From Green Shoots to the Harvest: Comments on Financial Stability

Posted by Moishe Alexander

It is a pleasure to be back in Saskatchewan. This great province has been one of the fastest-growing parts of the country in recent years, benefiting from increasing diversification into biotechnology, alternative energy sources, and carbon-management solutions, among other industries.

Today, I will refer to the traditional backbone of this economy: agriculture. I do so because lately there has been much talk of "green shoots" in the global economy. From the initially careful references to data that suggested a slowing of the rate of decline in global activity, the use of the term "green shoots" has quickly evolved. Some now refer to green shoots as if the global recovery is a foregone conclusion or even as if sustainable growth had already begun.

Would that it were so easy. Saskatchewanians know that it is a long, anxious time between the appearance of seedlings and the harvest. Much hard work remains, and external forces can profoundly influence the outcome: too little or too much rain, hail, pests, and disease can all frustrate even the most promising beginnings. And, in the end, global forces of supply and demand determine the prices received. Old adages usually contain great wisdom: Just as you don't count your chickens before they are hatched, we shouldn't presume that green shoots today guarantee a bumper crop tomorrow.

Financial Stability and the Bank of Canada

I want to extend this analogy to provide some perspective on recent developments in Canadian financial stability. Financial stability is the resilience of the financial system to unanticipated adverse shocks. This resilience determines the extent to which Canadian households and businesses have access to the credit they need at appropriate terms and conditions.

While our financial system is one of the soundest in the world, the ferocity of the once-in-a-lifetime global financial tempest has affected all Canadians, regardless of their location or occupation. So, does our financial system still leave us well positioned for our green shoots to mature into a viable crop of summer wheat?¹

The Bank of Canada is well placed to make this judgment. As part of our commitment to promote the economic and financial welfare of Canada, the Bank actively fosters a stable and efficient financial system. The Bank constantly assesses the major risks to the soundness of our system, and helps to develop policies to mitigate them. In essence, we worry not only about prospects of external shocks (the equivalent of weather or crop prices), but also about the buffers that our banks, businesses, and households have (the equivalent of the financial reserves farmers need to carry in case the harvest disappoints).

Twice a year, the Bank publishes its Financial System Review, or FSR – the most recent edition appeared earlier this week. My talk today will draw on that analysis and assessment. I will concentrate on three risks, in particular: 1) the liquidity and funding positions of our banks, 2) the adequacy of their capital, and 3) the financial health of Canadian households. I will conclude with a few observations on the economic outlook.

Assessment of Overall Financial Stability

Since the autumn, the global economy has been in a deep and synchronized recession that was triggered by the worst financial crisis since the Great Depression. In recent months, financial market conditions have improved noticeably and further, gradual progress is likely as numerous international policy initiatives gain traction. Equity markets have seen strong gains in recent months (see Appendix, Chart 1), and credit markets have also rallied (Chart 2). While there is still a long way to go before economic and financial conditions return to normal, markets seem to be turning their backs on worst-case scenarios. The panic that engulfed global financial markets last fall is over.

Developments in Canadian financial stability over the past six months reflect the competing influences of improved financial market conditions on the one hand and a deterioration in the economic outlook on the other. Overall, the level of risk to the Canadian financial system is judged to be broadly unchanged since last December.

I would sound a note of caution familiar to those who work the land. We are well prepared but will still be tested. While the strong position of our banks has improved further in recent months and the balance sheets of Canadian households remain relatively sound, the global recession will mean that these reserves will be drawn upon in the months ahead.

Let me now turn to the three risks that I cited a moment ago, starting with liquidity and funding for banks.

Liquidity and Funding

At the heart of the financial crisis was the collapse of wholesale funding markets for banks. Since August 2007, the very short-term interbank and repo markets have been under great strain. During the most intense periods of the crisis around the collapse of Bear Stearns in March 2008 and Lehman Brothers and others in the fall of last year, these markets seized up entirely: Good collateral became unfinanceable overnight, firms failed, and risk aversion across all financial markets skyrocketed.

