A hike too far?

Ian Pollick: Even Kashkari, who’s the dovish dive dive of all time, is still talking about seven hikes this year. So I think to your point, that is symbolic of a central bank that’s behind the curve. So this is a very special episode. This is actually our 50th episode. Mr. Grantham, how are you doing?

Andrew Grantham: I’m doing good, thanks. More importantly, how are you doing?

Ian Pollick: I’m feeling better. You know, we’ve been out of commission for a little bit. I’ve been running away from it from two years. But I did catch COVID. It’s a nasty, nasty virus. I hope everyone out there is fine and safe and healthy. But let’s jump into it because dude, we have a lot to talk about. Obviously, we had monthly GDP yesterday. Let’s kick off with some of the growth numbers. January numbers looked pretty consistent with what we were thinking. The February estimate, the flash estimate was massive at 0.8. And correct me if I’m wrong, but does this not start tracking Q GDP? That’s close to 4%. What are you thinking?

Andrew Grantham: It does, absolutely. And let’s just rewind back even before we had that advance estimate for January, because, you know, at the start of the year, we were really expecting, as a lot of people were very little growth or no growth at all in Q1. People were expecting a decline in January. They were expecting a rebound in February. But coming off kind of a low base for January. So, you know, relative to where we were at the start of the year, January is still the big surprise, the fact that we, you know, had all those restrictions, yet we still managed to eke out growth of 0.2%. It is pretty impressive. But then to get on top of that, you know, the reopening in the service sectors, continued strength in wholesale and some other areas driving that 0.8. You know, you’re absolutely right. About 4% is where we’re tracking now for Q1 isn’t just above where we were expecting at the start.

Ian Pollick: Where the bank was.

Andrew Grantham: Year, but exactly 2%, they were at 2%. So it’s about double where they were at. You know, the one thing I would say and we’ve talked about this before when it came to Q4 from the banks point of view, is that where there’s two things? Firstly, you know, you look at the details of January, February, wholesaling was a big driver and that suggests that it was supply chains, easing bottlenecks, ease in, which drove at least some of the growth. And also when we think back to when the bank hiked for the first time in earlier in March, you know, they did suggest at the time that Q1 was looking a little more solid, I think is how they put it.

Ian Pollick: They’re very good at their very short run forecasts. So, you know, whenever we see something like that, we always have to pay attention. But let me ask you this. Like, what is your expectation for inventories? Because we’ve seen the inventory swing being a very big factor in the quarterly growth numbers and the expenditure data. You know, we see a lot of wholesaling, but is this going straight into inventories? Does that mean inventories aren’t being whittled down? Like could we be surprised is my point.

Andrew Grantham: I think we will see when we get the expenditure breakdown. That inventory in was a fairly significant part of growth again in Q1. And, you know, not to belittle that that’s that’s needed, but you know, from a bank’s point of view, if it wasn’t so much demand driven, but a replenishing of inventory, that should be looking forwards. And obviously a lot has happened, you know, already over the last month since February. That should be somewhat good news from a a growth versus inflation point of view. Yeah, but what we’re still on the topic of the GDP figures as economists, the numbers come out, we spend like an hour and a half looking through them, you know, revising our growth forecasts upwards in this respect. And I looked at the market reaction after I’d finished that, and there seemed to be very little. So even these numbers which which seem pretty positive, you know, a market is reacting anymore to to these GDP numbers. Is it just a case of inflation and maybe the unemployment rate that markets are reacting to?

Ian Pollick: It’s a good question.

Andrew Grantham: The other thing I was going to suggest was, you know, are we in a position now where, you know, there’s so much priced in already that maybe the markets are more susceptible to to bad news than good news?

Ian Pollick: So it’s interesting, right? Because I would say without a shadow of a doubt, there’s been a very low sensitivity between the rates market and non inflation, non labour market data. And I think that makes sense. Right. You are talking about both sides of the mandate in Canada, in the US. So I had thought that given the potential for an upside flash estimate coupled with the speech that we had from Sharan Kosinski last Friday, that a really good number that puts growth anywhere near where it now looks like it’s going to be would have a much larger impact on the market. I think what’s it’s offsetting that to a degree is just like you said, there is so much priced into the market right now and we’ll talk about it in a second. But you know, what I want to talk about is this idea of what the Bank of Canada discussed last week, where they used the word forceful and they talked about this forceful response to inflation. When I think of forceful, I think of something as being deliberate. And I think of a 25 basis point hike and quantitative tightening as being forceful. But we are getting the 50 basis point narrative. My question to you is, given the growth numbers that we saw today, does that change your definition of what forceful is in the context of policy?

