PrefBlog

Some interesting remarks from BoC Deputy Governor Toni Gravelle:

Lately, though, we’ve all seen a lot of speculation about whether QT may need to end before we get to those levels. What’s driving that speculation is the upward pressure we saw in overnight repurchase agreement (repo) markets over an extended period, starting late in 2023 and continuing into the early part of this year. We don’t think the decline in settlement balances linked to our normalization process has been much of a factor behind that tightness in overnight markets. Nor do we see any signs of stress in the financial system that can be tied to those pressures.

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.10 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.

The more policy rates fall, the more those bonds will be worth. And the promise of big gains led many to borrow in repo markets to fund the trades. Starting in December 2023, high demand for repo funding caused a wider-than-usual spread between our target overnight rate and the benchmark overnight interest rate, which is calculated from transacted overnight repo rates (Chart 3).

In addition to leveraged long positions, the “basis trade” that is common in the US Treasury market has recently become more popular in Canada.

This is an arbitrage strategy used to exploit gaps between prices for government bonds and the futures that are tied to them.11 The basis trade also boosted demand for repo funding, particularly from the growing presence of active hedge funds in Canadian fixed-income markets (Chart 4).

When the pressures in repo markets became evident earlier this year, we used our routine policy implementation operations to reinforce our policy rate. This is something we’ve done for decades, whenever it was needed.

This entry was posted on Friday, March 22nd, 2024 at 8:33 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.