Bank of Canada warns trade war poses financial stability risks #CanadaFinance

U.S. President Donald Trump‘s erratic tariff agenda risks creating financial market disorder and an economic downturn in Canada that could test the country’s banking system, the Bank of Canada is warning.

Over the past year, the central bank has become less concerned about domestic risks to financial stability, as interest rates have fallen and Canadian households have paid down debt, implying a less severe shock for homeowners renewing their mortgages.

But optimism about the home front has been replaced by worries about the U.S.’s sharp protectionist turn, which the bank highlighted as a major new risk in its annual Financial Stability Report, published Thursday.

“In the near term, the unpredictability of U.S. trade policy could cause further market volatility and strains on liquidity,” Bank of Canada Governor Tiff Macklem said in a press conference after the release of the FSR. “In an extreme case, market volatility could turn into market dysfunction.”

Meanwhile, an escalation of trade hostilities that pushed the Canadian economy into a severe recession could put pressure on the country’s banking system, Mr. Macklem warned.

“With debt still at high levels, some households and businesses may be unable to keep up with payments. If loan losses occur on a large enough scale, banks could cut back on lending in response.”

He was quick to point out that this is not a forecast. Instead, the FSR is an opportunity for the bank to voice its concerns and to cajole financial market participants into managing their riskier positions.

“You put your gloomy hat on,” Mr. Macklem said, and “you think about what could go wrong, and then you ask, ‘How well prepared are we?’”

In the current context, both upside and downside risks for the Canadian economy and banking system are tied to the mercurial Mr. Trump, whose plans appear to change day-to-day.

The President had announced crippling tariffs on Canada and dozens of other countries, only to backtrack on the most severe levies – with the exception of the ones on China. The White House is now pursuing trade deals with dozens of countries that may result in lower trade barriers.

Prime Minister Mark Carney had a cordial meeting on Tuesday with Mr. Trump, where the pair agreed to continue trade negotiations. On Thursday, the U.S. announced a deal with Britain. U.S. officials will meet with Chinese officials this weekend to kick-off trade talks.

Mr. Macklem acknowledged in the press conference that there have been “some positive developments” on the trade file since the bank’s interest rate decision in April. But he cautioned against complacency.

Royce Mendes, head of macro strategy at Desjardins, noted that the FSR’s downside scenario shows the share of mortgages in arrears could rise to levels not seen since the early 1990s if a full-blown trade war breaks out.

“While that‘s not the central bank’s base case forecast, it‘s a reminder of the urgency with which Canadian officials must address the trade spat with the U.S.,” Mr. Mendes wrote in a note to clients.

Mr. Trump‘s trade policy has already roiled financial markets. The President‘s announcement on April 2 of high tariffs on dozens of countries caused a huge drop in equity markets. In the following days, this morphed into a more worrisome sell-off of U.S. treasuries and U.S. dollars, as investors abandoned these typically safe-haven assets and hedge funds were forced to liquidate highly leveraged positions.

Mr. Trump relented a week later after a sharp spike in U.S. treasury yields, noting that markets had become “yippy.” He announced a three-month pause for the “reciprocal” tariffs placed on trading partners.

The Bank of Canada highlighted this episode and warned that market dysfunction could return with potentially serious consequences.

“Continued US trade policy uncertainty could spur further market volatility and an abrupt repricing of assets, which in turn could lead to acute and persistent liquidity pressures that test the financial system’s resilience,” the FSR says.

In such an event, market volatility could be compounded by the increased presence of hedge funds in the Canadian bond market, the report says. Hedge funds have been gobbling up a growing share of government bonds, using large amounts of leverage to finance their positions. In a crisis, they may be more likely to hit sell than other types of financial institutions, creating the risk of a downward spiral.

“Really the message for the hedge fund community is: We’re in a more turbulent period, make sure you’ve managed your liquidity, make sure you’re risk managing your positions,” Mr. Macklem said.

While much of the FSR focuses on risks created by U.S. trade policy, it also highlights domestic improvements.

The rapid rise in interest rates in 2022 and 2023 – a period when Bank of Canada lifted its policy rate from 0.25 per cent to 5 per cent – put significant pressure on Canadian households that had to renew their mortgages. Starting last June, the central bank cut interest rates seven times, bringing the policy rate to 2.75 per cent.

Around 60 per cent of Canadian households will renew their mortgages over the next two years. Most are still facing a jump in their monthly payments, but the shock won‘t be as severe as the central bank was expecting in its 2024 FSR.

At the same time, measures of household indebtedness have declined over the past year, as incomes have increased and people have paid down debts. The ratio of household debt to disposable income fell to 173 per cent from 179 per cent.

That said, the FSR highlights “pockets” of financial stress, particularly among households without a mortgage who have seen arrears on credit card debt and auto loans rise over the past year.

Debt sustainability for Canadian businesses and households will depend to a significant degree on the trajectory of the broader economy, which remains highly uncertain in the evolving trade environment.

Even in a severe downturn, however, Canada‘s banking system is well placed to withstand a shock, having built up loan loss provisions and capital buffers in recent years, Mr. Macklem said.