This crisis of confidence was less acute in Canada, but still produced severe strains in our wholesale funding markets. Heightened uncertainty made counterparties reluctant to extend financing beyond the shortest maturities, resulting in intense funding pressures for Canadian financial institutions. Banks cut back their market-making activities in order to conserve balance sheet capacity, which further aggravated market volatility. These dynamics raised the risk of an adverse feedback loop between the financial system and the real economy.

The Bank of Canada responded to these pressures by dramatically expanding our liquidity facilities, and the Government of Canada implemented a program to purchase insured mortgages with the help of the Canada Mortgage and Housing Corporation, thereby increasing the access of Canadian institutions to longer-term financing. Reflecting both the strength of our banks and the scale of our actions, conditions in Canada have been consistently better than elsewhere (Chart 3). Since December, these policies have gained considerable traction, helping to reinforce the improvement in domestic funding conditions as the global financial crisis subsided (Chart 4).

This improvement has been reflected in a decline in the spreads on bank financing in money markets, a moderate extension of maturities, and a substantial reduction in the cost of term funding for Canadian banks. In addition, policy initiatives have allowed banks to increase substantially their holdings of government securities, which has helped boost their liquidity situation in a capital-efficient way. These improvements have been further supported by strong growth in retail deposits and slowing credit growth (Chart 5). Market-making activity in Canadian financial markets has also been recovering, although it remains less than satisfactory.

Policy Response

There are important lessons to be drawn from this experience. The performance of core funding markets during the crisis intensified the financial panic and helped trigger the recession. This is totally unacceptable. As a consequence, one of the Bank of Canada's top priorities is to promote institutional changes to create more robust core funding markets. Promising avenues to break such (il)liquidity spirals include introducing clearing houses, standardizing products, implementing through-the-cycle margining, and ensuring more effective netting. As the ultimate provider of liquidity to the system, the Bank is thinking through whether to adapt its facilities to support continuous private liquidity creation.

Bank Capitalization

Since the crisis began, the capital adequacy of banks around the world has been the subject of intense scrutiny. Concerns moved quickly from bank exposures to U.S. subprime debt on to structured products of all types as the crisis spread and, finally, to more traditional credits to businesses and households as the recession took hold. Concerns about capital adequacy for banks outside Canada were made worse by uncertainties caused by accounting standards, valuation methodologies, and a loss of credibility of the Basel II regulatory capital standard. It was not lost on investors that every single financial institution that failed had a capital ratio well above its Basel II regulatory minimum the day before it went down. As a consequence, investors have demanded ever-higher capital ratios from all banks, creating a dynamic that has exacerbated the recession.

In this context, Canadian institutions have benefited from several factors: high initial capitalization (minimums set by the Office of the Superintendent of Financial Institutions are well above the Basel threshold), high-quality capital (with one of the highest proportions of common equity), the clarity provided by a simple leverage cap, low exposure to structured products, and clear valuation and disclosure standards (including rapid implementation of the Financial Stability Forum's enhanced disclosure guidance of April 2008) (Chart 6).

Writedowns by Canadian banks have been relatively moderate to date, reflecting their conservative lending practices and low exposure to highly impaired asset-backed products. But Canadian banks, as the principal source of finance in our economy, are still exposed to the risk of a marked deterioration in economic conditions, which would depress earnings and generate losses in their household and corporate loan portfolios. In general, this risk is why banks carry high capital buffers.

The macroprudential risk is that these capital buffers may not be allowed to play their intended role in absorbing these losses because of market pressures to maintain inordinately high capital ratios. This could force banks to curb balance sheet growth, causing a tightening of credit conditions that would reinforce the negative impact of the economic downturn on the financial system. Reflecting the generalized nature of the financial panic, as the crisis unfolded, Canadian banks came under pressure from markets to increase their capital ratios. In response, Canadian banks raised significant additional, high-quality capital from private sources.

