Tuesday, September 25, 2007

RBC ECONOMICS - Repricing of credit risk "an ongoing process" according to Bank of Canada Governor Dodge

Repricing of credit risk "an ongoing process" according to Bank of Canada Governor Dodge

In a speech to the Canada-U.K. Chamber of Commerce this morning, Bank of Canada Governor Dodge said that the repricing of credit risk is an ongoing process that began the spring of 2007 and accelerated in August as investors became more uncertain about the creditworthiness of their holdings. As a result, "the 'wall of liquidity' evaporated under the summer sun" Governor Dodge stated, and investors moved their holdings into short-term assets, noting that the repricing of risk "may take somewhat longer than in previous periods".

The Governor highlighted the actions of the Bank of Canada has taken to ensure that Canada's money market continued to function. While the overnight market appears to moving "back to normal operations," the Governor acknowledged that "term funding remains somewhat expensive".

He stated that the Bank's actions to provide liquidity "did not in any way signal a change in our monetary policy. In fact, it was a step in maintaining our monetary policy stance by keeping our target for the overnight rate at 4 1/2 per cent, which we judged appropriate for keeping inflation on target over the medium term."

On the current economic outlook, the Governor maintained the view articulated in last week's release that "there are significant upside and downside risks to the inflation outlook" and reaffirmed the view that "the current level of our target for the overnight interest rate – 4-1/2 per cent - is appropriate." On balance, the speech confirms the Bank's steady-as-she-goes stance on monetary policy.

Highlights of the speech

    · The re-pricing of credit risk is an ongoing process. Unfortunately, it may take somewhat longer than in previous periods, because of the opacity and legal complexity of so many of these structured products. All of this implies that it's too early to draw any definitive conclusions from the current experience.

    · But while the overnight market in Canada is well on its way back to normal operations, this does not mean that all of the problems in money markets have been resolved. Term funding remains somewhat expensive, and the yield spread between bankers' acceptances and treasury bills remains abnormally wide.

    · With respect to the market for asset-backed commercial paper, Canada – like other countries – has seen some problems. One specific segment of the Canadian ABCP market – the market for third-party, or non-bank-sponsored, structured finance, asset-backed commercial paper – has had particular problems. This represents roughly one-third of Canada's about $120 billion ABCP market….. Efforts to resolve problems in the market for third-party ABCP are under way. Discussions between investors and liquidity providers – most of whom are international banks – are continuing in Montréal. And I remain hopeful that, over time, we will see useful results.

    · the major banks appear to be well placed to deal with the current dislocations. In a joint statement last month, these institutions said that their commitment to support the ABCP market is underpinned by the strength of their financial positions, their confidence in the underlying assets, and their ongoing commitment to provide liquidity for their conduits upon maturity. Further, data published by Canada's Superintendent of Financial Institutions show that our domestic banking sector is well capitalized. At the Bank of Canada, we welcomed this effort to help re-establish well-functioning money markets in Canada.

    · Recent developments suggest that the near-term economic prospects for the United States are weaker than earlier expected. It now seems likely that the adjustment in the U.S. housing sector will be more pronounced and more protracted, exacerbated by the dislocations in financial markets. This implies weaker demand for Canadian exports than had been earlier expected. However, economic growth in Canada in the first half of this year turned out to be stronger than we had projected.

    · However, there are significant upside and downside risks to the outlook for inflation. On the upside, there is a possibility that household demand in Canada could be stronger than anticipated, while on the downside, the ongoing adjustment in the U.S. housing sector could be more severe and spill over to the U.S. economy more broadly. In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand.

    Courtesy of RBC Economics Research Dawn Desjardins. Senior Economist

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