CIBC says Bank of Canada must end or fix quantitative tightening

financialpost.com:

The Bank of Canada needs to wrap up its quantitative tightening program or fix distortions in short-term funding markets that are keeping effective interest rates higher, according to Canadian Imperial Bank of Commerce strategists.

Canada’s central bank has been shrinking its balance sheet for more than two years, withdrawing the extraordinary stimulus it provided during the COVID-19 crisis. Assets have fallen to around $273 billion from a peak of more than $570 billion as officials have allowed the bonds on their books to mature without replacement, draining liquidity from the country’s financial system.

For Canada’s financial institutions, that means settlement balances — interest-bearing deposits used as a means of payment in Canada’s high-value payment system, called Lynx — are disappearing. Their scarcity has led to hoarding, CIBC’s Ian Pollick, Sarah Ying, and Arjun Ananth wrote in a report to investors on Wednesday.

During the pandemic, firms traded their bonds for settlement balances from the Bank of Canada amid quantitative easing. The balances are meant to be exchanged freely, but “too few counterparties own a disproportionately large amount of reserves,” the analysts say.

Since the end of February, nearly 80 per cent of the remaining settlement balances are held by just three of the country’s financial institutions, up from two-thirds last year, according to CIBC’s research.

That concentration is a big reason why short-term funding markets aren’t functioning efficiently, and it’s contributing to higher borrowing costs, even as the Bank of Canada has started cutting interest rates.

If left unchecked, the problem “has the potential to exaggerate weakness in aggregate demand” as interest rates effectively sit