The recent improvement in market sentiment has been reinforced by the release in May of the stress-test results for the 19 largest U.S. banks. These tests showed that the amounts of additional capital that need to be raised are manageable – indeed, more than half of the estimated shortfall has already been filled. The results have contributed to a general improvement of confidence in the global banking sector. To the extent that global levels of uncertainty and risk aversion have been lowered, this should also relieve some of the market pressure on Canadian banks to maintain inordinately high capital ratios. It would be welcome if buffers could serve their intended purpose, particularly in light of the extraordinary liquidity and funding support that public authorities have provided to our financial institutions. More info HERE

Good News Interest rates rise.

This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and easing monetary policy, the Fed has caused the price of bonds to fall, and interest rates to rise. Yep, an increase in demand for bonds causes the price to fall.

How does an increase in demand for something cause the price to fall? This could only happen if the increase in demand by one buyer caused other buyers to reduce their demand.

I can think of examples where this might happen. I remember a recent case where an "Essex girl" appeared on a British reality TV show wearing a Burberry bikini, and thereby ruined the Burberry brand image. This reduced demand for Burberry from everyone else.

Why are central banks buying bonds like an Essex girl buying a Burberry bikini? Isn't their money as good as anyone else's?

Well, no, it isn't. A central bank's money is actually better than anyone else's. That can't be the problem.

This is the problem. When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity. When you buy a bond, what you are buying is a promise of money in the future, and the value of that future money depends on its exclusivity. When a central bank buys a bond, and thereby increases the stock of money, it is doing something that other buyers of bonds don't do. The money will be worth less in future, and so the bond is worth less too. When Essex girl buys a Burberry bikini she lowers the fundamental value of Burberry bikinis. When the central bank buys a bond, with new money, it lowers the fundamental value of the bond.

Try telling that story without mentioning the supply of money, you Neo-Wicksellians!

This is the same argument I have been making in the past. It's not so much "I told you this would happen"; it's "I told you this ought to happen". Low nominal interest rates can be seen as a sign of tight money as much as easy money.Posted by Canadian Funding Corp. Read more HERE

Bank of Canada holds line on interest rates

The Bank of Canada gave the market a surprise on Tuesday as it left a key interest rate unchanged amid inflation worries.

The central bank left the overnight rate — what the country's big banks charge each other for overnight loans — steady at three per cent.

Many economists had forecast a cut of a quarter of a percentage point.

"The Bank of Canada proved today that it has a mind of its own," said Beata Caranci, the director of economic forecasting at TD Bank.

The Canadian dollar shed 0.08 of a cent to settle at 97.81cents US.

The Bank of Canada is currently grappling with mixed signals — a slowing economy and inflation tensions.

The country's GDP unexpectedly contracted by 0.3 per cent annualized in the first quarter. Housing is cooling, last month's job-creation figures were the lowest this year, and a couple of recent surveys indicate consumer confidence in Canada has fallen to a six-year low.

On the other hand, inflation pressures are building, with oil hitting a record $139 US a barrel last week. Food prices also took a big jump in April.

In the commentary accompanying its latest rate decision, the Bank of Canada said that while U.S. economic weakness "has not been favourable for demand for Canadian goods and services, overall, global growth has been stronger and commodity prices have been sharply higher than expected," the bank said.

"At the same time, many of the downside risks to inflation identified in the April [Monetary Policy Report] have eased, while the evolution of credit conditions has been in line with expectations," the bank said.

If current trends in energy prices continue, inflation is expected to rise above three per cent later this year, the bank said, adding it believes the current level of interest rates are enough to help bring inflation back down to its two-per-cent target.

Read more Posted by Canadian Funding Corp

Carney May Cut Canada Interest Rate to Record 0.5% as GDP Drops

Canada’s central bank will probably cut its key lending rate to its lowest level ever today to counter record job losses and an economy shrinking at the fastest pace in almost two decades.

Bank of Canada Governor Mark Carney will probably cut the target rate on overnight loans between commercial banks to 0.5 percent from 1 percent today at 9 a.m. New York time in Ottawa, according to 15 of 23 economists surveyed by Bloomberg News.

