The Bank of Canada has expanded the size of its daily bond sale and repurchase program, making more securities available to dealers in an attempt to counteract the impact that its large ownership of Government of Canada bonds is having on short-term funding markets.
The Bank of Canada owns nearly 40 per cent of the federal government bond market as a result of its $4-billion-a-week bond-buying program, also known as quantitative easing, or QE. This is putting pressure on the “repo” market, a key funding market for financial institutions, where dealers swap bonds for cash on a short-term (often overnight) basis.
With more bonds on the central bank’s balance sheet, there are fewer available for private-sector institutions. That means more money chasing fewer bonds in the repo market, bidding up their price and causing the benchmark Canadian Overnight Repo Rate Average to trade below the central bank’s 0.25-per-cent target for overnight funding. Bonds are said to trade “on special” in the repo market when demand outstrips supply.
On Friday, the central bank adjusted its securities repo operations (SROs) to increase the availability of government bonds to financial market participants. These repo operations are similar to short-term securities lending: The bank sells bonds it holds on its balance sheet to dealers for the term of one business day, with a promise to repurchase the bonds the next day.
It said on Friday that it would make $2-billion worth of bonds and treasury bills available daily to each primary dealer, up from $1-billion.
“The SROs provide a temporary source of Government of Canada nominal bonds and treasury bills to primary dealers and the increase in size announced today will help support liquidity in the securities financing market,” the bank said in a market notice.
The bank launched the program last summer to help mitigate the impact of QE on market functioning. This is the second adjustment it has made to the program this year.
“The reason they did this was that the shortest of interest rates, the overnight repo rate, has been disconnected from the policy rate,” Ian Pollick, global head of fixed income, currency and commodities strategy at CIBC Capital Markets, wrote in an e-mail.
“That is because the BoC’s footprint is so large, it is causing more bonds to go on special in repo and thus driving down rates. The move today is an important step in normalizing that. But, until we get a taper, this is an issue that will continue to show up again and again,” he said.
The discussion around “tapering” – slowing the central bank’s weekly purchases of federal government bonds – often focuses on “macro” questions: Is the bank providing too much or too little stimulus to the economy? The bank is buying government bonds to force their yields down, which suppresses borrowing costs across the economy. (Bond prices and yields move in opposite directions.) If the economy is heating up faster than expected, the argument goes, the central bank can slow its pace of bond buying and let rates move higher.
At the same time, the tapering discussion is also about market functioning. Economists are increasingly calling on the bank to slow its pace of bond buying to ensure it does not end up owning too much of the market, which could negatively affect market liquidity and price discovery.
Bank of Canada Governor Tiff Macklem has said the bank can own between 50 per cent and 70 per cent of the Government of Canada bond market before impairing market functioning.
Analysts are currently split on whether the bank will begin tapering its QE program in April or June. The bank could slow its pace of bond buying for technical reasons, while still providing as much stimulus. This would mean buying fewer bonds each week but targeting more longer-dated bonds. The bank did this in October when it “recalibrated” its QE purchases to buy $4-billion worth of bonds each week instead of $5-billion.
The technical argument for buying fewer bonds each week is bolstered by the fact that the federal government will be issuing fewer bonds going forward as the pandemic support programs wind down. If the central bank doesn’t adjust its purchases in the coming months, it could soon end up owning over 50 per cent of the market.
“We’ve been anticipating the BoC will taper QE in April for some time. That argument has been largely technical, as [government bond] issuance is likely to fall precipitously in the coming budget,” Benjamin Reitzes, director of Canadian rates and macro strategist at BMO Capital Markets, wrote in a note on Friday.
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