I thought it was supposed to be a quiet week?

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Royce Mendes: Welcome, everyone, to the 13th episode of Curve Your Enthusiasm. I’m your host, Royce Mendes, Executive Director and Senior Economist at CIBC Capital Markets. I’m joined, as always by my co-host, Ian Pollick, Global Head of Fixed Strategy at CIBC Capital Markets. Ian, I hate wasting time. So let’s tackle the elephant in the room. Canada was just downgraded by Fitch as we’ve hit the record button. Why don’t you tell us, what do you think the implications are for markets?

Ian Pollick: Well, honestly, it’s episode number 13, unlucky number 13. There’s been a lot of stuff thrown at Canada in the past 48 hours. So this is just kind of topping it all off. You know, I think when you look at it and say, was this expected? We do know that relative to the AAA peer group globally, Canada’s debt burden was a bit on the high side and therefore had a little bit less flexibility for the AAA rating than, let’s say, some other jurisdictions. Fitch has been the most out front on this. They’ve talked about this before. There’s been a few market spillovers since the announcement came out. It isn’t really being reflected in the level of interest rates. You know, that’s similar to what we saw when the US got downgraded in 2011. It didn’t really do much for rates outside of a knee jerk reaction. What the real implication here is twofold. Number one is, does this spill over into some of the sub sovereign issuers like provinces, potentially Canada mortgage housing trust bonds? And what is in turn that do to potential portfolio outflows and thus the Canadian dollar. What’s at least the best part about being downgraded by Fitch is the fact that Fitch actually doesn’t rate Canada mortgage housing trust bonds. But if you look at the market reaction thus far, 10 years are out by about two basis points, which doesn’t sound like a lot but for that market, it’s pretty heavy. And I think when you think about the forward expectations on what this means, I think it raises the probability that you get some other rating agencies to move as well.

Royce Mendes: Now, you mentioned high government debt ratios, which Fitch pointed out, but they’re talking about general government debt, right, which includes the provinces. But then you also see Fitch pointing out that the federal government has done a lot of the heavy lifting to support the economy, which actually means that provinces, municipalities, businesses and households will bear less of the brunt in supporting the economy moving forward. You know, in a world where 10 year interest rates are trading at roughly 60 basis points and we know that to contain debt to GDP ratios, it’s often more important to support GDP rather than restrain debt given the large multipliers when the economy is in such a depressed state, I find it very interesting move on the part of the rating agency. I guess the thing to keep in mind is that if Canada is, you know, downgraded or if it does see some ratings pressure, more generally, the federal government is still in a very strong fiscal position relative to its G7 and G20 peers. And that’s where we really expect the heavy lifting to be done in terms of fiscal support. Now, we had another announcement yesterday, which was the Federal Finance Minister’s comments regarding the term and duration of the Government of Canada’s outstanding debt. Ian, why don’t you talk a little bit about what that means and how the comments affect your forecast?

Ian Pollick: For sure. You know, this is one of those things when you look back at the week of June 21st, it’s the week where all of a sudden the prospects for Canadian duration to continue outperforming really fell apart. It’s not just the fact that we were downgraded today and that creates some trepidation by global investors. It’s also the comments that Finance Minister Morneau made yesterday. And, you know, as a Canadian, as a taxpayer, they’re absolutely the right comments to make. In an environment of very low interest rates, yes, you should absolutely term out your debt. But if you think about what it actually means for the bond market, it’s a bit scary and it’s scary because when you think about Canada’s bond market, how it functions between the Government of Canada, provincial issuers, corporate issuers, it’s a very delicate ecosystem. And Canada’s always been known as that country that has a chronic supply demand imbalance in the long end of the yield curve. And that means in plain English, the government just doesn’t issue enough 10 or 30 year bonds. And that allows provinces to come and pick up the slack or fill in that gap and provide their own issuance. You know, if you draw this out to its natural conclusion, there’s a couple of really important implications. The first is that Canada really could be moving to a situation where these governing dynamics are starting to shift abruptly. And what that actually produces is a crowding out impact. So if the government, for example, start to term out its debt and then it’s important to understand, what does that actually mean? You know, the Government of Canada, if you look at all the bonds that are liquid on the curve. Exclude the high coupon bonds and stuff that is greater than one year maturity. Your average duration is about six point four years. So that immediately tells you that to term out your debt shifting from, say, bill issuance to two year bond issuance really doesn’t do a whole lot. I think where the shift actually has to occur is away from the five year sector of the curve, away from the three year sector of the curve and more towards the ten year point or even a brand new seven year point. I don’t think this is a situation where the government is going to start issuing a bunch of 30 year bonds. But again, what happens at the limit is that this will at some point start to crowd out some of that corporate and provincial issuance. That means that provincial spreads should be biased wider. But what it also does is it raises the likelihood that some of these provincial borrowers actually continue to go overseas. Now, if these guys go overseas and they swap their proceeds back into Canadian dollars, that puts a lot of upward pressure on swap spreads, which is just the mechanics of hedging out that cash flow. We’ve had a lot of questions on it today. And I think in conjunction with what we saw from the recent announcement from the Bank of Canada, given their bond auction schedule, that Canada’s going to have a lot of bonds coming its way over the next three months.

