The Bank of Canada expects to continue shrinking the size of its balance sheet until 2025, Deputy Governor Toni Gravelle said Thursday, pushing back on speculation that the bank would resume buying bonds in the coming months.
In a speech in Toronto, Mr. Gravelle said the bank intends to keep trimming its Government of Canada bond holdings, which ballooned during the early years of the pandemic. This process, known as quantitative tightening, or QT, involves letting the bonds it owns mature without replacing them.
In recent months, some Bay Street analysts had begun betting that the bank would end QT earlier than previously signalled, after overnight interest rates began drifting away from the bank’s target, suggesting a shortage of cash in parts of the financial system.
Mr. Gravelle poured cold water on this idea.
“The bottom line is the balance sheet normalization process is continuing as we laid out last year, and we have tools to manage any temporary funding pressures that might come up along the way,” he told the Bay Street audience.
QT is the inverse of the bank’s earlier quantitative-easing program, which saw it purchase more than $350-billion worth of federal government bonds in 2020 and 2021 to stimulate the economy when its main tool, the policy interest rate, couldn’t go lower.
Since the spring of 2022, the bank has been letting its bond holdings shrink. This reduces commercial-bank reserves held at the central bank – known as settlement balances – which were created to purchase the bonds in the first place. In effect, QT is pulling cash out of the financial system, bolstering the high interest rates that the central bank is using to combat inflation.
Mr. Gravelle said the bank intends to continue QT until the level of settlement balances is between $20-billion and $60-billion, down from the current level of around $100-billion
When QT does end – likely “some time in 2025″ – the bank will resume buying assets, although at a much slower pace than during the emergency phase of the pandemic.
Mr. Gravelle said the bank is still assessing what types of bonds and money-market instruments it will buy, and whether these purchases will be mostly in the primary or secondary market.
But early on, there will be a tilt toward buying shorter-term assets, such as treasury bills and term repos, he said.
“Currently, our asset portfolio is entirely bonds – a legacy of our pandemic response – and the maturity profile of these bonds skews longer than it did before the pandemic,” Mr. Gravelle said.
“After QT ends, we want to restore a more balanced mix of assets with a broader range of maturities, including more short-term assets than we hold now.”
Much of Mr. Gravelle’s speech was devoted to explaining the recent dislocation in overnight lending markets, called repo markets, which led to speculation about the impending end of QT.
Since the fall, the Canadian Overnight Repo Rate Average (CORRA), which captures ultra-short-term interest rates, has been trading consistently above the bank’s target of 5 per cent.
The gap was relatively small. But any drift from the bank’s target undercuts the efficacy of monetary policy.
In January, the bank intervened in repo markets several times, pumping billions of dollars of cash into the financial system to nudge overnight interest rates back toward its target. Then in February, it reintroduced daily auctions of excess government cash.
The market friction and the bank’s response led analysts to speculate that QT was growing long in the tooth and that settlement balances had fallen below the level demanded by market participants.
Mr. Gravelle pushed back on this notion. He said the drift higher in market interest rates was being driven by unusual bond-market dynamics, rather than an overall shortage of liquidity in the financial system.
“Our assessment is that the surge in demand for repo funding in Canada came from growing market expectations that interest rates are going to fall,” Mr. Gravelle said.
“Late in 2023, market participants around the world became increasingly convinced that major central banks would pivot to aggressive policy rate cuts this year. Because of this conviction, many participants in Canada and elsewhere took leveraged long positions in government bonds to get ahead of the expected shift in policy.”
He said these pressures have since waned, although he added that the bank will be watching for broader signs of market stress, which could indicate that settlement balances have fallen too far.
Ultimately, the decision about when to end QT is separate from questions about when the bank will lower interest rates, Mr. Gravelle said.
He said the bank will likely continue QT after it starts cutting interest rates – something many analysts expect to happen in the coming months. Although it could end sooner if the economy slows sharply.
“In that situation, we would probably be cutting rates quickly, likely into stimulative territory and, as such, we’d stop QT, at least temporarily,” he said.
Mark Rendell