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Andrew Grantham: Probably about 50 basis points. So if the Fed does go to five, then maybe we are kind of forced to go to four and a half. That’s not our forecast at the moment, but we have a-

Ian Pollick: Oh, it will be. Don’t worry.

Andrew Grantham: But we have a lower peak than the markets, so. (laughs)

Ian Pollick: Don’t worry. (laughs) Well, happy Friday, everybody. Let’s just talk about the elephant in the room, which is the Bank of Canada interest rate decision next week. We get a full forecasting update as well. I’m joined today by Andrew Grantham. Andrew, how’s it going?

Andrew Grantham: Good, thank you. How are you doing?

Ian Pollick: I’m okay, man. I’m excited for the weekend. I’m excited for next week. Why don’t we start off just talking about some of the intermeeting developments that have occurred since the September 7th meeting? You know, I think most importantly, when we look at the data cycle that was versus the data cycle that we’re in, the first thing that I’m noticing is that we are seeing a very big improvement, at least relative to forecasters. And we kind of argued about this a month ago. You’re in this really bad phase where economic forecasters were relatively optimistic and maybe arguably too high on the forecasts. And that created this huge stock of negative forecasting errors. And that’s kind of turned right? It started with the GDP report, followed by Labour, followed by CPI. Walk me through what you think’s happened in the intermeeting period.

Andrew Grantham: Okay. Yeah. It’s an interesting position that we’re in because we did have a number of weeks where some of these numbers came in below the consensus forecasts. That’s kind of turned the last week or two. But if we look over the last kind of six weeks as a whole, and certainly if we go all the way back to the July MPR and compare kind of the numbers, the forecast today that they were back then, we are still in a situation where GDP growth in Q3 is going to come in or at least is tracking at the moment slightly below that previous forecast from the Bank of Canada. Even headline inflation is coming in a bit below their previous expectations as well. Yet we’re pricing in more interest rate hikes than we were expecting back then. And this just comes back to some of the things that we’ve discussed before. It’s not really a case at the moment of the headline numbers and just how high inflation is at the headline or how strong growth is. But some of the underlying details, what’s driving this? Is it supply or demand factors or is it kind of headline inflation, energy prices, or are we seeing some slowing in core prices? And that certainly wasn’t the case when it came to the inflation numbers this week.

Ian Pollick: Yeah. So let’s just take a little bit of a baby step away from that and let’s just talk about the Canadian dollar for a second. You know, the last time Macklem spoke, one of the things that he was very vocal about was this idea that the Canadian dollar is not benefitting the way it normally would during a commodity boom. You can have a lot of different reasons for that. But primarily it’s just this ESG world that we live in and therefore we don’t benefit from big capital goods orders when oil prices are very high. And so you didn’t get that appreciation in the Canadian dollar. And he even said that, look, the Canadian dollar is not doing what it’s supposed to be doing and therefore interest rate hikes are going to have to supplement that and rates have to do more. When we look back over the intermeeting period, you look at the Canadian dollar versus the US dollar, it’s appreciated four and one half percent. You look at the effective exchange rate, which kind of measures on a trade weighted basis versus other partners, that’s also down three and one half percent. So I guess the question is why now? Why is he talking about the Canadian dollar so late in the cycle? He hasn’t really talked about it before. And do you believe that they’re that worried about inflation pass through from the currency or is this just an excuse?

Andrew Grantham: No, I think what he had to do is, you know, we’ve talked before that Canada, we probably don’t have to hike interest rates as much as the US. The US is where the kind of big excess demand is. They should be tightening or slowing their economy more. But he’s very aware that there’s a difference between peaking a little bit lower than the US and peaking a lot lower, which then will depreciate the exchange rate and pass through to inflation. And I think what we saw, actually a little bit of a hint at within the inflation numbers, we did see strength in food prices. We did see strength in some other goods like energy, which we didn’t actually see in the US numbers. So there is a little bit of evidence there of that pass through from the exchange rate. So I think he’s kind of right to be a little bit worried about that. But it just goes to show that in this world that we live in where we do have the exchange rate pass through, we’re not probably going to see 100 basis points divergence between the peak in the US and Canada, which if they were both closed economies, I would argue would probably be correct. But that kind of differential is going to be more kind of 25 to maybe 50 basis points.

