In a worrying replay of the crisis of 2008 and 2009, lending rates in Canadian credit markets continued to react to the growing turmoil over European debt, with key overnight bank lending spreads doubling since February.
"We are starting to see interbank lending rates back up again and that's an unfortunate development," said Doug Porter, deputy chief economist at BMO Capital Markets. "We are starting to see investors shun any kind of risky trade again, whether corporate bonds or equities. We are seeing risk aversion right across the board."
While Canada has only modest direct exposure to troubled European countries, like other major economies it is feeling the indirect impact of turmoil in global financial markets sparked by fears of a possible sovereign default.
The early days of the crisis that climaxed early last year were characterized by a steady retreat by lenders from any kind of risk, reflected in steadily rising rates that banks charged each other for short-term loans, which eventually moved so high that interbank lending was effectively halted.
Conditions in Canadian credit markets are still nowhere near where they were in March 2009 at the height of the storm but the widening of spreads in just about every sector is a worrying "echo of what happened," Mr. Porter said.
The comments come after German Chancellor Angela Merkel slapped a ban on the short-selling of certain kinds of stocks and bonds, that sparked anger among other European leaders and sent equity markets into a tailspin as investors concluded the European bailout was unravelling.
The closely watched London Interbank Offered Rate climbed to the highest level in 10 months earlier this week as international banks hoarded money and investors grew more leery of risk.
Meanwhile, a U.S. Federal Reserve governor yesterday warned that the European troubles could spark another financial crisis, with credit markets freezing up around the world all over again.
"The European sovereign-debt problems are a potentially serious setback," Daniel Tarullo said in testimony before congressional subcommittees.
But Mr. Porter said the markets have now moved beyond that and are now focused on the possibility of "a deeper global slowdown" that would result if the European issues are not contained.
As a major global economy roughly the size of the United States, Europe is a key driver of global growth and if European demand starts to fall, as is already happening, the rest of the world will feel it.
As a major global economy roughly the size of the United States, Europe is a key driver of global growth.
If European demand starts to fall, as is already happening, the rest of the world will feel it.
That includes regions such as Canada and China that have so far avoided serious recessions.
Indeed, Canada emerged largely unscathed from both the crisis and the economic downturn that followed partially because Canadian governments did a better job of handling their finances than most other countries.
But one reason for the widening of credit spreads on Canadian government debt may be that investors are starting to take a second look at the quality of that debt.
In a report titled Is Canada Really So Pristine on the Debt Front, Mark Chandler, a fixed-income strategist with RBC Dominion Securities Inc., notes that Canada is average with other major countries in terms of the size of its debt, about 83% of gross domestic product, sandwiched between Britain (78%) and the United States (93%).
As a result of being downgraded by most of the rating agencies about 15 years ago, Canada lost its appeal to many foreign investors and little Canadian debt is now held by foreign institutions, which is a good thing when credit markets are roiled.