Royce Mendes: It’s an interesting point that you say that there could be some crowding out because in pure economics, we would think that when the central bank is at the zero lower bound, the reason you’re really getting that large fiscal multiplier is that there isn’t really crowding out. But to your point, though, there could be some movements in the long end in the distribution of where issuers choose to issue bonds. Now, the important thing to keep in mind from a macro perspective is that debt service costs will be incredibly low no matter where on the curve the debt is issued. With the 10 year trading between 50 and 60 basis points, debt issued for pandemic support will compound at a much slower pace than the pace at which we expect nominal GDP to grow over the next 10 years. So just mechanically, the newly issued debt as a share of GDP will be worked down over the next 10 years without any tax hikes or program spending cuts as long as nominal GDP trend growth returns to roughly four percent, which I don’t really see an issue with.

Ian Pollick: Well, it’s interesting, right? Because if you look at the distribution of Canadian debt outstanding, you can see that most of the debt is really five years and under. And for a very long time, the government had explained it to us by saying, listen, there’s considerable rollover risk when we run the model. And that rollover risk, in the parlance of the COVID era, is a very different definition. In the past, all it meant was if we’re going to issue a bunch of 30 year bonds, then in 30 years when we have to refinance, yields could be considerably higher. And therefore, it’s not as economical to issue, say, a two year or a five year bond. But today, that rollover risk is related to the size of the amount that has to be refunded, not the level. And that’s a really important shift because I think it was a couple episodes ago, Royce, you correctly made the point that even if the budgetary balance improves and goes back to a flat reading next year or the year after that, the issuance as a result of 2020 is going to be with us for a very, very long time. And that prevents the government from scaling back its issuance levels. So this is on a go forward basis, very important for the market because it’s a one-time increase in the level of issuance on a go forward basis.

Royce Mendes: So there’s been a lot going on this week. I think probably in a period where we saw a quiet week in Canada because there really wasn’t a lot of economic data. Governor Macklem gave his first speech and his outlook for the market was very much in line with what we’ve been saying for some time about the economy. The initial stages of reopening could lead to a quick turnaround in growth. As of the last labour force survey, there were one million Canadians who saw their unemployment as only temporary. Many of them will probably be proven correct as they get called back to work as restrictions are lifted. However, what we saw is that sectors that had really nothing to do with physical distancing restrictions, things that we would consider more office work were still seeing losses in the last report. That’s disheartening, since that type of destruction in employment would seem more long lasting than the earlier round of layoffs. Those losses are no longer simply the result of forced shutdowns, but rather the result of an expectation of an extended timeframe of weak demand. That supports the governor’s view of a more gradual recuperation phase, which would be slow and probably bumpy. Obviously, that’s a less sunny outlook than the last words from Governor Poloz. Macklem also made a few comments regarding quantitative easing, which seem to differ from his predecessor. He said the bank was already engaged in quantitative easing in so far as normal market functioning had been restored. So the large scale asset purchases of Government of Canada debt were no longer simply adding liquidity, but also adding downward pressure on yields for the purposes of economic stimulus.

Ian Pollick: That was very interesting, I agree. Because, you know, three weeks ago we heard the situation where brand it whatever you want. Call it QE or call it bond buying, this is just market liquidity. But then you’re right, Governor Macklem said the market’s functioning. Therefore, this additional bond buying is providing real stimulus.

Royce Mendes: I wanted to ask you, how does that play in to your forecast for a central bank policy and interest rates further out the curve? I know we’ve been calling for a yield curve control in the five year sector, but if the governor thinks we’re already conducting QE, how fast do you think we see a switch in central bank policy to something more aggressive or actually, in my opinion, something more elegant, such as yield curve control?

