Will ending QE cause a taper tantrum?

When the economic support provided by the Bank of Canada’s quantitative easing (QE) program ends, will Canada experience a spike in bond yields and borrowing costs?

A report from CIBC Economics on Thursday provides evidence that it won’t.

As part of its pandemic response, the Bank of Canada (BoC) introduced a QE program, buying government bonds to support the market and provide monetary stimulus.

The program has coincided with a significant decline in Government of Canada (GoC) long-term bond yields. Yet, the BoC’s bond purchases “likely wield far less power than is currently being assigned to them by some observers,” the CIBC report said.

That could be considered a good thing, as QE may have to taper by mid-2021.

The BoC is on track to own about 40% of the GoC bond market by the end of 2021’s first quarter, the report said, and market dysfunction is a potential risk at 50% ownership.

A QE taper likely won’t lead to “severe” tightening of financial conditions, particularly if other larger central banks maintain their bond-purchasing volumes, the CIBC report argued.

That’s because longer-term GoC bond yields are heavily influenced by global factors and domestic developments that have little to do with supply and demand in the bond market, the report said.

For example, the report considered the term-premium component of the 10-year GoC bond yield. It noted that from January to March this year, the term premium fell by about the same magnitude as that of its U.S. counterpart.

“It can be reasoned that the decline in Canada was the result of a largely global phenomenon, particularly since the Bank of Canada didn’t announce its bond-buying program until almost the end of [March], with purchases beginning even later,” the report said.

“Moreover, such synchronous moves have been observed in the past when the Bank of Canada was inactive and not expected to make any changes in policy,” it added.

The report described the years following the 2008 financial crisis when the drop in term premium of the 10-year GoC bond yield was also similar to that of the 10-year U.S. Treasury — and that drop occurred despite an increasing supply of government bonds in Canada and no domestic QE program.

“Of course, during that time, the U.S. Federal Reserve was buying large volumes of Treasury securities and [mortgage-backed securities] to ease financial conditions in its battered economy,” the report said.

On the negative side, if Canada’s QE program is less powerful than many may assume, that also means the BoC can’t easily combat the effects of a rise in global term premiums, the report said.

So, Canada’s long-term bond yields will be largely influenced by decisions being made by other central banks, particularly the Federal Reserve.

“Fortunately, we see [the BoC] maintaining much of their current stimulus for some time,” the report said.

While a modest increase in long-term bond yields can be expected in 2021, “the Canadian economy will be healing and better able to absorb that type of blow,” it concluded.

For full details, read the report from CIBC Economics.