Ian Pollick: So let’s just talk a little more about what he said. And, you know, he had confidence. All right. This man had swagger when he was talking. He was talking very hawkish despite coming through what you had rightly observed, which is a six week period where the data just wasn’t that great. And so I had thought at the time, well, this guy is you know, he’s getting his mojo from somewhere. And definitely it was the Business Outlook survey. He’s for sure seen it. And the way that he was animating the outlook was not necessarily that you have a strong economy per say. It was one that was still in excess demand, but one where he was talking about the risks of a wage price spiral. And you’ll remember in the July MPR that got its own technical box. So, you know, they have thought about it. They are worried about it. But he did talk consistently about the job is not done. There’s no trade off yet between inflation and growth. Wage expectations and inflation expectations are sacrosanct. And then all of a sudden you get the Business Outlook survey, you get the Consumer Expectation survey. And I would argue that the activity questions in both those surveys were terrible, like in isolation. This was not a good survey. Headline measures down, input/output prices down, the forward looking sales components down, investment intentions down. But then you had this still relatively high level of inflation expectations in the BOS and in the consumer survey that was just extremely hawkish. I mean, you have one year inflation expectations at 7% to your inflation expectations not far behind it, and you had a really strong wage growth. So I guess my question is, do you think that he did have this data beforehand? Is that why he was talking so tough? And what do you think about the BOS and the CSCE?

Andrew Grantham: Yeah, that’s a good question, because the first one I looked at was the Business Outlook survey. And my initial response when I looked at that was, well, he obviously wasn’t talking about this when he spoke last Friday because, as you rightly said, it’s pretty weak. And like even though you said some of the inflation expectation numbers were still elevated, they did come down right across the board. And even the five year forecast for inflation came down. So, but then you looked over at the consumer survey and as you rightly said, that was very different. I think what we’re seeing there is the fact that what is important for Canadian households and consumers and what drives their expectations for inflation is slightly different than the US. So the US, you look at inflation expectation numbers, they are very correlated with gasoline prices, right? So going into these surveys, we don’t have a long history for the consumer survey here in Canada. So we were going into that thinking, okay, some of these inflation expectations on the consumer side will probably come down because that’s what’s happened in the US now that gasoline prices are off their peak. That obviously didn’t happen and I think that’s telling us that it’s the food price story, which is, you know, the biggest story for driving consumer expectations here in Canada. And maybe that goes back to kind of some of what he was saying about the Canadian dollar depreciation, how worried he is about that in the pass through, because particularly as we get to winter that pass through from the Canadian dollar through to food prices, if that is the thing that’s impacting consumers expectations the most, that’s a concern for him.

Ian Pollick: No, for sure. So I think we’re in agreeance there and you know it’s one of those things where this is further reinforcing the idea that we cannot just focus on the slowing growth data and let’s just focus on CPI for a second. You know, it was released this week. Obviously, it was another banger of a number. You know, I told you. I did. Remember? I told you it was going to be a big one. But let’s dissect it a little bit. You know, obviously, headline number, whatever. I don’t care so much about the headline. To me, I’m more interested in the core numbers and the old school core numbers like ex food, ex energy, non seasonally adjusted terms up 4/10s, seasonally adjusted up 3/10s. A big number, for sure. Not wildly different than what the expectations were heading into the print. What was interesting was obviously food prices were ripping, right? Like, you know, just such a strong reading for food prices. Mortgage interest costs are doing what they should be doing at this point in the cycle. Shelter as well. But what did you take out of it and what worries you?

Andrew Grantham: What worries me is the fact that ex food and energy prices are not below 0.2% each month at the moment because, you know, we talked earlier in the year kind of well before, you know, some of these really big inflation numbers started to come through, that just the difference between how we measure shelter here in Canada, how that impacts the Canadian inflation numbers and how different that is from the US would create a divergence. The fact that we are seeing, okay, yes, mortgage interest costs are going up, but the bigger components, like the homeowners replacement, we’re thinking about the transfer fees as well. Those are bigger components than the mortgage interest costs. They’ve been as negative as we expected, yet we’re still getting ex food and energy inflation at point three seasonally adjusted last month, 0.4% this time around. Those are big numbers. And if you thought about this-

Ian Pollick: Yeah, they’re chunky.

Andrew Grantham: Yeah. And if you thought about this ex shelter, they would be probably as big, maybe even a little bit bigger than the US monthly numbers for ex food and energy.