Ian Pollick: So it’s a good question because I think we have to think about the evolution of Canadian QE within the context of these two stages that you just mentioned, the first one being the reopening phase, which again, he said, listen, this is going to be a phase where supply is coming online very, very quickly and it’s going to exceed demand coming back online. That means this is probably the biggest delta for the output gap to open up. It’s when you have the most downside inflation pressures, which means that expectations have to be anchored during this period. But then as you move to that recuperation phase, as you rightly said, Royce, it’s long, it’s protracted, it’s uneven, and that’s when you need real accommodation. And I keep thinking about that word, real accommodation, what does he mean by that? Well, further in the speech, he made a very important point, said, listen, not only are we no longer just servicing market function because the market has healed, we’re lowering rates. And he drew the conclusion that five year bond yields are now so low that mortgage rates are now starting to get lower as well, which passes on real accommodation. To me in my mind that really strengthens the need to give us a little bit of guidance. We don’t know anything about the reinvestment policy. We don’t really understand when they say we’re going to have to calibrate our QE to a policy objective, something that’s consistent with your two percent inflation goal. They don’t really have the information. That’s why I concur with you. The elegance of YCC is that you don’t actually even have to buy that many bonds. And that is where if you listen to what he linked to us, that’s what accommodation is. You’re lowering household and business borrowing rates. You’re transmitting it to the economy. But I guess the question is one of timing. I had thought originally the October MPR would be the date that they would start to think about it. I don’t necessarily think that’s wrong, but I think we have to see how this recuperation phase goes, because the reopening phase, for example, Toronto just reopened today in its second phase. None of us are back at work yet. It may have to be a 2021 story.

Royce Mendes: So you think the risks are skewed towards later rather than earlier, maybe as early as the July MPR?

Ian Pollick: I think so. I don’t think the July MPR is when we’re going to hear something. But I think we need to view everything that we’ve learned this week within the context of the latest quarterly bond schedule that the Bank of Canada released last week. Remember from our conversation last week, one of the things that I’d been thinking about was Canada would be continuing to move into a very negative supply environment. The justification there was, listen, there’s a lot of cash from the Government of Canada sitting on the Bank of Canada’s balance sheet. Deposits have been rising for three consecutive weeks. The pace of issuance should slow because money is leaving slower as the crisis matures. It doesn’t seem to be the case, I guess, out of consensus cause or out of consensus for a reason. What we learned is that not only are we getting a larger amount of auctions in the second quarter of the fiscal year, there’s now 22 operations from 18 in fiscal Q1, but most of those operations are actually in the two year sector. So for context, almost all of the additional operations are now in the very front end. So you have seven two year options over the next three months. Now, if sizes are left unchanged, the government will be issuing roughly one hundred and ten billion worth of bonds in the next three months. You have to look at that from the context of once you whittle out what the Bank of Canada buys at auction, once we know what’s maturing and what we know QE does, the net issuance isn’t actually that big in outright terms. It’s between 20 to 30 billion. But it’s the swing in that issuance that ultimately matters for the curve. So for context, that issuance in fiscal Q1 was basically zero. So even though it’s not a huge number for the private sector to absorb. It’s a big number within the context of the swing factor. And to me, in conjunction with this idea that maybe the government wants to start terming out its debt into that 10 year sector, it produces two real implications. Number one is we no longer think Canadian duration can outperform the US in the very near term. And number two, it materially raises the probability that Canada’s yield curve needs to steepen out.

Royce Mendes: I feel your pain about not wanting to put too much faith in your ability to say when the Bank of Canada is actually going to switch to a more aggressive QE policy or calibrate its monetary easing. You know, we’ve been humbled over the past few months with regards to trying to forecast economic data. And as recently as the past week or so, we’ve been trying to forecast the scale of the downturn in terms of the economy for April. We received information on trade, manufacturing, wholesaling and retailing, which were all unfortunately worse than feared. So the Statistics Canada flash estimate of April GDP, which suggested a decline of something like 11 percent for the month, is probably too conservative. We haven’t finalized our forecast yet. Of course, GDP for April comes out next week, but I can say we’re expecting the decline to be somewhere in the magnitude of 13 to 14 percent. So in the words of Governor Macklem, that’s a deeper hole that the economy is in than previously anticipated. There is some good news and there’s a bit of a silver lining. Statistics Canada gave us a sneak peek into what they thought retail sales would look like in May. And I can tell you that it was better than what we would have originally anticipated, which means that while the downturn was more severe, the initial upturn is looking more robust. So maybe we get a little bit more of an initial bounce and we’re left with, coming into the early parts of the summer, with an economy that is not that much different than the forecast that we had put out a few weeks ago about a downturn in the second quarter on the order of magnitude of roughly 40 percent, seasonally adjusted annualized rates. Look, I think we’ve talked a lot here. We’ve hit a lot of great points. So in the words of George Costanza, let’s leave this on a high note. As always, remember, no bonds were hurt in the making of this podcast. And see you all next week.

Ian Pollick: Take care, everyone.

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