Canada is being pulled into a recession as global demand for its automobiles and lumber plunges along with the prices for the commodities it produces. The world’s eighth-largest economy shrank at a 3.4 percent annualized pace in the fourth quarter, Statistics Canada reported yesterday, the most since 1991.

“Weakness in global markets and a deep downturn in the global and Canadian economies tips the balance toward further rate cuts,” said Doug Porter, deputy chief economist with BMO Capital Markets in Toronto. “Events will force their hand again.”

Canada’s decision comes two days before the European Central Bank and the Bank of England are also expected to cut their key interest rates to new lows. ECB President Jean-Claude Trichet signaled policy makers may pare their benchmark rate to a record low of 1.5 percent March 5 as a recession in the euro area deepens. The Bank of England cut to 1 percent last month, the lowest since it was founded in 1694, and economists expect the rate to fall to 0.5 percent this week.

The U.S. Federal Reserve reduced its benchmark to a range of between zero and 0.25 percent on Dec. 16.

‘Further Stimulus’

Carney has cut the central bank’s policy rate from 4 percent since taking over in February 2008, and on Jan. 20 reduced it below the old record of 1.12 percent set in 1958.

“We will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required,” Carney told a parliamentary committee Feb. 10. The phrase echoes what the central bank said on Jan. 20 when the main rate was cut half a point to 1 percent.

More here from Canadian Funding corp

Canadian Funding Corp Market watch

Mortgage Rates Sideways as Market Seeks Leadership

As I stated in my blog yesterday, my public duty is calling as I have been selected for jury duty.(Don't you envy me?) This will require me to do things a little different with my blog. Instead of waiting until economic data is released to post, I will be forced to post the blog before the data sets. I will recap the prior day's data, and let you know what other reports are due out and how they may affect the markets. I highly encourage you to read the MBS Commentary blog throughout the day for updates. Matt and Adam will keep you updated on what is happening in the markets and how it relates to mortgage rates.

Mortgage backed securities(MBS) had a strong day yesterday improving in price by .50 basis points. As MBS improve in price, lenders can offer more attractive mortgage rates. Helping to spark the rally was a global sell off in equities. Stock markets around the world sold off resulting in the flow of money leaving equities and moving into the fixed income markets(MBS and treasuries). By days end, the par 30 year fixed rate mortgage had fallen to 5.125% for the best qualified consumers. Matt and Adam tell me that technical indicators are pointing to a supportive week for MBS, but we must remain defensive. If you can recall, on "Black Wednesday"(5/27) mortgage rates increased by 1/2 percent in one day!

Helping to spark the rally was a worse than expected reading on the Empire State Manufacturing survey. This survey of approximately 175 manufacturing executives from across New York gives investors a gauge into the strength of manufacturing. The stock market prefers a strong rapidly growing manufacturing base which leads to higher profits while the MBS market prefers slower growth which results in less inflationary pressures. After a strong improvement with last month's survey(-14.7 to -4.6), economists were expecting continued improvement with a reading of -2.0. The actual survey came in considerably worse than expectations at -9.4!! Once this report was released at 8:30am est, the rally in MBS started to pick up momentum. Check out this GRAPH that Matt posted and you can see how the rally began following this data(time is on bottom axis and MBS price is on verticle axis). Granted, the global selloff in equites had already begun, so odds were on our side for a postive day for MBS but sure looks like this data helped things along.

Today, the economic data picks up with Producer Price Index(PPI), Housing starts and Industrial Production. You can read my blog from yesterday by scrolling down or for an explanation of each of these data sets and their potential impact on mortgage rates.

