ANALYSIS-Yield targets could help reduce Bank of Canada's bond market footprint

TORONTO, Sept 16 (Reuters) - Setting a target for bond yields could help the Bank of Canada reduce the amount of debt it buys to keep interest rates low, checking a threat to market liquidity after the central bank's share of bonds more than doubled this year, strategists said.

Canada's central bank launched its first large-scale asset purchase program in April, committing to buy C$5 billion ($3.8 billion) of government bonds per week to support the economy after it was hammered by the coronavirus pandemic.

Last week, the BoC opened the door to adjusting the program, which helps lower borrowing costs but could cause some dysfunction for the market as the central bank's bond holdings climb.

The BoC's stake of bonds outstanding has increased to about 30% from 14% at the start of the year, including purchases at auction, data from the Bank of Canada shows. That is higher than the roughly 20% share of the much larger market for U.S. Treasury notes and bonds held by the Federal Reserve.

The BoC is "accumulating too large a slice of the Canadian bond market," said Ian Pollick, global head of FICC strategy at CIBC Capital Markets, adding that the growing share could impair market liquidity and reduce the signal bond yields send about the strength of the economy.

'CREDIBLE THREAT'

One solution could be yield curve control, under which central banks set a target rate for a chosen term on the yield curve and pledge to buy enough bonds to stop the rate from rising above target. For a credible central bank, like the Bank of Canada, the amount of purchases to enforce the target may not be very much.

"A 'cheaper' way for the central bank to respond is to provide a credible threat to have infinite demand for bonds without actually purchasing any," Pollick said.

The Fed has been skeptical about the benefit of yield curve control with yields already trading near record lows. But that may not stop Canada's central bank.

"I wouldn't rule out the possibility that the BoC embraces a formal target even if the Fed isn't there yet and in the absence of immediate market pressure upon yields," said Derek Holt, vice president of capital markets economics at Scotiabank.

In July, Bank of Canada Governor Tiff Macklem said yield curve control had been discussed by policymakers.

Still, without the Fed's participation it may be difficult for the BoC to target the rate on longer-term bonds, which are financing much of Ottawa's record budget deficit.

It is more likely to target a shorter term, such as the 5-year rate, Holt said. The majority of Canadian mortgages are set over a five-year term, so that part of the curve is particularly influential for the economy.

A stronger-than-expected economic reopening in Canada may have reduced the urgency for additional easing, but the BoC is expecting a "recuperation phase" that is more challenging.

"If there is a next step for the BoC, I think that (yield curve control) is the most likely candidate," said Andrew Kelvin, chief Canada strategist at TD Securities. "A credible yield curve control regime can be a more effective way to anchor longer-term yields."

($1 = 1.3179 Canadian dollars) (Reporting by Fergal Smith Editing by Denny Thomas and Paul Simao)

09/16/2020 13:03

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