Highway to the danger zone

Andrew Grantham: I think they would put something like that in. Yes. Now we are hiking interest rates by 75 basis points. We now think rates are in restrictive territory. They won’t say that means we’re going to be on hold.

Ian Pollick: No, of course not.

Andrew Grantham: But just mentioning that, you know, as you I think you phrased it quite well.

Ian Pollick: Mr. Grantham. How are you, buddy?

Andrew Grantham: I’m doing good. It’s been a while. I can’t believe it’s September already.

Ian Pollick: I know it’s going back to school. Summer’s over. You know, you and I have been both very busy travelling, speaking to clients. We’ve a lot to talk about, but before we jump into the episode, I have a question for you.

Andrew Grantham: Okay.

Ian Pollick: Have you seen the new Top Gun movie?

Andrew Grantham: So you know what? We haven’t, no. And we have children who are pushing us to watch it. But my wife and I want to watch it first just to make sure everything’s good with it. But we’ve heard it’s really good. So what do you think?

Ian Pollick: I watched it last night for the first time. And it is a banger. You know, it’s one of those things where I was a little bit nervous that just the nostalgic was the only part of the movie that was going to ride it through, but it was just awesome. And so, you know, that was my big question because I just watched it and I’m super jacked up about it.

Andrew Grantham: (laughs) That was the important question for the day.

Ian Pollick: That was the most important question of this episode. It’s a banger. Let’s talk about GDP. We had the GDP released two days ago. Let’s dig down a little bit because from my perspective, obviously, let’s ignore the miss to the headline. You can tell us why it missed in the event Q2 growth came in at three three. I think we were looking for four two, the bank was looking for 4%. But it was a really interesting composition and I would argue that there was a little bit of something for everyone. For the hawks, you can kind of point to the fact that compensation in nominal terms was ripping, it’s way above trend. Nominal growth is still very strong. Obviously that’s the inflation story, but in real terms, consumption was extremely strong. It posted another very decent advance and inventories had a very, very big build. Against that, you saw this kind of weak imbalance in trade, but you can kind of argue that the rise in imports help to fuel inventories is a function of demand. Export growth probably related to oil prices, but tell me if I’m wrong. And then all of a sudden we saw housing. Not too big of a surprise, but residential investment was down in a very large way. So I’m interested in how you saw the report and maybe frame it for us in terms of expectations.

Andrew Grantham: Yeah, I think you’ve covered it just a bit better than I could, to be perfectly honest, in terms of the details. Like one of the things I found striking within the report, I can’t remember a time, and I guess the pandemic quarters were probably the last time, but certainly before the pandemic, I can’t remember a time where there was such big swings in components kind of offsetting each other. So, you know, 3.3% is the headline. I wouldn’t be surprised if that gets revised or revised fairly heavily one way or another, just because there’s a lot of moving pieces upwards and downwards. I think the driver of growth was not surprising. It’s consumer spending and particularly consumer spending on services. We have been generally during this pandemic stricter than other countries when it comes to restrictions on services. They got lifted towards the end of Q1. So through Q2, we saw this big acceleration. And so that’s really what the big driver was. Yet, on the other side, growth during the pandemic period was driven by housing being well above the trend it was on before the pandemic started, given interest rate rises that is now coming back down to earth. So, you know where we think this is going to kind of unfold going forward, I believe we had a really big decline in the housing component this time. There’s probably one more big one to come in Q3, but then after that we kind of should stabilize at a level which is lower than where we were before the pandemic, particularly for resales and for renovation activity given the higher interest rate environment. But it won’t be that big negative that it’s been on growth. So, you know, going forwards, it’s all about the consumer, how they respond to higher inflation, higher interest rates, whether they can keep spending. And the other thing we need to think about, and I think this was something that came out of the monthly numbers for me, is can we supply what they want to spend when it comes to services? Because if you look at the monthly breakdown for June, we saw negatives in real estate finance, those things related to housing, which is what we would expect. But those are areas that are recovering: air transports, accommodation, arts, entertainment, you know, they’re still recovering, but certainly the pace of that recovery has slowed. And I don’t think that’s a demand problem. I think that’s a supply problem.

Ian Pollick: So let’s unpack that a little bit. And, you know, I have two questions for you. Number one was, do you expect when we move into kind of the Q3 data cycle that the inventory accumulation that we saw, does that get drawn down and therefore reduce production? Or is it one of the situations that this is a just in case inventory cycle where you have this almost permanent elevated level of inventories? So that is a pretty big contributor to growth. How are you thinking about that?

