Bank of Canada warns bets tied to timing of rate cuts are boosting leverage in some markets
Bank of Canada officials are monitoring pockets of increasing leverage and “stretched” asset valuations that could pose a threat to financial stability in the event of major price swings, but see no signs that a repeat of the 2008 Financial Crisis is imminent.
The central bank’s annual report on stability across Canada’s financial system, released Thursday, flagged a steep increase in the use of leverage in Canadian bond and repo markets by hedge funds, which appeared to be driven by arbitrage strategies tied to the timing and quantum of interest rate cuts.
“We pointed it out … not necessarily with the intention of saying you should stop doing it because there’s some value in having a good futures market, you create liquidity in normal times,” senior deputy governor Carolyn Rogers said in interview. “But the action that we would hope would come out of us featuring it and talking about it is that these institutions run stress tests and make sure that their margins are big enough to account for large swings in price.”
The central bank’s Financial Stability Report said leverage obtained by asset managers through borrowing in the repo market increased by around 30 per cent in the past 12 months. The increase was largely driven by hedge funds and pension funds increasing their repo leverage by about 75 per cent and 14 per cent, respectively. For hedge funds, the spike appears to be related to relative-value trading strategies, including increasingly popular cash-futures basis trades in the Government of Canada bond market.
While providing liquidity in both futures and bond markets, “the large degree of leverage employed can leave hedge funds vulnerable to changes in the price difference between the underlying securities as
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