Canada goes "All In" on Stimulus – Now is the time for caution

While most people’s attention has been focused on the front-line efforts aimed at slowing the spread of the SARS-2 coronavirus and the resulting economic shock, behind the scenes there’s been a coordinated intervention by both the Government of Canada (“GoC”) and the Bank of Canada (“BoC”) aimed at supporting the economy and mitigating the effect of shutdowns on businesses and households.This intervention has mainly taken three forms:

1. BoC policy rate cuts,
2. BoC asset purchases (a.k.a. quantitative easing), and
3. GoC deficit spending.

We’ll discuss all three measures but will focus mainly on the latter two, which have been entirely unprecedented in magnitude. In addition to their standalone effects, we’ll also consider the hazards of implementing asset purchases and deficit spending in combination, the effects of which may endure for much longer than either the pandemic or the economic contraction that they were intended to correct.

Overnight interest rates cut to nearly zero

Between March 4 and March 27, the BoC lowered the target for its policy rates three times by a combined 1.50%, bringing the cost of short term borrowing to effectively zero.  Policy rates tend to guide banks’ prime lending rates, which in turn determine the borrowing cost of many floating rate loans and lines of credit.  The BoC’s action was intended to reduce the interest burden paid by many borrowers, easing the financial impact of the shutdowns.Unfortunately, lowering policy rates does nothing to narrow credit spreads (the difference between the interest rates that government and non-government borrowers pay).  Instead credit spreads widened sharply as the economy contracted, resulting in significantly higher borrowing costs for corporate borrowers, especially those with higher default risk.Similarly, lowering the overnight rate only often has limited impact on longer term interest rates.  During the same period of March 4-27, even as short-term rates were brought sharply lower by 150bp, longer maturity bond yields did not follow suit.  For example, the 10-year GoC benchmark bond yield fell from 0.96% to 0.72%, a decline of only 24 bp resulting in a steeper yield curve.  With policy rates already at effectively zero, the Bank of Canada needed to do more but was unwilling to embark on the negative interest rate policies that have been undertaken by some other central banks.

Asset Purchases to the Rescue

In a flurry of announcements beginning in March, the BoC began introducing an alphabet soup of new asset purchase programs and expansions to existing liquidity facilities:(Please note: this table is best viewed horizontally on mobile devices.)

‍Source: Bank of CanadaMany of these announcements were notable because the BoC, like most central banks, had historically held only federal government and agency securities as collateral. Additionally, the BoC had historically only acquired securities in the secondary market (buying assets from a 3rd party) rather than participating in primary market transactions (initiating a new loan directly with the borrower).In addition to this non-exhaustive list of new or expanded asset purchase programs, on March 27 the BoC also mentioned that it would buy a minimum of $5 billion of GoC securities per week, across the yield curve.  

This announcement garnered much less attention because the BoC had in the past undertaken quantitative easing, most notably during the Global Financial Crisis in 2008-2009. However, the BoC’s announcement significantly understated the actual magnitude of the buying spree that would follow. Over the following 13 weeks, the BoC would buy approximately $200 billion in government securities, an average rate of $15.4 billion per week – more than three time larger than indicated.In total, these asset purchases have caused the BoC’s balance sheet to balloon from $120 billion at the end of 2019 to nearly $530 billion by the end of June, a factor of more than 4.4x.

Figure 1:  Bank of Canada Balance Sheet

Source: Bank of CanadaThe bond markets responded to the BoC’s announcements and purchases. Credit spreads quickly reversed direction and tightened as bond investors gained confidence that borrowers would have access to liquidity from the central bank. Also, longer term bond yields gradually declined, flattening the yield curve, with the 10-year benchmark rate now hovering around 0.50%.

Falling off the Deficit Cliff

Stepping out from of the Bank of Canada, a brief walk eastward along Wellington Street brings one to Canada’s Parliament Buildings. On July 8th, the House of Commons received an update from Finance Minister Bill Morneau, indicating that the government’s budget shortfall for the current fiscal year would likely hit a record $343 billion, very nearly the size of the entire amount of federal government spending in 2019 ($346 billion). For comparison, during the 2009 financial crisis and economic recession, the government posted a then-record deficit of $56 billion. The last time the government’s deficit as a percent of GDP reached this level was during the Second World War.The enormous deficit is mainly attributable to two financial aid programs (the Canada Emergency Wage Subsidy ("CEWS") and the Canada Emergency Response Benefit ("CERB"), combined with lower than expected tax revenue. Even this estimate comes with a high level of uncertainty; if the pandemic persists longer than projected, or the recovery is slower, then the deficit may be larger than estimated.

