Short-term credit market functioning and projected policy

This op-ed was provided by the Investment Industry Association of Canada (IIAC).

Short-term credit market functioning in Canada was at significant risk in the early stages of the COVID-19 Pandemic. Markets began to unravel quickly as many institutions rushed to access credit and funding lines at the same time. Material financial damage was prevented through aggressive intervention by the Bank of Canada and other central banks, and market functioning has generally remained robust.  

In late March 2020, the 3-month commercial paper/overnight index swap (CP/OIS) spread and the 3-month Canadian dollar offered rate/overnight index swap (CDOR/OIS) spread began to widen exponentially reflecting a material tightening of credit conditions at that time. Widening spreads not only risked creating material cost increases to short term credit borrowers, but there was also the concern that credit in general would become hard to readily access, or worse, unavailable to some firms. The Bank of Canada supported the short-term credit markets through various programs such as the Bankers’ Acceptance Purchase Facility, the Commercial Paper Purchase Program, and the Provincial Money Market Purchase Program. In addition, the Bank of Canada increased the amount of Government of Canada treasury bills acquired at auction. It also announced amendments to the Standing Term Liquidity Facility and assertively cut interest rates. As a result of these actions, the CDOR/OIS spread has remained fairly well behaved since the initial spike from 25 basis points to 1.30 basis points in March.  

As the short-term credit market returned to near normal operation in recent months, several emergency credit facilities have ended. Notwithstanding, there has been clear communication that programs can be re-introduced quickly, if conditions deteriorate again.  

The Bank of Canada still operates the Standing Term Liquidity Facility which provides loans to eligible financial institutions in need of temporary liquidity support. On October 27, 2021, the Bank announced that it is ending its Government of Canada Bond Purchase Program, so-called quantitative easing (QE). Ending QE is significant, especially considering that the U.S. Federal Reserve has yet to initiate tapering of its own QE program.  

There have been unforeseen consequences of forceful policy action. These include a historically high level of excess settlement balances that have kept downward pressure on repo and other short-term rates, and large QE purchases of Government of Canada bonds which have resulted in a very large percentage (approx. 40%) of outstanding Government of Canada bonds to reside on the Bank of Canada’s balance sheet. There have been efforts to mitigate these effects with some success, including Securities Repo Operations that makes up to $2 billion in bonds held by the Bank of Canada available to each primary dealer.  

A look back at Canada’s response to the market events of spring 2020, and the months that followed, reveals several important outcomes and lessons.  

First, the robust return of liquidity in short-term and overall credit markets that occurred after a significant credit event in April 2020, is testament to the effectiveness of actions undertaken by the Bank of Canada, federal and provincial governments, and regulators.  

Second, certain sectors of the economy have benefitted from low administered rates, liquidity provisions and stimulus, particularly housing and equity markets. How far these sectors can run without an improvement in underlying economic fundamentals remains to be seen. 

The question on the minds of many Canadians, is how long will Canada’s central bank wait before it begins to raise the overnight rate? The bond market is signalling that inflation pressures may not to be transitory and rates my increase sooner and more aggressively than many expect. 

Todd Evans is a Managing Director with the Investment Industry Association of Canada (IIAC).