When the stimulus stops: Economic danger points to watch for when the ‘punchbowl’ is pulled away

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When the COVID-19 pandemic struck, the federal government and the Bank of Canada responded with a broadside of support programs and monetary stimulus. People and businesses received benefit payments and interest-free loans, while financial markets got rock-bottom interest rates and a massive bond-buying program.  

The dollar amount of assistance has been huge. For example, the Parliamentary Budget Officer recently reported that the federal government will provide an estimated $122 billion in labour-market support for people in its 2020-2021 fiscal year, with roughly $42.8 billion more to come the following year.  

Yet the emergency measures were not intended to be permanent, and while the pandemic isn’t over, it is being beaten back by widespread vaccination programs, improving the economic outlook. The federal government and the country’s central bank are now facing increased concerns about debt and inflation, among other things. Speculation has already kicked up around the Bank of Canada tapering its bond purchases, while the government may find itself under growing pressure to curb its spending.

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However, removing support and stimulus measures could create a whole new set of problems for borrowers, investors and governments, who have been living with them for about a year now. Here’s a look at some of those concerns.

Governments 

Public-sector borrowing costs have been held down during the pandemic by the Bank of Canada, which is not only snapping up federal government debt, but that of the provinces as well. The yield on the Government of Canada’s benchmark 10-year bond went from around 1.3 per cent in February 2020 to around 0.5 per cent by last summer. 

However, while the Bank of Canada is still buying $4 billion a week in Government of Canada bonds via its quantitative-easing program — purchases it says it will continue to make until the economic recovery is well underway — markets are already looking past its promises.

“We see the Canadian economy returning to full capacity in 2022, sooner than the central bank has assumed,” Royal Bank of Canada economist Josh Nye wrote last week. “That leaves us expecting a rate hike in the second half of 2022 which markets are currently pricing in. Well before that first rate hike, we think the BoC will taper its QE program in April.”

The federal government is feeling these expectations, as its 10-year bond yield recently soared past 1.5 per cent on similar sentiments.

The BoC is also due to end its provincial bond purchase program in May, having bought more than $15 billion in those securities thus far.

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A recent report from the International Organization of Securities Commissions (IOSCO), a global policy forum for watchdogs such as the Ontario Securities Commission, looked at the effects of government support measures on credit ratings and found cause for concern as well. 

In particular, credit-rating agencies “noted that a more pronounced and longer period of fiscal loosening due to the failure to withdraw GSMs (government support measures) could have a negative impact on a sovereign rating due to persistent budget and debt deterioration expectations,” the report said. 

A post-COVID-19 future for Canadian governments could include higher interest payments. 

“Governments are only maturing a portion of their debt every year,” said Pedro Antunes, chief economist at the Conference Board of Canada. “And so the total debt financing costs don’t change as much, but eventually they will be ticking up as you’re rolling over new debt in these higher yields.”

Consumers and companies 

Former Bank of Canada governor Stephen Poloz oncesaidthat “no one has ever criticized a firefighter for using too much water.” 

Indeed, borrowers weren’t complaining too loudly when the central bank slashed its policy interest rate to the so-called “effective lower bound” of 0.25 per cent. 

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That, as well as programs like the $500-per-week Canada Recovery Benefit and payment deferrals provided by commercial lenders, have helped to keep many borrowers from defaulting on their loans. Consumer insolvencies in January were 35.8 per cent lower than a year earlier, according to the Office of the Superintendent of Bankruptcy. 

Although the federal government continues to extend pandemic-related supports — and has pledged further stimulus spending of as much as $100 billion — an eventual end to those programs (as well as the potential for higher interest rates) could allow debt problems to reemerge.

In February, right before the federal government proposed to extend recovery benefits, Canadian unions warned of a“benefits cliff” for unemployed workers when those programs run out. Mortgage rates have also been rising lately in response to climbing bond yields, and Equifax Canadareportedrecently that early-stage debt delinquencies rose during the fourth quarter of 2020. 

“The income supports are just playing a much bigger role in propping things up than I think we want to admit,” said Keith Emery, chief operating officer of non-profit counselling agency Credit Canada. “We know that some Canadians are using that income support to actually deleverage. But the big question is: when is that going to end? And when it does end, what’s going to happen to all those people?” 

Indebted corporations could prompt similar concerns.

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The Canadian Federation of Independent Business estimated in February that small businesses in this country owe a total of $135.1 billion because of COVID-19, with the average debt burden almost hitting $170,000 per business. Nearly six in 10 businesses also said they were using the federal government’s interest-free loan program, the Canada Emergency Business Account (CEBA).

“The current situation in which many businesses find themselves (i.e. holding a considerable amount of debt, being almost a year away from typical profits and making lower than normal sales) is unsustainable,” said a CFIBreportreleased near the end of February. 

IOSCO also noted that businesses received a lot of support in the form of loans and extra debt, packing it on top of their pre-pandemic burdens. 

“It is possible that corporates in COVID-19-affected sectors or in otherwise weakened conditions may not be able to sustain this amount of debt going forward, which could lead to significant defaults,” IOSCO said in its report. 

Investors

COVID-19 at first dealt a severe blow to stock prices and bond markets before central banks stepped in, slashing interest rates and eventually vowing to buy government and corporate debt. Financial markets found their footing and went on a prolonged rally that has seen everything from Bitcoin to commodities to stocks increase in value.

More recently, however, markets have been getting a bit jittery. At least part of the reason for this is expectations of central banks removing some of the extra liquidity they’re providing as the economic recovery continues and inflation picks up. 

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Past periods in which central banks removed liquidity from markets have been choppy ones for investors, such as the 2013 “taper tantrum” that resulted from the U.S. Federal Reserve suggesting it could slow its bond buying, causing U.S. Treasury yields to shoot up and stock prices to fall. 

Another time when the “punchbowl” of central-bank liquidity was yanked away was in 1994, when the Fed began hiking rates following a recession. This was noted by National Bank of Canada chief executive Louis Vachon during the lender’s first-quarter conference call, when he was asked about an end to the current environment of abundant government and central-bank support. 

“I think what happens in that particular positioning is you need to be very good at managing volatility in financial markets,” Vachon told analysts and investors on Feb. 24.  “And especially now, if there’s any kind of whiff of inflation, which again, I think it’s probably a couple years down the road at the earliest, I would think, but once that occurs, I think volatility … could be quite high.”

Vachon was proven right just a day later, when whiffs of inflation caused bond yields to spike and stock prices to fall.

Canadian investors are unlikely to be immune from these forces, especially if price increases blow past the Bank of Canada’s two per cent target for annual inflation and prompt it to withdraw some stimulus.

“Later in the year, we think that inflation and higher interest rates could cause the Bank of Canada to do a quantitative tapering — the opposite of QE — and put downward pressure on the stock market in the second half,” said David MacNicol, president of Toronto-based MacNicol & Associates Asset Management Inc. 

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