Andrew Grantham: You know, that’s that’s a great question. And, you know, obviously, we’re. We’ve been debating this internally. You’ve been part of those debates and we haven’t come to a firm conclusion yet. The things that I would mention is that really when it comes to raising interest rates, you know, it’s very much the level that you eventually get to rather than necessarily the path there, which is more important for how the economy reacts to that. So, you know, whether we get four, 25 basis points hikes in a row or two fifties only really for those people with line of credits and that sort of thing paying a little bit more interest, you know, over over a couple of months, there isn’t much difference when it comes to the economic impact. The one thing that I would suggest that the bank may be a little bit cautious of, and we come back to this point about what’s already priced in, given where the five year bond yield is at the moment and what that means for mortgage rates. I would be very worried if I was at the bank to overdeliver relative to what people may think. So, you know, yes, maybe they will take 50 basis points in April. I definitely would not want to be doing two or three in a row, because then you start to have, you know, those longer term rates, those mortgage rates move up even further. And we saw we are now at levels that we were in 2018 when there was a definite slowing in the housing market and the economy in general. So, you know, that’s our current thinking at the moment, really. It’s the level that is more important. And, you know, as we’ve discussed on this call before, when it comes to the level that we see interest rates peaking at, and my colleagues just put out something on the neutral rate just at the start of this week, really the Fed versus the Bank of Canada. The fact that GDP recovery is still even after today’s figures, much more advanced in the US, inflation is higher in the US, wage growth is stronger in the US. That does seem to be a greater kind of narrative for the Fed may be going above neutral with its interest rates rather than the Bank of Canada.

Ian Pollick: So that’s what I was going to say. That’s what I wanted to ask about, because I think ultimately, I think you and I differ a little bit in the sense that I think you think that the pace matters a little bit more than I do. And from the perspective of the economy, I would say, yeah, maybe it does. Because if you look at what’s priced at the limit, you say, well, what does that mean for prime? You know, the market has a terminal rate that’s quite high. Call it three and a quarter for the Bank of Canada. That puts prime at five and one half percent before any increase relative to that. These are very big numbers, but I tend to think of from a market perspective, the pace doesn’t matter all that much to me outside of what it means for a one year rate, outside of what it means for the shape of the meeting gap curve. Because we are of the view as a firm that if you were to do more by adding let’s say a non standard sized hike to the profile that we are taking out additional hikes from 2023 because we as a firm do not believe that the neutral rate is as high as the market expects it is. And I think that’s a really important narrative, right? That is, I think, what central banks need to start communicating to markets is that maybe in a market like the US, like you just said, sure, maybe short run terminal is above long run neutral. But for all of our listeners right now, why would that not be the case in Canada? Is that just because of the location of where our household sector borrows from, i.e. five years and under versus 30 years and over in the US? Is it just that simple?

Andrew Grantham: Well, there is that increased sensitivity to interest rates in that earlier sensitivity. The effective rate here in Canada just moves that much more quickly that when interest rates move than it does in the US. But the other things I would mention as well is that the US again after even after today’s strong GDP numbers, we are in February this year relative to pre-pandemic February 2020, you know, our monthly GDP is 1.2% higher. So, you know, that’s higher than the level, but certainly not back to the trend we were on before the pandemic. Whereas the US is much closer to that full recovery and the US is seeing increased inflation relative to US, increased wage growth relative to us. So I do think that there’s a stronger case if anybody is behind the curve, if any central bank.

Ian Pollick: It’s the Fed.

Andrew Grantham: Needs to take. Yeah, it needs to take terminal above neutral. It’s the Federal Reserve, not the Bank of Canada.

Ian Pollick: Oh, it’s interesting. And I think from the paper that you cited earlier that our friends in economics put out, to me, the most important point of that was that you can’t look at the momentum in inflation and try to calibrate that to what policy should be doing because you have had recession start even as CPI continues to rise. All right. So and I think central bankers get that.

Andrew Grantham: Yeah. I mean, we put out that paper. Central bankers are not robots. I think that was the title of it. Right. So if they do see some signs that inflation starting to ease, the economy is starting to slow down. It may be a bit earlier than they currently anticipate. Then they will stop. They will pause. They will see how it goes. They are not going to just keep on hiking. And because of the sensitivity of households to interest rates, because the effective rate does move quicker in Canada versus the US, maybe those signs of slow income a little bit earlier in the Canadian economy than they do in the US. Now we’ve talked a lot now about what’s priced in the fact we don’t agree with that necessarily, particularly for Canada. But maybe you could just shed some light for me because I’ve been away for a couple of weeks. You know how we got here in terms of market pricing and where you think any kind of opportunities are kind of in terms of where yields are at the moment?