Hot off the presses this morning is the release of housing starts. Last month's report showed that construction of new homes fell 12.8% to an annualized pace of 458,000 which is the lowest pace since 1959! To put this number into perspective, in January of 2006 the annualized pace was over 2 million units per year! Economists are expecting this report to show new home starts increasing to an annualized pace of 500,000. The report has shown a sharp increase in housing starts of 17.2% to an annualized pace of 532,000. This is positive for stocks and somewhat negative for MBS. View more here

Bank of Canada lowers overnight rate target by 1/4 percentage point to 1/4 per cent and, conditional on the inflation outlook, commits to hold current

Reviewed by Moishe Alexander the CEO of the Canadian Funding Corporation.
The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of a percentage point to 1/4 per cent, which the Bank judges to be the effective lower bound for that rate. The Bank Rate is correspondingly lowered to 1/2 per cent. The deposit rate - the rate paid on deposits held by financial institutions at the Bank of Canada - is left unchanged at 1/4 per cent and provides the floor for the overnight rate. Details of the Bank's operating framework at the effective lower bound can be found here.

In an environment of continued high uncertainty, the global recession has intensified and become more synchronous since the Bank's January Monetary Policy Report Update, with weaker-than-expected activity in all major economies. Deteriorating credit conditions have spread quickly through trade, financial, and confidence channels. While more aggressive monetary and fiscal policy actions are underway across the G20, measures to stabilize the global financial system have taken longer than expected to enact. As a result, the recession in Canada will be deeper than anticipated, with the economy projected to contract by 3.0 per cent in 2009. The Bank now expects the recovery to be delayed until the fourth quarter and to be more gradual. The economy is projected to grow by 2.5 per cent in 2010 and 4.7 per cent in 2011, and to reach its production capacity in the third quarter of 2011. Given significant restructuring in a number of sectors, potential growth has been revised down. The recovery will be importantly supported by the Bank's accommodative monetary stance.

The Bank expects core inflation to diminish through 2009, gradually returning to the 2 per cent target in the third quarter of 2011 as aggregate supply and demand return to balance. Total CPI inflation is expected to trough at -0.8 per cent in the third quarter of 2009 and return to target in the third quarter of 2011. While the underlying macroeconomic risks to the projection are roughly balanced, the Bank judges that, as a consequence of operating at the effective lower bound, the overall risks to its inflation projection are tilted slightly to the downside.

With monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound.

To reinforce its conditional commitment to maintain the overnight rate at 1/4 per cent, the Bank will roll over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively. These longer-term PRAs will be issued according to the schedule released today.

Today's decision to lower the policy rate by 25 basis points brings the cumulative monetary policy easing to 425 basis points since December 2007. It is the Bank's judgment that this cumulative easing, together with the conditional commitment, is the appropriate policy stance to move the economy back to full production capacity and to achieve the 2 per cent inflation target. The Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework to be outlined in the Bank's Monetary Policy Report on 23 April.

Canadian Funding Corp Review and Comments by Moishe Alexander On The Fall of Interest Rates in Canada

Canadian Funding Corp’s Review on the Fall of Canadian Interest Rates

In a stunning announcement today, Mark Carney declared that the Bank of Canada has taken an axe to the short-term interest rates and has reduced those rates to 1.5% - the lowest level in over half a century.

Unfortunately, the commercial banks refuse to pass on the same reduction to the consumers. In fact, TD Canada Trust and CIBC will only be reducing the interest rate by only .5% and dropping the Prime Rate to 3.5%. This reduction by The Bank of Canada was the largest single reduction since October 2001, shortly following the 9/11 terrorist attacks.

Moishe Alexander states that, “this .5% reduction is still not enough to stimulate the economy and restore confidence to the consumer. There should be an immediate further interest rate cut by a minimum of .25%.”

“The summer months,” adds Alexander, “produced some stability here in Canada. But we’re now entering a full-fledged recession.”

Mr. Carney is quoted as saying, “the outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated.”

“While I agree with Mr. Carney given his knowledge as to the true state of affairs, further interest rate reductions are needed to stimulate and spur on the economy,” Moishe Alexander responded.

In a weekly report issued by The Mortgage Centre on December 5, 2008, the best 1-year interest rate was 4.35% on a fixed rate mortgage and 4.60% for a variable rate mortgage.

Given this reduction by The Central Bank, we would expect the major institutions to reduce these fixed and variable rate mortgages by a minimum of .75%.



