Somewhat overlooked in last week’s interest-rate decision was the Bank of Canada’s declaration that once it begins raising rates, it will consider starting to reduce federal government bonds.CHRIS WATTIE/Reuters
The Bank of Canada’s maiden voyage into quantitative easing is coming to an end. Now we’re about to find out what the return trip – quantitative tightening – looks like.
Somewhat overlooked in last week’s interest-rate decision (summary: no rate hike, but the first of many is near-certain in March) was the central bank’s declaration that once it begins raising rates, it will consider starting to reduce the more than $400-billion in federal government bonds that it piled onto its balance sheet during the COVID-19 crisis.
The implication is that one of the boldest policy actions the Bank of Canada has ever taken could soon go into reverse – possibly at about the same time as interest rates start to climb out of their deepest valley on record.
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The Bank of Canada had never done a quantitative easing, or QE, program before, and it has never tried to exit one before. So, it’s hard to say just how big a deal that will be. We’re about to find out – if not in March, certainly in the following few months.
The bond buildup was the cornerstone of the bank’s first-ever QE program – an aggressive form of monetary stimulus in which a central bank buys market assets in order to press down on market interest rates. It started buying bonds at a rate of $5-billion a week early in the pandemic, first as a means to provide stability to extremely nervous financial markets, and later as a way to help keep borrowing costs dirt-cheap during the recovery from the severe recession caused by the pandemic, with the bank’s key interest rate already as low as the bank was willing to go (0.25 per cent).
The bank started gradually reducing its weekly purchases in October, 2020; by late last year, it had whittled its buying down to just enough to replace bonds that reached maturity, so that its holdings are neither growing nor shrinking. The next step is to stop replacing bonds as they expire – thus allowing the bond buildup to go into reverse.
It’s fair to assume that it will send some tremors through the bond market; after all, the Bank of Canada now owns about 43 per cent of the total supply of Government of Canada bonds. The fact that the slowdown in the central bank’s purchases has been gradual will probably make the adjustment easier. Nevertheless, the biggest buyer is poised to leave the market, in what should still be a pretty heavy year of government bond issuance. The absence of demand from the central bank should weigh on bond prices and, consequently, put upward pressure on yields – in other words, this will tend to push up market interest rates.
But based on the experience of the QE program, this upward push might not be much.
Ian Pollick, head of fixed-income, currency and commodities strategy at CIBC Capital Markets, has calculated that the entire QE program served to shave about 15 basis points – 15/100ths of a percentage point – off the benchmark 10-year government bond yield.
Given that the Bank of Canada has been gradually slowing its purchases for more than a year and put the program in neutral three months ago, it’s reasonable to say that some of that impact has already been removed. So we could assume that quantitative tightening, or QT, from this point might add something less than 10 basis points to market interest rates. By comparison, the Bank of Canada looks likely to increase its key policy rate (which is, officially, the target for the overnight lending rate) by at least 100 basis points over the next 12 months. QT will juice the Bank of Canada’s rate increases a bit, but it won’t be a game-changer.
Still, it’s notable that when the central bank began to reduce its bond purchases in the fall of 2020, it fine-tuned the program to focus its purchases on longer maturities, in order to ease borrowing costs in the part of the market where most consumer and business loans resides. So when the bank starts to allow its bond holdings to shrink, we can expect that the meatiest part of the lending market will feel the brunt of the upward pressure on rates, which could somewhat accentuate the impact.
All of which is to say that QT’s effects may not be huge, but they will add some weight to rising borrowing costs – and precisely how much added strain that will place on consumers, businesses and financial markets is hard to predict.
That’s probably why Bank of Canada Governor Tiff Macklem stressed in his news conference after the rate decision last Wednesday that he sees QT as a “supplement” to rate increases, which will serve as the bank’s primary tool as it tightens monetary policy.
That position suggests the bank will remain fairly cautious in reducing its balance sheet, which only makes sense. It has decades of experience with how rate hikes work their way through the economy and the financial system, but no experience with unwinding a QE program. It will want the uncertainties of balance-sheet reduction to take a back seat to the much more predictable forces of interest rates.
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