According to the Bank of Canada, risks to financial stability arise from the US trade war

    by VT Markets
    /
    May 8, 2025

    The Bank of Canada’s Financial Stability Report warns of risks to the Canadian economy from the trade conflict with the United States. It emphasised that market volatility could escalate into dysfunction.

    The BoC reassured that Canada’s financial system is robust, and banks are prepared to handle stress. However, concerns exist over potential disorderly market sell-offs requiring liquidity injections.

    Impact Of Prolonged Trade Conflict

    A prolonged global trade conflict may push mortgage arrears beyond 2008-09 levels, with large-scale credit defaults triggering more bank losses. Hedge funds could struggle in Canada’s government markets during stress periods.

    Household and business creditworthiness appear manageable compared to a year ago. More than 90% of mortgage holders can accommodate higher payments on five-year fixed-rate loans.

    Potential credit losses could curb bank lending, impacting economic recovery. The BoC will watch credit availability and market liquidity conditions closely.

    USD/CAD remained stable post-report, nudging up by 0.25% to 1.3872 on the day. The Bank of Canada steers monetary policy using interest rates, affecting the Canadian Dollar’s value.

    Effects Of Quantitative Easing And Tightening

    Quantitative Easing, employed in financial crises, often weakens the CAD by increasing money supply. Conversely, Quantitative Tightening, enacted post-recovery, typically strengthens the currency.

    The Bank of Canada’s recent Financial Stability Report, while assuring us of the current strength of the country’s banking system, paints a picture that demands more than passing attention. It sets out potential hazards not just in terms of volatility, but the sort that threatens actual functionality in financial markets. That’s not just noise. If trading becomes skewed by sentiment rather than structure, instruments linked to futures spreads and volatility indices may begin to show asymmetric pricing. In such a case, looking at implied correlation and shifts in curve steepness could be more telling than outright risk measures.

    Concerns around market sell-offs are not theoretical. We must not underestimate how liquidity gaps can evolve swiftly from brief dislocations into broader funding constraints. In moments like that, when central banks are forced to step in with injections, derivative spreads often detach from their fundamental anchors. When that happens, options pricing becomes distorted, and arbitrage assumptions we rely on may need adjusting. There’s often low tolerance for assumptions when delta profiles unwind faster than expected.

    If trade tensions stretch into months, rather than weeks, the link between real economic stress (such as rising mortgage arrears) and derivative pricing becomes more direct. Higher arrears don’t just suggest distress in household sectors; they reflect systemic credit stress bleeding into bank balance sheets. Once banks begin to reprice risk as a result of impaired loans, they scale back on credit. With that comes slowed leverage deployment in markets. That inevitably feeds into forwards, interest rate swaps, and CDS spreads. In that context, collateral requirements may rise even before headline volatility does.

    Interestingly, the BoC notes that over 90% of mortgage holders remain able to cope with higher fixed-term rates, offering a buffer underneath household credit risk. Still, caution should not only focus on defaults. Exposure tied to consumer debt is just one lane of risk. The broader issue often lies in how banks react to stress—who they lend to, how much liquidity they preserve, and how fast they adjust their pricing strategies.

    During these tapering periods, where Quantitative Tightening is in play, the typical effect is a push higher in CAD valuation due to reduced money supply. When that happens, traders with CAD exposures may see cross-currency basis swaps move in reverse compared to earlier easing cycles. With the Fed and BoC taking somewhat different stances, USD/CAD volatility could find itself suppressed at the surface, but building tension beneath. That quiet creep in the basis may offer early signals that premiums in vanilla options are underpricing potential divergence.

    Government bonds, which are often treated as pricing anchors in derivatives, may not remain as solid during stressed periods. This issue becomes more pronounced if hedge funds begin pulling back. In such liquidity-thinned markets, depth disappears quickly. If we trade in these conditions, tracking gamma exposure becomes more than just a routine—it becomes a way to see where pressure points could cascade.

    We must now watch correlations across sectors. A narrowing in credit spreads without an improvement in macro indicators can be misleading. That kind of dissonance tells us that positioning may be dictating price rather than fundamentals. In that environment, curve trades or calendar spreads may behave erratically.

    Lastly, looking at how the BoC absorbs all this, they’re expected to keep a close eye on both the pace and behaviour of credit supply. That doesn’t just affect rate markets; it shapes how quickly risk gets re-priced across instruments. The current environment isn’t neutral, even if headline market moves remain modest.

    Create your live VT Markets account and start trading now.

    see more

    Back To Top
    Chatbots