MNI INTERVIEW: BOC May Hold QE Bonds and Claim No Loss-CD Howe

The Bank of Canada will likely hold bonds purchased via quantitative easing just as the Fed did after the 2008 recession, meaning no losses will be claimed under the indemnity deal struck with the government last year, former BOC analyst and associate research director at C.D. Howe Institute Jeremy Kronick told MNI.

The long road back to normal monetary policy will first involve slowing down or ending federal bond purchases now at CAD3 billion a week, and then raising interest rates, he said. Active sales of bonds back into the market during the rebound seems too aggressive, he said, and policy makers will likely be able to skip that measure and still meet their 2% inflation target.

"Let's take the Fed after 2008, they kept an elevated balance sheet for a dozen years and still have one," he said. "The Bank would turn to the overnight rate first before they actually look to sell off the assets," and that decision would be "more complicated," he said.

The indemnity has been a little-noticed feature of bond purchases the BOC and other central banks began last spring, and the agreement would pay the BOC for any losses from future sales unwinding those programs, while remitting any profits to the government. With bond yields rising and prices falling in recent months as investors bet on an economic rebound, the BOC's weekly balance sheet reporting is now showing consistent potential losses.

Paper losses were first recorded in early November at CAD31 million and were less than CAD1 billion until mid-January. They rose steadily to a peak of CAD8.6 billion in mid-March and have never been less than CAD7 billion since then. Interest payments are excluded from the calculations, and the indemnity is listed as a derivative contract on the balance sheet because the value of any payment fluctuates along with market prices.

"Government indemnification against losses provides additional assurance that our use of these programs will remain closely tied to the Bank's inflation control objective and is a common approach taken by other jurisdictions for these types of central bank programs," BOC spokeswoman Rebecca Spence said in an emailed response to questions. The finance department didn't immediately respond to a request for comment.

If interest rates continue to climb from historic lows through the economic recovery, the value of the paper losses between the original purchase price and the future market price could increase, though it's difficult to estimate how exactly that will evolve.

The indemnities are still just a fraction of balance sheet assets that peaked at CAD575 billion in March. The first entries under the derivatives accounting showed up in July, when market yields were still falling, as potential profits of less than CAD1 billion.

While other programs to buy corporate and provincial bonds during last year's trading squeeze have been phased out, purchases of federal bonds now styled as QE to support the economy continue. The pace has been tapered twice from the original CAD5 billon.

The BOC has signaled there's no sudden bond selloff coming that could trigger the indemnity. The central bank has said it intends to hold its provincial government and corporate bonds to maturity, and policy makers have said further QE moves will be gradual and transparent. Deputy Governor Toni Gravelle signaled in a March 23 speech the BOC could in future stabilize the size of the balance sheet and reinvest the proceeds of maturing assets.

Policy makers haven't exactly been going as fast as they could to get out of QE so far given how the economic recovery is taking hold, Kronick said. While some investors see further tapering steps of CAD1 billion that would halt net purchases by perhaps January at the earliest, Kronick said they could get zero before the end of this year.

One of the opposition Conservative Party's economic spokesmen also wants the BOC to get away from buying federal bonds, pointing to losses as yields rise and for potentially underwriting government deficits. Governor Tiff Macklem has said those ideas are misguided, and Kronick largely agreed.

"This is temporary, the second the Bank stops doing this, the government is not going to stop being in deficit or debt," Kronick said, though he did say the indemnity adds extra complexity that may raise questions. "There certainly are side effects to QE, and one of them is this."