In its annual Financial Stability Report, released last week, Canada’s central bank said the U.S. tariff agenda could lead to near-term market dysfunction. 

“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.” 

Governor Macklem warned that an escalation of trade hostilities that pushes the Canadian economy into a severe recession could put pressure on the country’s banking system. “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 note that this is not a forecast. Instead, the FSR is an opportunity for the bank to voice its concerns and to encourage financial market participants to manage their riskier positions. 

Over the past 12 months, Canadian households have been carrying, on average, less debt relative to their income, and insolvency filings by businesses have dropped significantly. But there are pockets of financial stress. The economic impacts of the pandemic, as well as elevated housing prices due to persistent imbalances in the housing market, have led to higher levels of debt for some households and businesses. This has made them more vulnerable to financial shocks. 

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

However, Mr. Macklem noted that even in a severe downturn, Canada‘s banking system is well placed to withstand a shock after building up loan loss provisions and capital buffers in recent years.