The Toronto Star article is listed below or you can read it in its entirety by clicking here http://www.thestar.com/printArticle/550727

Bank makes deep rate cuts

December 09, 2008

ANN PERRY, RITA TRICHUR

BUSINESS REPORTERS

OTTAWA – The Bank of Canada slashed its key interest rate today by three-quarters of a percentage point to the lowest level in half a century, and confirmed that Canada's economy "is now entering a recession as a result of the weakness in global economic activity."

The deeper-than-expected rate cut takes Canada's benchmark overnight rate to 1.5 per cent – a level not seen since 1958 – as the central bank tries to revive the country's flagging economy and restore confidence by making it cheaper to borrow money.

"The outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated," the central bank said in a statement, adding that global financial markets "remain severely strained."

But it remained an open question whether Canada's major banks would pass along the full cut to consumers. After the central bank's morning announcement, the Toronto Dominion Bank, the Canadian Imperial Bank of Commerce and the Royal Bank of Canada lowered their prime lending rates – the rate they give their most credit-worthy customers – by only half a percentage point to 3.5 per cent. Other banks were expected to follow suit.

"I guess this would be further justification for people saying, 'Good thing the Bank (of Canada) did 75 (basis points)' if they only got a 50-point reduction in the marketplace," said Dale Orr, chief economist for Canada at Global Insight.

But he cautioned that commercial banks may lower their rates again later on. "There could be further moves after today, and it wouldn't necessarily be the end of the adjustment to the banks' move."

Although most private-sector analysts had predicted a half-point cut, Scotia Capital economist Derek Holt praised the central bank for exceeding expectations and rising to the needs of the economy.

Given the "dovish" tone of the bank statement, Holt said Canadians should expect another half-point cut at the next scheduled rate decision date on Jan. 20. He said it is possible the overnight rate – the rate banks charge each other on one-day loans – will fall below one per cent by late winter.

"Beforehand, they were criticized for not being aggressive enough but now they have come around," Holt said.

While most economists have already declared Canada in recession, Tuesday's statement was the first in which the Bank of Canada was unequivocal on the call. The closest governor Mark Carney had come previously was last month when he said recession was a distinct possibility.

But since then reality has bit hard. The vast majority of economic indicators have been in retreat, including retail sales, auto purchases, housing starts and prices, commodity prices – and dramatically – last month's 70,600 shrinkage in jobs.

The central bank's move was partly a "catch-up" after it did not cut rates more deeply in October, and was urgently needed because of the lack of economy-boosting spending by the Conservative federal government, commented Orr.

"Today the cry for fiscal stimulus for Canada is loud and clear," Orr wrote.

"Instead of examining what the government could do to stimulate the economy facing such difficult times, the government opted to try to present a balanced budget."

Prime Minister Stephen Harper and Finance Minister Jim Flaherty have said they will present a stimulus package in the budget scheduled for Jan. 27.

Opposition parties were prepared to defeat the government over its perceived inaction, forcing Harper to persuade the Governor General to shut down Parliament until late January.

Given the lag time needed to get major infrastructure projects started, Holt said it was essential for the Bank of Canada to show leadership because Ottawa's stimulus – when it comes – may not impact the economy for another year.

In its new outlook, IHS Global Insight projects the Canadian economy will shrink 0.4 per cent in 2009 and full recovery would not occur until late 2010.

The Bank of Canada did not predict how long the slump will last but said bold actions by governments and central banks, especially in the United States and Europe, are beginning to loosen up money markets and support world economic growth.

It said other factors are helping Canada counter the economic slowdown, including the depreciating loonie, which is making exports more competitive.

After the rate reduction, the currency fell by more than a cent to below 78 cents U.S.

With files from the Canadian Press

Information about Giuseppe Strazzeri can be found at: http://www.mortgagecentre.com/index.cfm?member=gst&sl=1&CFID=1286784&CFTOKEN=82403109

You can also access an updated, printable rate sheet through his site at:

http://www.mortgagecentre.com/templates/tools/rate_watch/Display_Member_Rate_Watch_Sheet.cfm?show_pgsheet=t&CFID=1286784&CFTOKEN=82403109