CIBC strategists suggest the Bank of Canada end quantitative tightening to fix short-term funding issues
According to Canadian Imperial Bank of Commerce (CIBC) strategists, the Bank of Canada needs to either end its quantitative tightening program or address distortions in short-term funding markets.
These distortions are keeping effective interest rates higher, as reported by BNN Bloomberg.
For over two years, the central bank has been shrinking its balance sheet, reducing the extraordinary stimulus provided during the Covid-19 crisis.
The bank's assets have decreased to around $273bn from a peak of more than $570bn, as officials have allowed bonds to mature without replacement, thereby draining liquidity from the financial system.
This reduction in liquidity affects Canada’s financial institutions, as settlement balances (interest-bearing deposits used in Canada’s high-value payment system, Lynx) are disappearing. CIBC’s Ian Pollick, Sarah Ying, and Arjun Ananth report that this scarcity has led to hoarding.
During the pandemic, firms exchanged their bonds for settlement balances from the Bank of Canada as part of quantitative easing. These balances are meant to be exchanged freely, but the analysts note that “too few counterparties own a disproportionately large amount of reserves.”
CIBC's research shows that since February, nearly 80 percent of the remaining settlement balances are held by just three financial institutions, up from two-thirds last year.
This concentration disrupts the efficiency of short-term funding markets and contributes to higher borrowing costs, even as the Bank of Canada has started cutting rates.
If this issue remains unresolved, it “has the potential to exaggerate weakness in aggregate demand” as higher effective interest rates stifle growth.
The analysts suggest that if the central bank does not end quantitative tightening, it should penalize firms that hoard settlement balances. Otherwise, the Bank of Canada will likely need to continue direct intervention in short-term markets.
For instance, on a recent Wednesday, the central bank conducted $9.2bn in overnight repo market interventions.
The central bank targets the overnight lending rate, currently set at 4.75 percent since June. The overnight funding rate in the repo market should align closely with this target.
However, the Canadian Overnight Repo Rate Average (Corra) has diverged, settling at 4.80 percent as liquidity in the repo market diminishes.
Earlier this year, Corra traded as much as seven basis points above the target rate, prompting concerns that the central bank might need to end quantitative tightening sooner than planned.
“Policymakers must choose a decisive path—they can’t work as pacifists on QT and as activists on ensuring Corra’s stability to the target rate,” Pollick stated in an interview.
Despite these challenges, the central bank has not indicated plans to end quantitative tightening. In March, Deputy Governor Toni Gravelle confirmed that the Bank of Canada expects to continue reducing its balance sheet until sometime in 2025.