Ian Pollick: So let’s just look forward a little bit, right? Because obviously when we think about the October number, gas prices are materially higher this month than last month. And so, you know, we’re tracking something like, what, 8/10s, 9/10s for the October print?

Andrew Grantham: In terms of gasoline prices? Yes. I mean, they-

Ian Pollick: No, no, no. In terms of headline like we’re what, 9/10s for the month?

Andrew Grantham: Yes. That’s where we’re at. I think, you know, gasoline prices seem to be stabilizing a little bit, but not enough for us to reduce that forecast, I don’t think.

Ian Pollick: So, let’s just think about that for a second, right? We’re going to have a huge number in October. If we know it, the Bank of Canada knows it. Then I was just looking back at 2021 numbers. And so, you know, you have October 2021, your month over month was 7/10s. So we’re going to beat that. That accelerates year over year. November was very, very small. It was less than 2/10s. And then you get to December and you had a negative print. And so even if you stabilize gas prices here and we’re talking about further depreciation of the Canadian dollar, you know, we’re in this six, nine, seven one headline world for the next three months. Do you agree with that?

Andrew Grantham: Yeah. No, we’re going to, if anything, accelerates a little bit from where we are today. But again, you’re looking back to the Bank of Canada’s previous forecasts, our previous forecasts, you know, they know those base effects as well. The Canadian dollar depreciation story, the pass through. That’s a little bit of a new development in that. But you know, everyone expected the kind of big slowing in inflation to be middle of next year. That’s when the interest rate hikes start to have the biggest impact on inflation. That’s when the base effects start to become much more manageable as well. But you’re correct. We are going to be, we’re certainly not going to make further downward progress on inflation over the next couple of months. And if anything, we’re probably going to accelerate again. That’ll make the Bank of Canada’s life a bit difficult because, you know, eventually they’re going to have to signal that we’re going to take a pause where we are and just see how the economy progresses. But it’s kind of difficult to do that if inflation is accelerating still. Right? (laughs)

Ian Pollick: That’s not now, buddy. That ain’t happening now. So let’s just talk about that for a second because, you know, as a firm, we’ve changed our view for the meeting next week. We’re looking for 75 basis point hike. I had been pretty vocal with the team about the move to 75. I think it’s obviously the right decision I guess, do you have any lingering doubts about 75? Are you pretty much in that camp?

Andrew Grantham: Question I have to ask you is like firstly, because I was out of the office yesterday, but you know, the market seems to be priced in pretty firm on the 75 rate. It’s pretty fully priced. Is that correct?

Ian Pollick: I mean, like the CPI data in of itself on Wednesday, once it was released, you know, kind of over the next couple of hours, the October OIS meeting, it was ten basis points in terms of repricing. This morning, you’re kind of at that 69, 70 basis point level. So you’re there, right, Like you moved almost 30% in terms of probabilistic, in probabilistic terms just after the meeting. So it’s expected. And then you kind of saw all the headlines, basically every bank well, most of the banks are now all in the 75 camp. Those that aren’t have kind of the wording like 50 basis points, but possibly more. I mean, maybe they’ll do more.

Andrew Grantham: That sounds like some wording we’ve used in the past. (laughs)

Ian Pollick: So I think it’s expected, right? But do you, that’s not really the question I have. I think you’re in the 75 camp. I think it makes sense. But let’s talk about after the fact, right? Like, are we talking about another mini insurance hike in December and does that slip into 2023? Because if you kind of look at the market pricing right now, you only have about 40% of a full cut by the end of next year. You have 15 basis points by Zeb three. So it’s not a big number. And I think markets are kind of coalescing around this higher for longer initial story that once you reach terminal, whatever that level is, that you stay there for a while. But talk to me about the path. Is it 75, 25 zero or is it 75, 25, 25, 75, 50, 25 Walk me through your logic.

Andrew Grantham: So, you know, our forecast at the moment is that they will go 75 next week. The market seems to be pretty fully priced for that. I do think they will move 75. I kind of think they’re kind of pushed into it a little bit. They don’t want the Canadian dollar to depreciate if they don’t deliver. But, you know, I wouldn’t say it was the slam dunk that the pricing is priced for at the moment. But after that, you know, we’ve just talked about the inflation numbers, the fact that even if it’s gasoline prices, even if it’s base effects, you know, we’re not going to be decelerating between now and December. So they’re going to have to hike again, probably at the December meeting. We have 25 basis points then. But by the time we enter next year, we think, you know, the growth numbers, the inflation numbers may have at least stabilized again, if not kind of starting to decelerate again. So we should see them then go on hold. But, you know, it is certainly possible that we get kind of November, December inflation accelerating still that you get one further 25 basis point hike at the start of next year.

