Canada’s central bank is still trying to reel in the mass liquidity injections it made in 2020. A new report from National Bank of Canada (NBF) explains they see quantitative tightening (QT) making progress in 2025. The Bank of Canada (BoC) policy reverses liquidity introduced during quantitative ease (QE) in 2020, and will raise borrowing costs as the credit supply shrinks. QT has been conducted for nearly 3 years now, but the drawdown of the Government of Canada (GoC) settlement accounts means the liquidity shrinkage will finally begin to “bite” in 2025, warns the bank.
What Is Quantitative Tightening?
Quantitative tightening (QT) is an unconventional monetary policy tool for tightening liquidity. It’s related to a term you’re likely familiar with—quantitative ease (QE). In fact, QT is the exact opposite of QE and used to reverse the liquidity injected by the central bank, especially in mortgage markets.
The central bank’s primary objective is inflation control, primarily via interest rates. When inflation is too low, they lower rates to stimulate borrowing & demand, hoping to intentionally overrun supply and raise inflation. When inflation is too high, they raise interest rates to slow borrowing and demand, helping to slow inflation. When rates are close to 0% and can’t be lowered much further, central banks have begun to use tools like QE.
To execute QE, the BoC competitively purchases bonds to drive prices higher, and yields lower. By essentially flooding the market with credit, they inflate the supply and drive costs lower. In Canada, it’s felt primarily in the 5-year Government of Canada bond yield, which influences 5-year fixed rate mortgages. The bonds are added to the BoC’s balance sheet, leading to balance sheet expansion. It’s the modern day equivalent of printing money, though the BoC hates when that term is used since there’s no printer. Money server goes brrr isn’t as catchy though.
Once the liquidity event is over, they need to use QT to reverse the QE liquidity. To shrink its balance sheet, the BoC will either sell the bonds it bought or let them “roll off,” which means mature without replacement. The reduced liquidity means higher borrowing costs, which slows borrowing without any changes to interest rates.
If a lack of liquidity was a fire, QE would be like a fire extinguisher—if used early on, it doesn’t burn your house down. QT is like refilling the fire extinguisher so you can fight the next fire.
All of those 5-year bonds bought during QE? It’s 2025, so they’re going to start rolling off soon. Where does the time go?!
Canada QT Progress Has Been Minor, But Expected To Pick Up Soon
Canada has gone through an epic QE binge, and it’s been struggling to reverse liquidity. The BoC balance sheet had $105 billion in assets at the start of 2020, surging 330% to ~$450 billion at its peak at the end of 2021. Since QT kicked off nearly 3 years ago, that amount has been halved (~$230 billion), but there’s still a long way to go. It hasn’t been discussed as upward pressure on rates yet, but that’s expected to change this year.
“QT is likely to run its course in 2025,” explains Taylor Schleich, an economist at NBF. Adding, “On one hand, if we are already at or near the steady state, we should see repo and receiver general auction usage climb higher as bond run-off drains liquidity further.”
In plain English, the BoC’s easing of liquidity will require more debt at market. That issue is further complicated by the drawdown of cash balances from the GoC’s settlement accounts. Any uncovered funding will have to seek public market debt, once again adding more demand when fewer investors are seeking to buy bonds.
“The government’s bank account is now back to its pre-COVID size so spending can’t come out of cash balances,” explains Schleich.
That’s a real doozie of a setup from Canada. The best-case scenario is the economy keeps humming along, and the cost of borrowing begins to rise for medium-term lending. The worst case is that rising unemployment and slowing GDP growth have already begun to appear, meaning the next round of stimulus may be needed before the normalization is complete. More bluntly, that fire extinguisher may not be refilled before it burns our house down.
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