COVID-19 Impact Theme #3 – The Economy — Fairway Wealth Management

We are back with the third installment of our COVID-19 impact themes series to have a look at some of the economic impacts of the pandemic. We have also taken this opportunity to break down some of the Bank of Canada’s response actions, and provide some explanation behind what they are doing and why they are doing it.

Introduction

The COVID-19 pandemic has spread with astonishing speed to every part of the world and infected millions and affected nearly everyone. The health and human toll is already large and continues to grow, with hundreds of thousands of deaths and many more suffering from diminished prospects and disrupted livelihoods. On top of that, the pandemic represents the largest economic shock the world economy has witnessed in decades, causing a collapse in global activity.

The pandemic has sharply curbed consumption and investment, as well as restricted labor supply and production. The cross-border spillovers have disrupted financial and commodity markets, global trade, supply chains, travel, and tourism.

Many countries have provided large-scale macroeconomic support to alleviate the economic blow, which has contributed to a recent stabilization in financial markets. Central banks in advanced economies have cut policy rates and taken other far-reaching steps to provide liquidity and to maintain investor confidence.

Economic Overview: Some Points to Consider

Canada added 246,000 jobs in August, a weaker pace than in previous months; the 418,500 jobs created in July was less than June, all of which suggests the initial bounce-back is now behind us.
The Canadian labour market has recovered roughly 64% of the three million jobs that were lost between February and April
- Getting the rest of the labor force back to work will be challenging as some businesses have permanently closed and others are struggling with less customer demand.
Canada’s economy continues to recover, as indicated by:

The US Federal Reserve’s mid-range forecast is for a -6.5 percent contraction in 2020 GDP overall. The Fed has estimated that pandemic-related loan losses for big US banks could reach $700 billion in a worst-case scenario.
Advanced economies are projected to shrink by 7 percent in 2020, as widespread social-distancing measures, a sharp tightening of financial conditions, and a collapse in external demand depress activity.
Assuming that the outbreak remains under control and activity recovers later this year, China’s growth is projected to slow to 1 percent in 2020—by far the lowest growth it has registered in more than four decades.
The global economy is expected to shrink by 5.2 percent this year in a baseline forecast. This would be the deepest global recession since World War II, and almost three times as steep as the 2009 global recession.
The COVID-19 recession has seen the fastest, steepest downgrades in consensus growth projections among all global recessions since 1990

Since 1870, the global economy has experienced 14 global recessions. Current projections imply that the COVID-19 global recession will be the fourth deepest in this period and the most severe since the end of World War II.
It is expected to involve per capita output contractions in an unprecedently high share of countries. Current projections suggest that the COVID-19 recession will involve a 6.2 percent decline in global per capita GDP, making it the deepest global recession since 1945-46.

To be clear, a global recession is a contraction in global real GDP per capita accompanied by a broad decline in various other measures of global activity.

The COVID-19 recession is unique in many respects. It is the first recession to have been triggered solely by a pandemic during the past 150 years
Current forecasts suggest that it will be the most severe since the end of World War II.
It is also expected to trigger per capita GDP contractions in the largest share of economies since 1870.

An Overview of Implications Business Sectors

Although these statistics are hardly a surprise, in Canada the sectors that rely on social interactions, non-essential spending and foreign sales have been particularly hard hit by COVID-19.

The initial impact of the pandemic was greatest in the travel, entertainment and food service sectors.
Sectors involving face-to-face personal services, such as hair salons and dental offices, have faced significant losses.
Commodity-producing firms dealing with lower global prices for resources continue to be heavily affected, especially in the energy sector. Sectors considered essential, those that were able to move easily to telework and those that could offer their services in a different way—such as virtual health care and grocery delivery—may not have felt the impact as deeply.

Source: Bank of Canada

The Response From Monetary Authorities

Monetary authorities in advanced economies across the globe have faced the challenge of containing the economic fallout from the pandemic. Economies across the globe are using quantitative easing (i.e. buying longer-term securities - usually government bonds - from the open market in order to increase the money supply and encourage lending and investment) on an enormous scale and developing new tools to bolster demand and keep financial markets functioning. Large-scale fiscal policy responses have been implemented to support activity and enhance social safety nets.

Advanced economy central banks moved quickly to ease monetary policy in the wake of the pandemic, bringing policy rates in most advanced economies close to zero.

Overall the amount of government support has been unprecedented in terms of sheer size, even when compared to the 2008 financial crisis.

What the Bank of Canada (BoC) is Doing – An Overview and Brief Explanation

It can be confusing trying to understand what central banks and monetary authorities do and trying to understand exactly what they are doing can be extremely convoluted. The goal of this section is to provide an overview of what the BoC has done, and a brief explanation behind its purpose.

The main goal the BoC is trying to achieve is to help Canadians bridge this difficult period by making credit affordable and available. At a basic level this means that while many economic activities are hindered, companies rely on credit to continue to pay their employees, and households need credit to continue to meet their basic needs. But they may be unable to borrow if financial turmoil curtails lending activity.

With that, the BoC needed to intervene to prevent a sudden contraction of credit when credit was/is most needed, because if Canadians can’t borrow to weather this economic storm, the impact on the economy would be worse, the recovery would take longer and there would be long-lasting damage to Canada’s productive capacity.

In normal times, the BoC can achieve their inflation objective by setting the policy interest rate at the appropriate level. However, during major disruptions to the economy and financial markets such as the one we are experiencing with COVID‑19, the BoC is forced to take more comprehensive measures to ensure that the financial system continues to play its role of providing credit where it is needed.

