Bank of Canada Deputy Governor Toni Gravelle, pictured at an event in Toronto last year, says the bank's main concern is a shock that leads to a 'deep recession and a sharp rise in unemployment.'Sammy Kogan/The Globe and Mail
Canada’s financial system has weathered a period of economic uncertainty well, but it could be tested by a combination of geopolitical conflict, changing U.S. trade policy and the spread of artificial intelligence, the Bank of Canada said Thursday.
In its annual Financial Stability Report, the central bank said that the Canadian financial system remains resilient.
Canadian households have largely made it through a period of pricey mortgage renewals without a significant rise in insolvencies, and the country’s banks are well capitalized to absorb potential losses, even in a severe economic downturn.
However, the overall risk to the financial system is rising, the bank said, due to high stock market valuations that could be disconnected from reality, the growing issuance of government debt which is being bought by highly leveraged hedge funds, and the risk of an economic downturn if trade negotiations with the United States go sideways or global oil prices remain elevated.
“Individually, these and other vulnerabilities look manageable. However, the economic and geopolitical environment has become more volatile. And this has made it more likely that a new shock or a combination of shocks could cause several vulnerabilities to crystalize at once,” said Carolyn Rogers, the bank’s senior deputy governor, said in a press conference.
“A cascading series of events could cause a sharp loss of investor confidence and lead to a spike in demand for liquidity or rapid asset sales. Funding markets could come under pressure, and stress could spread more broadly,” she said.
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The Financial Stability Report is not a forecast, and the bank does not put probabilities on various scenarios. The FSR also says nothing about monetary policy and the direction of interest rates. Rather it’s an attempt to outline key risks to the Canadian financial system.
On the crucial issue of household finances and mortgage renewals, the risk level remains largely unchanged from a year ago and looks considerably less concerning than it did several years back, the bank said.
Following the sharp rise in interest rates in 2022 and 2023, there were worries that Canadian homeowners would have trouble renewing their mortgages at higher interest rates, leading to significant loan losses for lenders.
So far, however, the situation has proven manageable. Mortgage stress tests worked, pinched homeowners extended their amortization lengths, incomes grew and interest rates retreated.
“To date, most borrowers have managed this risk well. With the final wave of these renewals set to happen over the next 12 months, we expect this risk to have fully passed by the second half of 2027,” deputy governor Toni Gravelle said in the press conference opening statement.
For homeowners with fixed-rate mortgages renewing over the next year, the bank expects them to see a roughly 15-per-cent increase in their monthly payments on average. This represents about 12 per cent of all outstanding mortgages.
While the risks stemming from Canadian household balance sheets remain largely unchanged, other vulnerabilities are increasing, the bank said.
Stock markets have continued to march higher despite various macroeconomic and geopolitical shocks, and are increasingly being driven by excitement about the potential for artificial intelligence.
That raises the risk that we’re in a stock market bubble, which could deflate if the commercial promise of AI is called into question.
“An abrupt repricing or deterioration in economic fundamentals could cause asset managers to face significant losses, a sudden increase in liquidity needs and forced asset sales to reduce leverage,” the FSR said.
The bank outlined one severe scenario where an economic shock caused by high global oil prices due to the war in the Middle East combines with a sharp sell-off in equity markets.
In that situation, according to bank modelling, gross domestic product would fall 1 per cent, unemployment would hit 10 per cent and home prices would fall by 25 per cent.
Another vulnerability is growing in the bond market, where the higher issuance of government debt to fund large deficits is being purchased by hedge funds that use large amounts of money borrowed in short-term funding markets.
While the hedge fund involvement in government bond markets can provide important benefits, helping lower borrowing costs and provide liquidity for trading, it can also increase volatility if markets become stressed.
If hedge funds lose access to short-term funding markets, called repo markets, it could lead to a firesale of bonds that would ripple throughout the financial system, with huge implications for borrowing costs and other financial assets.
The bank has highlighted this growing risk multiple times in recent years.
Looking beyond the mechanics of the financial system itself, the biggest risks ultimately stem from things that could happen in the real economy, the bank said.
If the talks to renew the United States-Mexico-Canada trade agreement break down and the U.S. slaps more tariffs on Canada, that could have major impacts on Canadian businesses and their workers.
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Likewise, the ongoing war in the Middle East could push oil prices up further, forcing the bank to raise interest rates and increasing the likelihood of a recession.
“The main concern for both households and businesses is a geopolitical or economic shock that leads to a deep recession and a sharp rise in unemployment,” Mr. Gravelle said.
The silver lining is that Canada’s banks are well-placed to handle these shocks, he said.
“Our overall view is that the Canadian financial system remains well positioned to weather shocks. Over the past year, it has faced repeated tests. While there have been some strains, those episodes did not lead to broad-based financial stress. Still, we must remain vigilant.”