Ian Pollick: So what do you think they have to do so? Where I think I’m a bit different from that forecast is I have find it hard to see a deceleration from 75 to 25 and six weeks at a time where we just talked about not much is likely to change in terms of the Canadian dollar. We are going to accelerate in CPI. Why would they downshift to a normal size hike?

Andrew Grantham: Well, because they’ve got interest rates which are very, very high already, and their forecast, they have a chance next week to reset their forecast a little bit, to reset kind of their logic, right? So it’s going to be having to explain to people that, yes, we do think that growth is going to decelerate probably a lot more than we expected, maybe getting close to a recession. But we need these high interest rates. I think what they need to do and isn’t necessarily to keep hiking interest rates, you know, until we start to see some deceleration. But as you were mentioning about interest rate cuts not necessarily being priced in anymore, but there have been some priced in by the end of next year. You know, they have to kind of reset some of the logic about supply growth, what that means not just for the terminal rate today, but how high interest rates will have to be in the future. Because the one thing that the Bank of Canada and the Federal Reserve in fact need to worry about is not just whether we should stop at 425 or 450, but once we do stop, we don’t want the situation that we had earlier in the year where, you know, equity markets start to rally, bond yields, longer term start to come down and monetary conditions start to get easier again, they will want to at some point stop hiking interest rates, but not have that loosening of financial conditions that we had in the markets earlier. And that’s where I think they need to provide guidance for the future rather than necessarily continuing to hike in the near-term.

Ian Pollick: That’s a fine balance, my friend, because what I just heard from you is that any pause, whenever it comes, has to be a hawkish hold. To have a hawkish hold after you’ve decelerated and communicated that, that is a very tricky order of operations that I don’t know. Well, actually, I do know. I have very little faith that’s going to happen without causing some disruption in the market. You know, and let’s just talk really quickly about what these forecasts may have to look like. When we look at CPI, we know that their Q3 numbers are undershooting by almost a full percentage point. They had like 8%. I think we’re coming in closer to seven one or seven two. As you said, growth we’re tracking, let’s call it 1%. They had 2%. We’ll get Q4 numbers for the first time. So what do you think that has to happen for the quarter? They’re going to bring down headline obviously, they’re going to have to bring down growth maybe. Remember, they’ve been pretty good at their short term growth forecasts. So if they don’t move it, then we’re probably wrong. Just walk me through what you think is going to have to happen, not just with the current quarter stuff, but also what’s Q4 looking like.

Andrew Grantham: Yeah, I mean, Q4 is looking well, pretty flattish because that’s what the monthly numbers have been doing at the moment. They’ve not been making too much progress. So Q4, I would expect them to be in the kind of 0 to 1% range for their forecast for that. You know, Q3, they did have 2% previously. You know, that should come down. But as you said, they don’t really kind of rely on these monthly numbers and what they’re tracking. They look more at the expenditure side. So it’s possible that they could have a forecast either above or below even what the monthly figures are tracking at the moment. I think most interesting is what they say about what’s going to be driving growth next year. They’re going to have to, I believe, downgrade what they have been saying about supply growth and how quickly that’s going to come through and what that means for inflation and what that means by extension.

Ian Pollick: Well, consumption has to come down. Consumption looks very high in these numbers.

Andrew Grantham: Consumption will come down and interest rates have gone up probably more than they themselves expected when they last made their forecast rate. But that’s kind of necessary if you’re not getting that supply growth that they were relying on in their previous forecast. It’s kind of necessary for consumption and some of those elements of domestic demand to be weaker.

Ian Pollick: Okay. So let me ask you this, right, how would the Bank of Canada communicate to markets that it is anticipating a deceleration to a more normalized rate hike, especially if you have to keep inflation expectations high? Like that to me is the big disconnect in this forecast. So walk me through your logic.