Ian Pollick: Well, I would say that you’re not allowed to go away anymore, because literally every time you go away, something happens. You know, I think it’s easy to understand how we got here. And it’s really just the narrative from the central banks. The Fed has continued to talk relatively hawkish. Even Kashkari, who’s the dovish dive dive of all time, is still talking about seven hikes this year. So I think to your point, that is symbolic of a central bank that’s behind the curve for Canada. We’re obviously just getting moved along. But you did have that really important speech from Deputy Governor Kozinski, and it was the first time that the markets have heard from her. And boy, did she make her mark on the markets by talking about how forceful they need to be. Then you get up with this relatively strong GDP number. I think that ultimately the problem with the market right now, the problem with fading something that you may or may not believe in is that it’s quite likely that at least in the US that the Fed is going to match the forwards over the next couple of meetings and therefore it becomes a situation where even if you don’t believe in the pace that’s being priced into the market, there’s not much repricing that is likely from the policy narrative alone because central banks are going to do what they said they’re going to do and they’re gonna do what the markets think they’re going to do, at least for the next couple of meetings, where I think the big opportunities are, is in this idea that you have to draw a line in the sand, at least in a market like Canada. Number one, do you believe the narrative that short run terminal is above long run neutral? If you do not believe that like we do, then you have to have an assessment of where you think the terminal rate is. And if it doesn’t go above where neutral is, then a really important gauge is going to be in the MPR in a couple of weeks where they talk about their new update on the neutral rate. When I look at some of the longer dated forward rates in Canada, whether it’s ten year, ten year, whether it is kind of 20 or ten year, they are all around three and a quarter. These are very big numbers that historically over time have proved to be a ceiling, not a floor. And therefore, I think there’s a lot of opportunity for the market to receive some of these rates versus the US, for example. I think in general though, if we’re talking about the shape of the curve, we are about to get a lot of information next week in the Federal Budget about bond issuance. I still think people don’t understand how large of an issuance profile is about to be introduced and we’re about two weeks away from quantitative tightening. So when I look at the shape of our tens thirties curve, we’ve talked about this before. I do think there’s a relative opportunity relative to STEEPENED versus the US just because I think there’s a lot of weakness that needs to be injected into the 30 year sector. And then if I look at some of these short term interest rates, you look at one year, one year, that’s above 3%. And if I look at just the carry that is offered to me by putting on, for example, a 2/10 steeper, I can lock in repo today, put on a steeper, I can make 25 basis points a quarter. So I think the maths now becomes what is the sensitivity of the curve to a non standard sized hike. If you don’t believe it’s all that large then you have a very big degree of buffering that you could have a steeper on and that’s a really good telltale risk hedge. Just really quickly before we talk about the federal budget and some other things, because I think it’s worthwhile just digesting some of your points on it. I know that you’re working on a really interesting paper right now about the labour market and obviously Canada’s labour market. We have our report next week, not not this week or a week delayed from the Fed. You just shed a little bit of light on what you found, in particular what you’re doing some work on NAIRU.

Andrew Grantham: Yeah, So I mean, we started doing this work because we have reached a level five and a half percent, probably likely to go lower next week. That is near historic lows in terms of the national unemployment rate. And so it is very tempting to say that we are now lower in terms of the unemployment rate than NAIRU and that we would need to maybe be tighten in the economy enough to slow the economy down. When we think about a lot of that is based on just comparisons between where we are now and where we were before the pandemic. Right. And that’s the easiest that’s the most kind of or was the most relevant comparison up until well, up until when we passed the pre-pandemic levels just recently. But when we think about where the economy was before the pandemic and if we think about because I do the provincial forecasts as well for the economics team when we think about different provinces. It’s a lot easier to think of areas of the country that definitely were not at full employment than areas of the country that definitely were through full employment before the pandemic struck. So Alberta, Saskatchewan, the oil producers, they had unemployment rates that were still fairly elevated. Other parts of the country still had unemployment, had unemployment rates that were quite low, but probably not low enough to generate wage inflation. And really only Quebec was the province that was seeing that wage inflation. So, you know, our thinking is that, yes, we are very low in terms of the unemployment rate. Yes, the labour market is tightening. We’re starting to see some pickup in wage inflation. But consistent with our message that we don’t necessarily need interest rates above where we think the neutral rate is, we think that maybe we haven’t quite reached Naru yet. We haven’t quite reached full employment in terms of that unemployment rate, but that’s something we’re still working through at the moment.

