Canada’s Economy: Strong Banks, Vulnerable Consumers

Higher interest rates are contributing to slower growth and activity in much of the developed world, and Canada’s economy appears particularly sensitive to these higher rates, especially relative to the U.S. This is largely due to Canada’s housing market, where short-duration and floating-rate mortgages are prevalent (versus the typical 30-year fixed rate mortgage in the U.S.), meaning the generally highly levered Canadian households quickly felt the squeeze of higher rates starting in 2022.

Though the Canadian economy has slowed – and we expect this to continue, with modest recession more likely than not – the potential upsides of its market structure are also becoming clear. Inflation is moderating back toward target in Canada more quickly than in most other developed market (DM) economies. Meanwhile, the shorter-duration nature of the mortgage market appears to be a strength for Canadian banks relative to their U.S. counterparts, some of whom have come under significant stress this year amid unrealized losses on their (generally longer-term) assets along with a rising cost of deposit funding. Together, these trends suggest that the interest rate sensitivity of the Canadian economy may be a benefit in the medium term, potentially helping inflation return to target more quickly while enabling a soft(er) landing than we may see in the U.S.

All of this will likely make the Bank of Canada’s (BOC) job of bringing down inflation somewhat easier. With the economic effects of monetary policy becoming clearer sooner, the BOC could potentially hold rates at less restrictive levels than other DM central banks. The BOC may also start normalizing rates sooner as inflation risks recede, reducing the risk that its restrictive policy “breaks” something in financial markets and leads to a deeper downturn.

Higher rates, slower growth, lower inflation

In March 2022, the Bank of Canada began one of the most aggressive monetary tightening campaigns on record. Just over a year later, the effects of this and other macro developments are becoming clear. Higher mortgage rates are squeezing discretionary spending, while cyclical tailwinds from the post-pandemic reopening (which initially bolstered growth in many sectors) and higher energy prices (which tend to benefit Canada as a net energy producer) have largely faded. Canada’s real GDP growth decelerated from a 3% average pace in 1H 2022 to a 1% average pace in 2H 2022, according to Statistics Canada.

While the Canadian economy appears to be off to a good start in 2023, as evidenced by solid employment gains and a reacceleration in consumption growth, we expect the lagged effects of BOC tightening to continue to weigh on activity going forward. In our baseline view, recessions across developed markets – including Canada – are likely in the coming quarters. (For our detailed views on the global economy, read our Cyclical Outlook, “Fractured Markets, Strong Bonds.”)

Meanwhile, we continue to believe that the inflation picture looks less worrying in Canada relative to other DM economies, and that the BOC has made more progress toward achieving its inflation objective than other DM central banks. On a three-month annualized basis through March 2023, core CPI is running at 3.1% in Canada, 10 basis points (bps) above the top of the BOC target range, versus U.S. core CPI at 5.1%, well above the Federal Reserve’s (Fed) target of 2% (sources: Statistics Canada and the U.S. Bureau of Labor Statistics). (Read more about the differences between U.S. and Canadian inflation in our October 2022 Viewpoint on Canada’s economy.)

The combination of moderating inflation and slower but resilient growth allowed the BOC to signal a pause in the rate hiking cycle earlier this year, affirming our expectations of a terminal rate in Canada that is perhaps 25 bps – 50 bps lower than the terminal rate in the U.S. Looking ahead, we expect the BOC to remain on hold as global spillovers and the lagged effects of tightening continue to weigh on the Canadian economy. Further out, we expect both the Fed and the BOC to begin easing around the same time, perhaps toward the fourth quarter of 2023.

Banks a source of relative stability

Last month, two U.S. regional banks failed after fears about unrealized losses on long-duration assets held on the banks’ balance sheets led to a bank run. U.S. regulators quickly responded in an effort to stem a broader banking sector crisis, guaranteeing deposits at the failed banks and introducing a new bank funding facility created by the Fed. While in our baseline we don’t expect significant further contagion from these U.S. bank failures, we also see several reasons why the Canadian banking system may be more insulated from these risks.

First, although the significant rise in interest rates in 2022 was a sharp headwind for many Canadian homeowners and consumers (due to their generally short-duration and floating-rate mortgages and greater leverage versus their U.S. counterparts), the flip side of this cyclical challenge is that Canadian banks do not have the same overall magnitude of unrealized losses on their balance sheets as U.S. banks. Second, tighter interest rate risk management as well as stricter implementation of the Basel rules on liquidity in particular also put Canadian banks in a relatively better position. Third and finally, because Canadian mortgages have recourse to the borrower, and banks can seize other assets in the event of default, there is much less incentive for Canadian households to “turn in the keys” if their properties are underwater.

Meanwhile, Canadian banks may not face the same competition for deposits as many U.S. banks, for a couple of reasons. First, the Canadian banking system is significantly more concentrated than that of the U.S., where smaller regional banks remain critical lenders to homeowners and smaller businesses. Canada’s six largest banks account for 94% of the country’s total deposits; the U.S.’s six largest account for only around 45% of U.S. deposits. Second, the money market fund industry – an alternative to bank deposits for many households and businesses – is relatively small in Canada, with money market assets under management (AUM) at about 1% of the size of Canadian bank deposits, according to the Bank of Canada. In the U.S., money market AUM is about 32% of the size of U.S. bank deposits, according to Crane data. Facing less competition than their U.S. counterparts, Canadian banks will likely see a more muted increase in their cost of capital, thereby lowering the potential for a sharper tightening in bank lending.

While tighter global financial conditions may still ultimately spill over to the Canadian economy, we believe the lower concentration of low-yielding, long-duration assets on bank balance sheets is a relative strength for Canadian banks, which may increase the BOC’s chances of achieving a soft(ish) landing.

Investment implications

The arguments outlined above suggest that overall Canadian bank credit standards may not tighten as much as in the U.S. Higher rates are still reducing the affordability of the Canadian housing stock, but the faster pass-through of higher rates to the consumer through the shorter-duration structure of the Canadian housing market arguably should make the BOC’s job of bringing down inflation easier and allow it to pause before other DM central banks. We believe the BOC will hold the policy rate steady through the next several months at a terminal rate lower than that of the Fed, before beginning to ease policy perhaps toward Q4. In our view, this implies U.S. duration may be marginally more attractive than Canadian duration, especially in the long end of the yield curve, given higher starting levels. We continue to expect Canadian rates to remain in a broad range, yet volatile within that range.

We believe the recent banking sector volatility may present opportunities in select high quality credit both in Canada and globally. Specifically, we believe senior bank credit should remain resilient, especially that of both global and domestic systemically important banks. However, we expect credit spreads to remain volatile amid the threat of a recession.

Lastly, given the drop in five-year Canadian rates by about 75 bps from prior highs, we expect mortgage refinancing rates will ease marginally. At the same time, greater immigration into Canada is likely to boost demand for housing. On balance, we believe we are in the early stages of Canadian home prices stabilizing at around 15%–20% below the peak levels seen in early 2022.