Canadian Dollar Could Benefit from BoC’s Balance Sheet Shrinkage

• BoC seen beginning QE unwind early in 2022
• Announcement could come as soon as March
• Holdings may shrink faster than BoE & Fed’s
• As 48% of portfolio to mature within 3 years
• Rolloff potentially lifts CA yields & helps CAD

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The Canadian Dollar could benefit in the near future from a possibly imminent bid by the Bank of Canada (BoC) to passively reverse the pandemic-inspired enlargement of its balance sheet, according to strategists at Credit Suisse.

Canada’s Dollar rose against the Japanese Yen and Swiss Franc during the week to Wednesday but was otherwise an underperformer within the G10 contingent of major currencies after the USD/CAD pair edged higher amid a softening of many other U.S. Dollar exchange rates.

The Loonie’s lethargic performance follows last Friday’s report of a larger-than-expected decline in employment and an earlier decision by the BoC to pass up a January opportunity to begin raising its cash rate, although some strategists say the Canadian Dollar is likely to find its feet again before long.

“Market focus on the BoC’s balance sheet reduction plans is likely to pick up in coming weeks. Due to the relatively short average maturity of its bond holdings, the BoC stands to have a much faster pace of balance sheet reduction than any other central bank in G10. We suspect this can add interest rate support for CAD,” says Alvise Marino, an FX strategist at Credit Suisse.

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Marino and colleagues have flagged the recent announcement of a planned February 16 speech by Deputy Governor Timothy Lane as an indication that the BoC could be about to begin reducing the size of its Canadian government bond portfolio, which would potentially have positive implications for Canadian Dollar exchange rates.

“The timing of the announcement is in our view quite interesting in the light of Governor Macklem’s comments, especially with markets pricing in rate hikes starting at the upcoming 2 March rate decision, with no pushback from officials so far,” Marino and colleagues wrote in a Tuesday note to clients.

“The BoC also has a history of preannouncing balance sheet policy decisions, as an example when it presented a roadmap to reducing QE in a speech by Deputy Governor Gravelle on 23 March 2021, before formally starting to taper asset purchases at the following rate decision,” they added.

The Bank of Canada bought up more than 40% of all Canadian government bonds on the market between when its first quantitative easing programme was announced in March 2020 and when it ended earlier than previously planned in October last year.

Source: Credit Suisse.

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The quantitative easing programme was announced the same month the BoC cut its cash rate from 1.75% to 0.25% and formed a key pillar of its effort to help companies and households survive economic closures and social distancing measures used in the attempted containment of the coronavirus.

But the bank has said frequently in recent months that its monetary support will likely be further withdrawn in the near future.

This would mean a potentially imminent pivot by the BoC to a process known as quantitative tightening, under which the BoC would cease the reinvestment of monies it receives each time an existing bond on its balance sheet reaches its maturity date.

Credit Suisse's strategists suspect this could be helpful for the Canadian Dollar because of the uplifting impact it would likely have on the yields of Canadian government bonds.

Above: CAD/USD shown at daily intervals alongside CAD/JPY.

“While we continue to target 1.25 in USDCAD in Q1, we now see less attractive risk-reward in selling EURCAD rallies in the light of the sharp turn in ECB policy at last week’s policy decision, and would rather express our bullish CAD views in the CADJPY cross, where we target November 2021 highs around 93,” Marino and colleagues say.

A part of the reason why Marino and the Credit Suisse team see quantitative tightening benefiting the Loonie is because of the large concentration of the BoC’s holdings in government bonds that have maturities of three years or less.

This means the bank’s balance sheet would be quick to shrink in the wake of any decision to cease reinvestments of matured assets. And much more so than is the case with the Federal Reserve and Bank of England.

“One possible key risk to our view is that the prospect of a much faster pace of balance sheet reduction in Canada might drive markets to see less need for aggressive policy rate hikes from the BoC. We acknowledge this risk, but for the time being we view it as less than pressing, as still high levels of inflation remain firmly in the spotlight,” Marino cautioned on Tuesday.