Andrew Grantham: So when it comes to inventories, like as they are put into the GDP figures, this isn’t necessarily the level of inventories, this is the change in inventories relative to the prior quarter. And, you know, we have been through this period where inventories have been very low because of strong consumer spending on goods because of strong consumer spending in the US on goods in particular. What’s interesting is we had this big inventory build in Q2. You look at the data, the inventory data that they give us on inventory to sales ratios, for example, and for the retail sector is virtually unchanged and still well below where it was before the pandemic. So, you know, I don’t believe this is necessarily the end of rebuilding those inventories. We probably won’t get quite as much growth going forward. So contribution to GDP becomes lower, but I think there is still an inventory build that needs to happen or needs to continue to happen. And from an inflation point of view, as much as anything else.

Ian Pollick: Okay. I mean, and I guess the second question is, is that when you think about one of the things that you just said, which is that the areas where growth is slowing is not necessarily indicative of falling demand, it’s more a function of just still lingering supply chain issues. Are we that worried about growth going forward? Because when I saw the flash estimate for July and you do the basic math, the handoff from Q2 to Q3, it looks basically flat and it does look pretty hard for the bank to achieve its 2% forecast. So is it fair to say that even if growth is slowing, given what we’re seeing in terms of the silhouette today, it’s not necessarily indicative of demand falling?

Andrew Grantham: Well, I think the demand aspect is the areas that we already knew, housing, right? And I think demand on goods is going to start falling with higher interest rates and inflationary pressures. There is a lot of pent up demand still for services, and some of that pent up demand cannot be supplied at the moment. That’s where the supply issue comes in. So I think, you know, when we’re thinking about our forecasts and, you know, we are in the middle of just kind of redoing our forecasts and will publish a big piece on this in a week or two’s time. We’re kind of somewhere between the soft landing and recession, hard landing. It’s more of a bumpy landing we’re expecting. So, you know, Q3 could be kind of flattish, maybe some mild growth. Q4, it’s possible that that’s negative. There’s some supply issues, but then also demand coming through on the goods side. But, you know, there are some reasons to be positive as well when it comes to consumer spending further out because people do still have some savings to fall back on. The fact that there’s the supply issues means that they cannot spend on those services at the moment. So they might do that in the future and that, should, we think, keep us out of kind of a recessionary scenario, although it will be a fairly close call, we believe.

Ian Pollick: Okay. So growth is slowing. The narrative is not yet entirely clear in terms of what consumption does going forward. But is there anything else in terms before we move on to some other topics, is there anything else in terms of the growth outlook that we need to think about?

Andrew Grantham: So I think the next thing to think about is consumer spending on goods, the retail sales numbers. I think those are important for the Bank of Canada. And just judging how the consumer is responding to higher interest rates and to inflationary pressures. You know, the bank, obviously, and everyone else knew that there was going to be a big negative in housing. It’s probably happened a little sooner and a little more abruptly than maybe the bank was expecting. But it’s not unsurprising where the impact of interest rates comes in. Next is how consumer spending on goods evolves. And, you know, part of the July disappointment was that we saw a pullback in retail sales in July. If we continue to see a pullback there, then that’s when, you know, maybe we become a little bit more worried about the growth trend. So, I mean, we talked about this slowing growth trend, but we still have high inflation in the background. This combination slow growth at the moment, still high inflation, but hopefully that will start to ease going forwards. What’s the impact been on the yield curve here in Canada?