Andrew Grantham: Yeah, I mean, while we do have another 25 basis point hike in December. So I don’t think there’s going to be that much change in language within the report next week, within the statement, they’re going to still say that interest rates will need to go higher. You know, what I was talking about previously is the fact that at some point they are going to have to say they’re going to have to communicate to people that interest rates are already very, very high. So even though inflation is above our target, you know, we are going to take a pause. We are going to see what happens because, you know, you raise interest rates so aggressively, you don’t see the biggest growth impacts until maybe 6 to 9 months afterwards. And then the biggest inflation impacts may be 12 to 18 months afterwards. So they are going to have to make that signal at some point. Probably doesn’t happen next week, though.

Ian Pollick: Yeah, I would agree with that. The last thing I want to talk about is in the Fed minutes that were released last week, there was a, buried in the report, there is this discussion around potential and it was very eerily similar to the discussion that the Bank of Canada had about a year ago where they basically changed their definition of the output gap. And so Fed basically said, look, the Fed staffers believe now that potential is lower and therefore the economy is much more heated than they thought. And so going back to earlier in the episode, one of the things that we were talking about was when you have one closed economy, one open economy, your rate differential cannot be that wide because your currency has to do all the heavy lifting. If the Fed now believes that the economy is hotter than they thought, that raises their kind of potential peak rate estimate, which, by the way, right now is close to 5% of markets. Doesn’t that mechanically just pull us higher as well as you were saying earlier? And so how should we think about that within the context of this 25 basis point deceleration in December?

Andrew Grantham: Yeah, I mean, the Fed is going to eventually decelerate to more normal rate hikes as well, even if the terminal rate is what the markets think it is at the moment with maybe 475, 5%. You know, as I mentioned earlier, like I think just purely looking at the economies as they are without having to think about the exchange rate, you know, I would say that the US is much more overheated. We’ve talked about this before, even before the Federal Reserve staff has changed their potential, like we’ve known this for a long time, that the US economy is the most overheated economy. They probably need interest rates about 1% higher than us. But with that exchange rate, I think the maximum differential we can expect in the peak is probably about 50 basis points. So if the Fed does go to five, then maybe we are kind of forced to go to four and a half. That’s not our forecast at the moment. But we have a-

Ian Pollick: Oh, it will be. Don’t worry.

Andrew Grantham: But we have a lower peak than the markets, so. (laughs)

Ian Pollick: Don’t worry. (laughs)

Andrew Grantham: So you’ve asked me a lot of questions here, giving me a good grilling on our forecasts. You know, all of what’s been going on about in the markets, the terminal rate repricing, you know, how is that impacting the rest of the curve and where do you think there are kind of opportunities at the moment?

Ian Pollick: Well, I think the big story obviously has been the data cycle and kind of the cross market outperformance of Canada really, really over the past kind of six weeks. And one of the observations we made when Canada US valuations reached extremes was that, look, this is a data cycle that we think is about to turn. It is starting to turn and you are starting to see a little bit of that underperformance. It’s not as linear as I would hope we would see, but we still like these kind of cross market trades in the back end. So CAN to US ten years, CAN to US 30 years, I still think there’s a lot of scope for those to turn, particularly if we are in this stronger data cycle. The other thing, too, is that more in the short end, you know, there are certain contracts like BAZ2 still looks very expensive relative to what SEDOR has been doing. You are entering that time of the year where the demand for physical VAs to start to wane a little bit. People don’t roll over some of their holdings into the new year and so that puts a lot of upward pressure. And what we’re seeing in terms of the movement in the fixings versus the implied by the contract is a bit disconnected and it’s kind of eerily similar to what we kind of saw in the U2 contract. Outside of that, I think it’s really interesting when you look at the shape of the OIS curve. You basically have, like I was saying earlier, there’s not a lot of cuts in the back end of 2023, but in the early part of 2023, you have a very, very flat curve like your slope between your March and April contracts is basically zero. Call it maybe plus one. I like owning that upside tail risk for all of the kind of dynamics we talked about today. So I don’t mind kind of owning March to pay April. And then I think on a cross market basis to if you do believe that Fed terminal stays sticky where it is, potentially moves a little bit higher, I think there is scope for twos fives to steepening Canada. So I don’t mind having this twos fives box on so you kind of steepen Canada relative to the US. I think that’s a very good way to play or to remove some market directionality and just kind of focus on the fundamentals. But look, we’ve talked a lot. We’re going to the Bank of Canada next week. We’re going to the weekend today. So thank you very much for being on the show, Andrew. We’ll speak after the fact. And remember, there are no bonds harmed in the making of this podcast.

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