Powell’s December Pivot
We all remember it — stocks surged and “7 interest rates cuts were coming soon, hikes are over”.
At least, that was the prevailing sentiment in December 2023, after Jerome Powell’s FOMC statement that “the Fed believes interest rates are at or near their peak in this cycle”; it also didn’t help that he added 25 bps to the dot-plot of anticipated 2024 cuts.
Hedge Funds Bet Big That Interest Rates Were Going to Fall
This unbridled euphoria reached across the border into Canada, with hedge funds and retail traders in Canada (yellow line below) going from being net providers of liquidity, to borrowing billions of dollars to try and make money from falling bond yields.
Bank of Canada data suggests hedge funds used both leveraged positions and “basis trades” to try and capitalize on falling interest rates. (a basis trade is a complex arbitrage strategy used to exploit gaps between prices for government bonds and the futures that are tied to them)
The result? CORRA (green), which is actual market interest rates, started to uncouple from the Bank of Canada’s overnight target of 5%.
They Borrowed So Much, Canada Almost “Ran Out” of Cash
This sudden surge of borrowing put so much pressure on the banking system that the Bank of Canada was forced to intervene.
In early January, they performed overnight repo operations in order to supply enough liquidity to ensure that its interest rate target (CORRA) didn’t keep creeping above 5%.
In short: There was a shortage of cash, and interest rates couldn’t be contained without intervention.
Bank Makes it Clear the Risk is Gone, For Now
This week, Deputy Governor Gravelle stated that he feels the liquidity risk has now subsided as speculators no longer see an interest rate collapse as imminent. He also insisted that Bank of Canada will continue Quantitative Tightening, and reiterated that the two issues were not connected.
“The appeal of leveraged long bond positions that gave rise to upward pressure also appears to have waned, as market participants no longer expect that central banks will ease policy aggressively.”
Most Who Took These Positions Lost Money
Unfortunetly, the market isn’t that easy; Powell doesn’t know where inflation is headed, either.
Anyone who bought long bonds in January, especially with leverage, has likely lost money. Long bonds have since sold off, and yields are up 25 to 40 bps on both sides of border. Oopsie!