Ian Pollick: Well, it’s interesting, right? And I think to answer that, we kind of have to look back over the past two months. And really, you’ve been to this very interesting situation where starting in early June and definitely into July, it was the idea that slowing growth was going to become more pronounced in terms of the reaction function of central banks relative to inflation. And it was this slower growth that could lead to a recession type of narrative that was really this idea behind the pivot. You know, everyone was pricing a Fed pivot. In Canada, you had a very similar spill-over such that you actually had interest rate cuts being priced into the very early part of 2023. And you know, what was interesting is that the cuts weren’t a full cycle. There were this mini course correction that basically said we think the central banks in both Canada and the US are going to take interest rates above what they believe to be neutral into restrictive territory and then have this kind of mini cute, acute little easing cycle that takes rates back to the top end of that neutral range. It never made a ton of sense to us that that was the right type of way to price this apparent pivot. And I think once you go into Jackson Hole, the narrative was basically, listen, we are not as concerned about growth as most people think we are. We know we have a job to do. We’re in a risk management world and therefore we have to continue before we say mission accomplished. And we’ve done a lot of work on the subject. And what we found is that if you if you only look at growth and what that meant for, you know, for example, ten year yields, there was a very big difference in terms of how the yield curve reacts when you were starting from a place that’s above potential versus a place that’s at or below potential. So, for example, Canada is now operating at 3.3% growth in Q2. If you’re right, and we do get sub 2% growth in the third quarter, let’s say we’re right on top of potential. That decline from above potential is actually a flattener. And you kind of saw that in the way the market traded. We did go through a period where we did have this bull flattening move in the curve. But then once you’re at potential or slightly below and when you fall further from there, that is a situation where you can start to see the curve steepen out because you have more realistically begun to price in a longer string of interest rate cuts. Now, at the end of the day, as it stands right now, you have not only pushed out the start of the timing of interest rate cuts in 2023, but you’ve also reduced the depth of it. So pre Jackson Hole, at the height of the rally in July, you had roughly 80 basis points of cuts priced for the Bank of Canada for next year. Right now you have about 50 basis points priced, but the starting point went from March to November. That’s really important. And it’s also important for the level of yields. And, you know, as you know from our bond forecast, we have a very low level of ten year yields projected for the end of 2023. So I think this is a long way to say, Andrew, that if you think about our forecast and you start to get this deceleration of growth below potential, and that’s really a Q3 to Q4 story, but we’re not going to get that data until early next year. And so therefore, you know, curve inversion is with us for a while and that is around the first quarter of 2023 where we start to think that you’ll start to get that steeper curve. But I want to pivot a little bit because we are talking about moves in the curve that are very long in terms of when they might come. I want to talk something about a bit more immediate, and that’s the Bank of Canada next week, obviously very big meeting. It’s not an MPR, it’s a statement only affair. And there’s been a huge amount of intermeeting volatility. You know, oil prices are 7% lower. Financial conditions are actually easier than they were at the time of the last hike in July. We seemingly seem to have peaked in inflation. We’ve had one inflation report since then that showed we’ve had a deceleration, at least in the headline number. And against that, we’ve had two consecutive job loss reports and then we’ve had softer growth, as we talked about earlier on in the podcast. So how is the Bank of Canada taking all these developments in terms of their deliberations? And what are your expectations for the meeting?

Andrew Grantham: So I mean, firstly, like just thinking back to the last Bank of Canada when they hiked 100 basis points, surprised people by hiking that much. You know, what they were talking about at the time was front loading and getting into restrictive territory. Now restrictive territory means above 3% because they think the neutral range is between two and three. So they talk about getting into restrictive territory that’s above 3%. So where they are now, two and a half percent, I believe that they were thinking at the time of the last meeting, if we do 200 basis point hikes in a row, then that will get us to three and a half. We can stop there for a bit, see how things go, take a pause and see how the economy evolves. Now, as you mentioned, the data in the interim has been not massively negative, but a little bit on the softer side. Inflation’s been a little bit below their forecast, albeit mainly due to commodity prices and oil in particular. We’ve had those employment reports, but some of that seems to be supply rather than demand. And we’ve had the GDP figures. So, you know, I believe that they believed back then that they were going to be hiking 100 basis points and be done in restrictive territory, at least done for the time being. We expect going up to next week that the slightly weaker data will actually see them raise interest rates by 75 basis points to three point two five. That would still be in restrictive territory. They can still add in their statement some verbiage to say we are now in restrictive territory. They won’t necessarily tell us that they are pausing, but now they are in what they consider restrictive territory, it will give them some time to reassess. And as you mentioned, this isn’t the MPR, but the October MPR will give them time to reassess just where they think they should be taking interest rates, if anywhere else in the future.