Figure 2:  Government of Canada Budget

Source: Government of Canada, PBO

How Government Deficits are Financed

Governments spending more than they collect in tax revenue in nothing new. It happens more often than not, and the routine approach to financing any given year’s spending shortfall is to simply borrow from the public. The Treasury sells bonds into the market, and investors earn a modest and safe yield on their loans to the government.  

There is no statutory upper bound to how much a government can borrow. Market discipline is what enforces a limit on government borrowing. If the government’s debt level becomes excessive, or its debt service payments begin to consume too great a share of the revenue it relies upon to fund all of its other spending and administrative functions, the market begins to see the government as a less attractive borrower, and demands higher interest rates on that government’s debt. Rising interest rates help put the brakes on government spending… it simply becomes incrementally more expensive for the government to spend.

But when the central bank gets involved and begins monetizing government debt, these market safeguards get disabled. The BoC’s monetary policy interventions artificially lower the interest rate on GoC bonds relative to what the market would normally demand. Without the feedback of rising interest rates, the government is given free rein to continue to spend excessively.How does the BoC hold interest rates down? By stepping in ahead of other prospective buyers in the bond market to acquire bonds, and in doing so bidding up the prices of securities. How does the BoC pay for these bonds? With newly created money. The Bank of Canada can issue notes (i.e. cash) in unlimited quantity.  

This creates a dangerous loop… the central bank can print an unlimited quantity of money to buy treasury bonds to hold interest rates low. And the government, seeing that interest rates are low, can spend more money and issue an unlimited quantity of treasury bonds for the central bank to buy. It would be concerning enough if the central bank’s intervention was strictly limited to the government bond market. At least the distorting effects would be limited to that one arena. Unfortunately, the BoC’s interventions have extended into provincial bonds, mortgage bonds, and corporate bonds. How the Bank will unwind these asset purchases without causing serious disruptions in their respective markets is anyone’s guess.

Where do we go from here?

Any time a government’s debt burden becomes excessive and it reaches a point of reckoning, there are only a few possible paths to resolution:

1. Growth: The rate of real economic growth exceeds the rate of debt accumulation.
2. Austerity: Taxes increase and/or spending decreases, and the debt is fully repaid.
3. Inflation: The debt is repaid with devalued currency, resulting in a loss of purchasing power.
4. Default: The government fails to honour its debt obligations.

There are no other options.The first question is, how much debt is “excessive”? We don’t actually know where the edge of the cliff is, or how much farther the debt burden can be extended before it reaches the tipping point. As an example, Japan has accumulated debt levels previously though unsustainable, but has yet to experience a day of reckoning. Instead it has endured decades of lethargic growth and failed attempts to inflate its way out of its debt burden. But Japan’s example may not be a blueprint for other countries because of fundamental demographic and cultural characteristics unique to that country’s population. Other countries, like Canada, may hit the debt wall much sooner.

Knowing this, what should Canadians expect once this pandemic has subsided but the accumulated Federal government debt and bloated BoC balance sheet remain?It’s safe to assume that the GoC and BoC will have a very strong incentive to orchestrate some combination of growth, inflation, and austerity, in an attempt to get out from underneath the debt burden.  

Growing our way out of the debt would be the most desirable outcome but is probably the least likely. It’s extremely difficult to envision an economic environment with a higher sustained real GDP growth rate post-COVID than before.That leaves us with an unattractive option (inflation) and an even less attractive option (austerity), or most likely, some strikingly unattractive combination of the two. Without the benefit of a crystal ball to see the future, we should position ourselves for whatever circumstances might arise, and we should allow for the possibility that years ahead might hold both higher inflation and higher taxes… two of the most insidiously destructive forces for financial wealth. Protecting and growing wealth in this sort of environment is still achievable, but the uncertainties are greater and the key assumptions that go into planning will likely need to be more conservative than they have been in the past.