Bank of Canada backs off as credit tensions ease

By Louise Egan

OTTAWA (Reuters) - Tensions in Canada's money markets have eased enough to prompt the Bank of Canada to suspend operations to get short-term lending back on track, but analysts say it's too early to declare an end to the credit crunch.

The central bank said on Tuesday it would sell back C$1 billion ($980 million) worth of securities it bought on the market on June 10 instead of rolling them over, citing an improvement in bank funding costs.

This was the second time it has decided to conclude a transaction of this sort, known as a PRA, and it marks the withdrawal of all of the bank's extraordinary help to once-stressed markets.

"The credit crunch came a little bit sooner to Canada than it did elsewhere and it seems to be going away sooner as well," said David Wolf, chief economist and strategist at Merrill Lynch Canada.

"The Bank of Canada is, as far as I know, the first of the G7 central banks that is in the process of unwinding its extraordinary liquidity measures," he said.

The news came on the same day that the U.S. Federal Reserve said it might keep open a lifeline to big financial firms past year-end, a sign that credit conditions in the United States are not recovering the same way they are in Canada.

The funding indicator closely watched by the Bank of Canada -- the spread between the three-month CDOR (a benchmark for bankers' acceptance notes) and the overnight index swaps -- was 29 basis points on Tuesday, the lowest level since early August 2007, but not quite at pre-crisis levels of 11 or 12 basis points. At the end of last year, that spread was 79 basis points.

"It's something that's somewhat unique to Canada. That's certainly why the bank has ceased the operations," said Mark Chandler, fixed income strategist at RBC Capital Markets.

Shortly after the global credit turmoil erupted last August, the Canadian central bank began helping banks meet their funding requirements by injecting cash into the overnight market only. The frequency of those operations began winding down earlier this year and the bank has not provided liquidity in that market since June 12.

Then in December, in coordination with other central banks, the Bank of Canada said it would also provide funding for term markets via 28-day PRAs. Those too will end this month, as announced on Tuesday.

But the bank didn't rule out further action to help markets if necessary.

"The case for any further operations will be reviewed in light of conditions in financial markets," it said in a statement.

There is still a risk that turmoil in other financial markets will spill over into Canada, analysts said.

"There is such a strong interlinkage between the financial systems around the world that you certainly can't say we're completely out of the woods," Chandler said.

Avery Shenfeld of CIBC World Markets argued that people involved in longer-term funding are still feeling the squeeze from tighter credit conditions.