Ian Pollick: I mean, it’s typical, right? Because given what you just said in terms of all the volatility in the data and still some underlying pressure in the economy, they are not building this off of new forecasts, right? So, you know, you’re going to look back, they’re going to reference the July MPR as our expectation per the July MPR, but we know there’s a few things that they’re going to have to revise and growth is potentially one of them. So if I hear you correctly, this is a situation where we get another non-standard sized hike next week, overnight goes to three and a quarter. And given our forecast, that’s it. They are done. Now, we don’t expect them to explicitly say that they are done because that’s not how they operate. And even in October, I don’t think that they say that they’re done. They keep it unchanged. They say it’s signs of economic cooling and suggests that maybe they’re going to watch the data to determine if further hikes are necessary. So you don’t get mention of cuts. It’s not symmetric, but you still have this string of meetings thereafter where we also don’t expect any move in the overnight rate. So do you expect all these statements well into 2023 just to talk about we are in restrictive territory. It’s almost like a hawkish hold until there’s an actual pivot. Is that your expectation?

Andrew Grantham: The old hiking bias, remember that? They’ve gone past where they stop raising rates but retain a hiking bias. So I do believe that that’s the case, at least until inflation gets much closer to 2%. I believe that maybe by April next year, they may be kind of dropping this hiking bias to something a little bit more on the one hand, on the other hand, because maybe by then they should be kind of closer to at least their range, the top end of their range. But yes, even though we expect them to be big hike and then done for a while, they’re certainly going to retain that hiking bias. They’re certainly going to say if inflation doesn’t ease, if growth picks up, that we will be raising interest rates more in the future. We just don’t expect that to be the case because our forecasts are for growth and inflation to decelerate later this year and into next year.

Ian Pollick: So that’s really important because, you know, for our clients listening on the episode right now, are we trying to tell them that we need to look for that word? We’re now in restrictive territory. Is that indicative of them soft sounding the pause? Is that what you would interpret that to mean?

Andrew Grantham: I think they would put something like that in. Yes. We now are hiking interest rates by 75 basis points. We now think rates are in restrictive territory. They won’t say that means we’re going to be on hold.

Ian Pollick: No, of course not.

Andrew Grantham: But just mentioning that, you know, I think you phrased it quite well. Kind of a soft hold. We’re just kind of planting in people’s minds that, okay, maybe they don’t think they need to do any more, at least at this stage.

Ian Pollick: Okay. So for everyone listening, I think that is a very good rule of thumb going into the meeting. Look for those words. We are in a restrictive territory and that really just signals that you are much, much closer to the end than you are at the beginning. And you know, Andrew, while you were talking about kind of that April time frame in 2023, I’m just looking at our inflation forecast. So, you know, year over year, we have it decelerating to 3.1% in 2023. If you kind of look at it on a two year basis, that’s still 4.9%. I know you’re in the middle of a forecasting round. Can you give us a hint in terms of what you’re thinking? Are you going to raise the level of CPI next year? We have an end point for 23 at 2.1%. You know, it’s so hard, given everything we know to say that inflation is going to fall all that much. You know, there’s not a lot of certainty around it. But what are you thinking in terms of your forecast revisions right now?

Andrew Grantham: So, I mean, in terms of our forecasts, if anything, what we’ve seen from gasoline prices over the last few weeks, there’s maybe even some downside when it comes to those prices. Now, that just assumes that oil prices and those refining margins don’t rise again. But just from where they are today, in terms of average gasoline prices, if I just pull that forward throughout the forecast horizon, there would actually be a bit of downside risk. I think where we’re looking at more detail and where we are thinking of maybe raising our forecast a little bit and I do mean a little bit, not hugely, would be in terms of core inflation. And I think this will kind of lead us into something that we’ve been talking about before as well. And we’ll talk about later in this podcast, is that, you know, this idea of there being an output gap and that being correlated to core inflation, that’s how our forecast was done. That’s how other people’s forecasts have done. That has broken down, obviously, fairly spectacularly during the pandemic. And, you know, the supply issues outside of just what’s kind of demand driven in GDP is driving inflation to a greater extent. And so we’re looking in a little bit more detail at some of the breakdown within the core measure, not relying on the GDP based output gap and looking in a bit more detail there, although, as I mentioned, any increases in that core forecast will be fairly minor, I think.

