The Bank of Canada yesterday had a more interesting than usual rate announcement:
The Bank is ending quantitative easing (QE) and moving into the reinvestment phase, during which it will purchase Government of Canada bonds solely to replace maturing bonds.
The headline is “ends quantitative easing”, but in reality, this is a reduction from $2 billion per week to $1.3 billion per week, which is enough to keep its $425 billion load of government treasury bonds level (the average duration of the Bank of Canada’s portfolio is 6.2 years, with most of it front-loaded in the first five years).
The picture painted (in the Monetary Policy Report) is projecting a restoration in the next couple years, but I believe such forecasts are going to prove misguided in that they are too optimistic. I do not want to provide much evidence to this claim here, however.
The Bank of Canada is trying to slow down the liquidity party without crashing the asset markets. This is going to be very interesting. In Canada, the big number to watch out for are the reserve levels of the banks that the BoC has bought the government debt from – this is the feedstock for the creation of currency, and there is still a lot left in there.
If history is true to form, things will appear to proceed until monetary conditions start choking and that’s when you’ll see the onset of further monetary policy induced volatility (which will then trigger another round of QE). We’re a bit of a ways from this point, however. The BAX futures are predicting quite a few interest rate hikes by the end of 2022.
A word of caution – any of your investments relying on this excess liquidity, be very careful.
There are two options here. The Bank can choke off the excess reserves by unwinding the expansion of the balance sheet. Or the Bank can start paying substantial interest on reserves.
In 2009, the Fed started paying interest on reserves. This allowed them to move to an excess-reserves system. Even when interest rates started to climb in the recovery, American banks still had gargantuan amounts of excess reserves on the balance sheet, because the Fed was raising rates not by forcing rates higher through tightening money supply and forcing the price up, but by paying higher rates on the balances held by banks. https://fred.stlouisfed.org/series/TOTRESNS
Interest on reserves allows, in some sense, the central bank to sterilize this cash. “We want the banks to hold lots of cash for safety. But we don’t want it all to spill out when we raise rates, so we’re going to pay the banks to hold the cash on their balance sheets”.
Right now, Canadian banks are sitting on close to 300 billion in reserves that the Bank of Canada is paying 0.25% on. That’s the force keeping the policy rate at 0.25%. Otherwise it’d be lower. You can see there’s no actual action in the “market for overnight funds – all the activity numbers are at 0. https://www.bankofcanada.ca/rates/indicators/market-operations-indicators/
After all, there’s no point for the banks to borrow from each other. They all have tons of surplus cash. The surplus cash is parked at the Bank. But Canada has never paid meaningful interest on reserve deposits. Pre-covid, the Canadian system didn’t operate on an excess-interest-paying-reserves model, so the policy rate was actually determined in a functioning market. Okay, fine, if you look up the overnight rate, you’ll see a few fluctuations, but nothing meaningful. I guess some participants can’t use Lynx? Not sure.
The Bank will probably start raising rates by embracing the US model – keeping the liquidity on the balance sheets, and paying the commercial banks to keep it there. It’s not super material, but that implies each percentage point in higher rates translates to about a $3bn a year increase to bank earnings just from this channel.
They could shrink the balance sheet as well, but I think they’re more leery of doing that directly. I understand that money gets tight if you just unwind all the asset purchases and move back to a scarce-reserves regime, but it’s harder to get a feel for what “monetary tightness” is when the liquidity doesn’t dry up directly, but the banks are just paid to keep it as is.
This is a very, very insightful comment Andrew. Thank you for writing it. BAX March 2023 is -158bps from present levels and will nearly flatten the yield curve if it actually happens (and all other things being equal, which one surmises will not happen).