The Bank of Canada (BoC) has seen a lot of speculation about whether quantitative tightening (QT) may need to end before the central bank’s target levels. What’s driving that speculation is the upward pressure in 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,” said Toni Gravelle, BoC deputy governor, in published remarks.
“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,” he 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.
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 the target overnight rate and the benchmark overnight interest rate, which is calculated from transacted overnight repo rates. In addition to leveraged long positions, the “basis trade” that is common in the US Treasury market has recently become more popular in Canada.
“The pressures have already waned. That’s partly because upward pressure on overnight funding rates tends to attract new cash providers to supply repo funding to the market. Indeed, the recent launch of daily auctions to lend out a portion of excess cash that the government holds in deposits with us has helped push the overnight market rate closer to our target rate. The appeal of leveraged long bond positions that gave rise to upward pressure also appears to have waned, as market participants no longer expect that central banks will ease policy aggressively,” he said.