Ian Pollick: Ok, And I mean I look forward to the paper. It’s obviously pretty interesting. And you know, it’s funny because not a lot of people talk about neighbouring Canada. In fact the only person that’s really estimated neighbour from the Bank of Canada was actually Stephen Poloz in the eighties and it was a ridiculously high number too and we have never seen any formal Naru research come out after that. Let me ask you this. Federal budget, it’s coming up April 7th. The question that I think is on everyone’s mind is when the fall economic statement was introduced late December, that was largely before the move in commodity prices. So to what extent are higher commodity prices feed through to higher tax revenues? And is that enough by itself to take the deficit lower, or can we expect some offsetting spending?

Andrew Grantham: It would it would take the deficit lower, not just the fact that we’ve got higher commodity prices, but just the growth in general has been fairly solid, both in terms of real GDP and nominal GDP recently. That suggests, as we’ve seen from some of the provincial budgets over the last month or so, that revenues are indeed or will indeed be even stronger than they were in that mid-year update. But I think you’re absolutely right that any kind of lower deficit that we see for outgoing 21, 22, because of those higher revenues may be offset. You know, at least when we look forward to 20 to 23 budget with higher spending, we’ve we’ve had the, you know, the announcement of the alliance between the Liberals and the NDP. We’ve had the commitment from the Liberal government to increase what it is spending in terms of defence spending. So all of these kind of spending issues will probably offset when it comes to 22, 23, any better starting point in terms of revenues? The other thing that it could do, and I’m not sure you know how much this is an issue for for you in terms of the bond market. But these are not what is being discussed. Know, pharmacare, dental, the defence spending. These are not one year handouts. These are ongoing projects which could see deficits be somewhat larger, not just in 20 to 23 to offset some of that tax revenue, but also beyond that as well. And that could suggest that maybe the debt to GDP ratio isn’t quite as quick to come down as maybe prior projections had been. So I guess my question for you is those longer term projections, does that matter much at all in terms of the bond market or are you really mainly focussed on what issuance will be like in the coming year? And how do you see that issuance evolving?

Ian Pollick: It’s a good question because I think, you know, not a lot of sensitivity between the projections of the budgetary balance in the out years is typically digested by the bond market. I would say that this time may be a little bit different. So I think people are going to be surprised just how large issuance is going to be in a year. That is really considered to be a non-pandemic year. And just to kind of for context, we see bond issuance after the 30 year auction yesterday for all the fiscal year, 21, 22 gross issuance came in around $245 Billion. We think that gross issuance for fiscal year 22 to 23 is going to be around 200 to 225 billion. And yet the deficit is almost a third lower. So your proportion between the movement and the deficit relative to your bond supply is very misaligned, and that’s really a reflection of just this huge amount of bond maturities. So I think when the market recognises that and looks at some of the projections in the future years that see a marginally worse budgetary balance, I think it could matter. And I think again, when you think about where it matters, it’s in this idea that the composition of bond supply in Canada has changed. There’s much more longer dated issuance than we’ve ever had before, making it much more easier to source longer term duration. So at the margin, that’s why we really like these trades that speak to the relative steepness of our curve versus other markets before we go, because we’re hitting the 20 minute mark and. That’s when people tend to fall asleep. Any final words that you have as we look ahead to the Business Outlook survey on Monday? I suspect it’s going to be relatively strong, but is there anything weird that we should be thinking about?

Andrew Grantham: I think it is going to be strong. It wouldn’t surprise me if it’s not quite as strong in terms of, you know, some of the labour shortages, that sort of thing.

Ian Pollick: Because its healing, Labour markets healing.

Andrew Grantham: Yeah, the labour market is healing. We’ve got the monthly job vacancy numbers have started to come down a little bit, which is very different, by the way, from what we’re seeing in the US, the US, those job vacancy rates have have levelled off. They’re no longer increasing, but they’re not coming down.

Ian Pollick: Still high.

Andrew Grantham: Here in Canada. They are coming down a little bit. So it wouldn’t surprise me if yes, it’s still going to show that the labour market is very tight. Yes, it’s still going to show that people are expecting inflation to be above target. But it wouldn’t surprise me if it’s not quite as strong as the one that we saw earlier this year, which really kind of sparked the Bank of Canada, I think, into earlier interest rate hikes.

Ian Pollick: Yeah, I agree. And and from my perspective, I’m going to be paying attention to a survey that I never pay attention to, which is the accompanying household survey. I think the survey of the household expectations, particularly the inflation component. And that’s going to be a very important driver because I think it holds a lot of weight with the Governing Council. So I’m keen to see whether or not that’s had any big movement, particularly over the first quarter of this year. All right. Listen, thank you very much for joining the call, as always. And 50th episode is a great episode. Everyone, hope you have a great weekend. We’ll speak to you in a week’s time. And remember, there are no bonds harmed in the making of this podcast.

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