sellers.”

The number of newly listed homes jumped 7.3% in February compared to January, more than erasing the declines of late last year. New supply gains were posted in some large markets, including the Fraser Valley, Calgary, Edmonton, the GTA, Hamilton-Burlington, Kitchener-Waterloo, Windsor-Essex, Ottawa and Montreal.

The Aggregate Composite MLS® Home Price Index (MLS® HPI) rose 0.7% in February 2020 compared to January, marking its ninth consecutive monthly gain. The actual (not seasonally adjusted) national average price for homes sold in February 2020 was around $540,000, up 15.2% from the same month the previous year. See the table below for the regional move in prices.

But this is old news, particularly given all that has happened in the past two weeks. What comes next for the housing market? That depends on the course of the pandemic. Lower interest rates would typically be great news for the housing market, particularly for first-time homebuyers. But social distancing is hardly consistent with open houses and home shopping.

Moreover, volatility and instability reduce consumer confidence. Buyers that parked their downpayment savings in the stock markets have lost nearly a third of their money on paper. And how many sellers want a trail of strangers wandering through their homes during the pandemic. So the housing market, like everything else, is likely going to slow over the near term.

The Bank of Canada is hopeful that its rate cuts will stabilize the housing market from what might have otherwise been a substantial shutdown. Lower rates will filter through to lower monthly payments for floating-rate mortgage borrowers. Expect the Bank to cut rates again to near-zero levels, following in the footsteps of the Fed. So far, as of this writing, the Canadian banks have not responded to Friday’s BoC rate cut. The prime rate went down a full 50 bps on March 5 after the Bank cut its key rate by that amount on March 4. But so far, the Big-Six banks have not responded to the 75 bps cut three days ago.

Following yesterday’s surprise emergency 50 basis point (bp) rate cut by the Fed, the Bank of Canada followed suit today and signalled it is poised to do more if necessary.The BoC lowered its target for the overnight rate by 50 bps to 1.25%, suggesting that “the COVID-19 virus is a material negative shock to the Canadian and global outlooks.” This is the first time the Bank has eased monetary policy in four years. 

According to the BoC’s press release, “COVID-19 represents a significant health threat to people in a growing number of countries. In consequence, business activity in some regions has fallen sharply, and supply chains have been disrupted. This has pulled down commodity prices, and the Canadian dollar has depreciated. Global markets are reacting to the spread of the virus by repricing risk across a broad set of assets, making financial conditions less accommodative. It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.” The press release went on to promise that “as the situation evolves, the Governing Council stands ready to adjust monetary policy further if required to support economic growth and keep inflation on target.”

Moving the full 50 basis points is a powerful message from the Bank of Canada. Particularly given that Governor Poloz has long been bucking the tide of monetary easing by more than 30 central banks around the world, concerned about adding fuel to a red hot housing market, especially in Toronto. Other central banks will no doubt follow, although already-negative interest rates hamper the euro-area and Japan.