Ian Pollick: Well, let’s move a little bit forward, because I think one of the interesting parts of this cycle is you come in this situation where we know that in 2023, we’re going to run into a situation where you have these very big base effects that are going to start to hit the data. We start to get this very rapid deceleration, particularly from that 7% level to kind of that 4% level. It happens within a matter of months. But when you get into 2024, you know, you almost have this reverse impact where you have very weak year ago comparables that actually lifts the level of inflation. And at least compared to where it ended in 2023. And I want to just talk about this for a second, because one of the things you and I have been talking about is this idea that if you believe that you’re in this very mini cyclical break from disinflationary forces, you have ESG, you have deglobalization. You have wage growth because you have a skills mismatch. All this leaves the average level of inflation higher over the cycle. And therefore, you could be in a situation where the average level of overnight rates are higher than they normally would be, which is another way to say that, would you realistically continue to revisit the lower bound in the next recession? Obviously, you know, there’s obviously tail events that happen and those tail events would obviously push us back to zero. But absent that, in a normal course recession, do you believe that we’re entering a period where there is a higher floor for policy?

Andrew Grantham: Yes, I do. And that’s something we’ve been talking a lot over the last few months within the team. You know, as you mentioned, with the base effects, you know, the housing component for Canada, CPI being different from the US, I have no doubt that the Bank of Canada at some point in 2023 will hit its 2% target and probably inflation might even be a little bit below that for a month or two. Now hitting 2% again and staying at 2% is very different in this current environment where we have these supply issues from the pandemic, COVID is still with us. It’s still causing supply issues coming from China. It’s still causing supply issues within service sectors domestically, people, the number of sick days being higher than they used to be. So flight cancellations, train cancellations, all that sort of stuff. So we still have some of these supply impacts going forward. So, you know, I believe and what we’re kind of talking about at the moment is that, yes, we could fall into a recession or yes, we could have a period of very slow growth. That doesn’t necessarily mean that the Bank of Canada will be cutting interest rates very, very quickly. You know, we had a, I don’t even know if it’s technically a recession or a close call just after oil prices fell in 2014. But the Bank of Canada cuts interest rates to almost zero lower bound at that period of time, right? We got down to 0.5%. So it was a fairly low, fairly aggressive response to something that wasn’t actually that big a downturn for the economy as a whole. I don’t believe where we are now in supply demand dynamics going forwards that policymakers will be able to be quite as aggressive to any downturn that they see when it comes to lowering interest rates. And that means that maybe if we hit a recession, we don’t go down to 0.25 or 0.5. We go down to 1 to 1 and a half, maybe at the lower bound. So that’s something that we have to keep in mind going forwards. And I have to ask you, you know, what does that mean for bond yields? If we are in this kind of new environment where the zero lower bound isn’t visited quite as frequently as it may have been over the last ten or 15 years?

Ian Pollick: Well, listen, I think this is the most important macro question for rates right now, is that, like you said, if the zero lower bound is now by definition not zero, let’s say it’s 1%. When you think about nominal bond yields, you know, there’s really just two components. There’s some type of bond risk premium and there’s some type of average policy rate that lives in that bond which echoes or mimics the expectation of what policy B will be over the life of that security. And so for saying that the lower bound is going to be somewhat higher than it was, then you just don’t have to have as much of a reduction in the level of this average interest rate. So on average, it just means that higher for longer story does extend to the level of yields. Where I think this is really interesting too is not only do you have more of a bond yield that’s now representative of your average policy rate, but you also have a yield curve that over time will struggle to flatten as much as it did in prior cycles, because you have much more pressure on these longer term interest rates, particularly if inflation is the reason why we’re not revisiting that lower bound. Now, obviously, on these very long cash flows, when you do the analysis, you know, these long bonds are going to have to absorb more of that volatility. So I can actually make the case that you have a steeper curve, not a flatter curve. If this idea that you have an average higher lower bound is reality. And we’re fleshing this out in a paper that should be, or teasing out in a paper, that should be out next week. So for everyone whose interest is piqued a little bit, look for that. But Andrew, we’ve talked a lot. It’s been a complicated technical show. We’ve been bouncing around from computer to computer. Any last words for everyone before we start the long weekend?

Andrew Grantham: I’m not sure I should, because you’ve had technical issues. I’ve had kids screaming in the background. So I think we should just be thankful that we’ve got through it. Everyone should enjoy the long weekend and we’ll revisit the Bank of Canada after the meeting next week.

Ian Pollick: Okay, last question. If I were to put pressure on you, what is more likely next week, 50 or 100?

Andrew Grantham: I would say 100 because I think that’s what they were planning. That’s my personal view, is they were planning to do 100 and then pause because of front loading getting into restrictive territory. So I do believe 100 is more likely than 50, but-

Ian Pollick: I agree with that. All right. Listen, everyone, have a great weekend. And remember, there are no bonds harmed in the making of this podcast.

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