Monetary Policy

Back in March, when the BoC rapidly lowered their policy interest rate to 0.25 percent the action was not really expected to boost spending in the early days of the pandemic, but rather its immediate purpose was to help support confidence and provide some interest rate relief. But as more retail businesses reopen, low interest rates will help to encourage spending in the economy.

In short, the BoC lowered interest rates to support economic activity and to keep inflation low and stable. These moves work by lowering payments on existing and new loans throughout the economy.

As the new BoC Govener Tiff Macklem put it “low, stable and predictable inflation is the best contribution [the Boc] can make to Canada’s economic welfare, because low, stable and predictable inflation lays the foundation for sustainable economic growth…keeping inflation near to its target means the economy is running close to capacity with full employment”.

Support to Financial Markets

The BoC launched a series of purchase programs that involved buying different types of assets. They launched programs to buy Canada Mortgage Bonds, commercial paper, bankers’ acceptances, corporate bonds, and provincial and federal government debt. These programs were introduced to make sure that key markets would function properly, and that credit would continue to flow. Macklem states that “credit is the lifeblood of market-based economies and during a crisis, it is imperative that central banks maintain access to credit in order to avoid a credit crunch”.

Here is a brief overview of a few of the BoCs purchase programs:

Government of Canada Bond Purchase Program (GBPP)

This program involves the BoC purchasing Government of Canada bonds in the secondary market to support market functioning and provide monetary stimulus. The GBPP was established to address strains in the Government of Canada bond market, and to enhance the effectiveness of other actions taken to support core funding markets.
More recently, as market conditions improved, the focus of the GBPP has shifted to supporting the resumption of growth in output and employment.
The program targets a minimum of $5 billion per week and will continue until the economic recovery is well underway
Graph of BoC Assets from 2000-present:

To note is the difference between 2008 and now and the significant surge since the onset of the pandemic.

Provincial Bond Purchase Program (PBPP)

The aim of this programs is to maintain well-functioning provincial funding markets in the face of significant demands for funding as governments implement their emergency measures, and businesses and households seek to bridge this difficult period
The BoC agreed to buy up to $50-billion in provincial bonds
The program began on May 7, 2020 and operate for 12 months from May 7, 2020 to May 6, 2021

The Canada Mortgage Bond Purchase Program

Bank will target purchases of up to $500 million per week
Financial institutions use Canada Mortgage Bonds (CMBs) to finance their mortgage lending to Canadian homeowners. The functioning of this market was also becoming impaired amid broader market turmoil. In response, the Bank of Canada introduced a program of purchasing CMBs in the secondary market. This helps provide the means for financial institutions to renew mortgages during this period, as well as supports the flow of credit more generally.

In short, these programs are delivering stimulus through a process called quantitative easing or QE. Here’s how QE works through these programs:

Purchases of government bonds help to lower their yields.
With funding markets now functioning properly, weekly purchases make borrowing cheaper for households and businesses.
1. For example, when the bonds are purchased, they effectively lower the yield on five-year government bonds, this is being reflected in cheaper fixed-rate mortgages.
QE also sends a signal that the policy interest rate is likely to remain low for a long period.
1. By giving more certainty about the path of short-term interest rates, this can help lower longer-term borrowing costs for households and businesses.

Corporate Bond Purchase Program (CBPP)

The aim of this program is to supports the liquidity and proper functioning of the corporate debt market, by purchasing bonds in the secondary market. A liquid and efficient market for Canadian-dollar corporate bonds allows companies, currently challenged by the impact of the COVID-19 pandemic, to continue to obtain necessary longer-dated financing to support their operations, ultimately aiding the Canadian economy.
The program will hold up to a total of $10 billion par value of eligible assets
The CBPP began on May 26, 2020 and will operate for 12 months until May 25, 2021

This type of program also provides stimulus by providing liquidity, helping to narrow the difference between corporate and government bond yields. By reducing the premium that corporations have to pay relative to governments, we are lowering interest rates for businesses.

This is often called credit easing, or CE.

Here is an breakdown of the Government of Canada’s Corporate Bond holdings:

Liquidity for financial institutions

Given that the size and duration of the impact of COVID‑19 are highly uncertain, credit markets may become impaired. This is both because financial institutions face difficulties in obtaining funding for their lending and because they may become reluctant to lend in fear that many borrowers may be unable to pay. This is where the repo market and Standing Liquidity Facilities kick in.

Enhanced term repo operations and Standing Liquidity Facility (SLF)

To provide ready access to funding to individual financial institution
The central bank has lengthened the term over which they lend money to banks, widened the collateral they accept to provide lending, and expanded the list of eligible institutions that can access lending. Widening accepted collateral helps in two ways: it enables institutions holding that collateral to obtain financing so they can continue other lending, and it supports the functioning of markets for those assets accepted as collateral.

Summary - The actions the BoC is taking are mutually reinforcing:

Liquidity for individual financial institutions improves market functioning.
Well-functioning markets positively affect the ability of financial institutions to operate.
Monetary policy easing (a lower interest rate) is more effective when markets are functioning, and banks have the liquidity they need to lend to business and households

Latest economic update with Stéfane Marion and Martin Gagnon

With that, we hope you have better idea of the degree of some of the economic impact resulting from COVID-19 and a bit more clarity towards how the BoC is combating it domestically.

As always, please reach out if you have any questions.