Bank failures impact path of rate hikes
The bank collapses demonstrated to the broader banking industry what poor risk management and duration mismatch could lead to. As the regulators get busy in tightening up regulations, the more immediate fallout of the banking crisis will likely be tightening of lending standards. If tighter lending standards do materialize, it will have a tightening effect on financial conditions, not unlike the effect of rate hikes. This increases the likelihood of the economy slipping into recession later this year. The fixed income markets swiftly softened their views on the path of policy rates. Currently, markets are pricing in Fed rate cuts of 0.75% and Bank of Canada cuts of 0.50% by year end. At the beginning of March, December policy rates for both BoC and Fed were expected to be flat from current levels.
Source: Bloomberg data as of March 31, 2023
While some analysts speculate that central banks may pause on tightening given the uncertainty on how much the banking crisis may weigh on the economy, central banks stayed the course and remained focused on inflation. The European Central Bank hiked rates by 50 bps on March 16 and the U.S. Federal Reserve hiked by 25bps the following week. Despite the Fed’s insistence that there is still more tightening required to tame inflation, contrary to market views that they will need to start cutting rates by the summer this year to mitigate economic contraction.
The steep rise in interest rates and the confidence crisis on banks improved the attractiveness of money market funds as a safe haven, contributing to increased flows to money market funds over the past 12 months. As much as $600 billion of deposits have left banks since the hiking cycle began. By the end of March, US$5.2 trillion is sitting in money market funds, a new record high.
Canada ramps up spending in “green” budget
On Tuesday March 28, 2023, Finance Minister Chrystia Freeland tabled the Liberal government’s 2023-24 Federal Budget in Parliament. The budget includes plans to spend nearly $70 billion more between now and 2027-28—with $59.5 billion rolling out over the next five years—while offsetting this with close to $25 billion in cuts and savings. As a result, the federal deficit is projected to be $43 billion this fiscal year.
A core focus of the budget is developing Canada’s green economy by introducing new corporate tax credits meant to encourage investment in clean energy, by focusing on clean electricity and for clean technology manufacturing and processing and critical mineral extraction. Plus $20 billion commitment to the Canada Infrastructure Bank to support building of major clean electricity and clean growth infrastructure projects.
Despite the federal budget spending pushing deficit well into 2027-2028, it was well received by markets. Canadian stocks, bonds and CAD gained modestly for the day. The increase on spending provides targeted support for clean and sustainable growth projects, which is essential to keep Canada competitive, especially considering the Inflation Reduction Act in the U.S.