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(Bloomberg) — The Bank of Canada needs to wrap up its quantitative tightening program or fix distortions in short-term funding markets that are keeping effective interest rates higher, according to Canadian Imperial Bank of Commerce strategists.
Canada’s central bank has been shrinking its balance sheet for more than two years, withdrawing the extraordinary stimulus it provided during the Covid-19 crisis. Assets have fallen to around C$273 billion ($199 billion) from a peak of more than C$570 billion as officials have allowed the bonds on their books to mature without replacement, draining liquidity from the country’s financial system.
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For Canada’s financial institutions, that means settlement balances — interest-bearing deposits used as a means of payment in Canada’s high-value payment system, called Lynx — are disappearing. Their scarcity has led to hoarding, CIBC’s Ian Pollick, Sarah Ying, and Arjun Ananth wrote in a report to investors on Wednesday.
During the pandemic, firms traded their bonds for settlement balances from the Bank of Canada amid quantitative easing. The balances are meant to be exchanged freely, but “too few counterparties own a disproportionately large amount of reserves,” the analysts say.
Since the end of February, nearly 80% of the remaining settlement balances are held by just three of the country’s financial institutions, up from two-thirds last year, according to CIBC’s research.
That concentration is a big reason why short-term funding markets aren’t functioning efficiently, and it’s contributing to higher borrowing costs, even as the Bank of Canada has started cutting rates.
If left unchecked, the problem “has the potential to exaggerate weakness in aggregate demand” as interest rates effectively sit above target and choke growth, the analysts said.
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The analysts added that if the central bank isn’t willing to wind down quantitative tightening, it needs to create penalties for firms that are holding on tightly to settlement balances.
Otherwise, the Bank of Canada will likely need to keep directly intervening in short-term markets — it did so regularly in January in the form of repo operations to push down borrowing costs. As of 12:30 p.m. in Ottawa on Wednesday, the central bank had conducted C$9.2 billion in overnight repo market interventions that day, showing a resurgent need for its involvement.
The central bank conducts monetary policy by setting a target for the overnight lending rate, which has been at 4.75% since officials cut rates in June. Overnight funding in the repo market is meant to stick close to that level.
However, the Canadian Overnight Repo Rate Average, known as Corra, has detached from the Bank of Canada’s target. Corra has settled at 4.80% as liquidity in the repo market dries up. Earlier this year, funding markets faced similar distortions, and Corra was trading as much as seven basis points above the target for the overnight rate, raising questions about whether the central bank would be forced to end quantitative tightening earlier than expected.
“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 said in an interview.
The central bank hasn’t yet shown signs of winding down quantitative tightening. In March, Deputy Governor Toni Gravelle reiterated that the Bank of Canada expects to keep shrinking its balance sheet until sometime in 2025.
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