Live free or diverge

Andrew Grantham: I had a similar interpretation of the way they interpreted the numbers. I still have concerns about some of the figures that they showed because I think they’re absolutely right and we’re seeing this within the economy at the moment.

Ian Pollick: Good morning, everyone. I hope everyone is ready for a great week ahead. I’m joined today by Andrew Grantham, Senior Economist in CIBC Economics. Andrew, how are you?

Andrew Grantham: Good, how are you doing?

Ian Pollick: Divergence, divergence, it’s the word, it’s on everyone’s mind, particularly coming from the labor market report on Friday. Let’s kick into this because divergence, divergence, it’s everywhere and then it’s nowhere. So let’s talk about the most classic Canadian data point we could have gotten, jobs market report right ahead of the June meeting. That was an absolute blockbuster. Walk us through what you saw.

Andrew Grantham: Yeah, and I’m not going to sugarcoat this. I’m not going to pretend that this is good for our June call because it wasn’t. But, you know, I do think, you know, if we step back and look at the labour market in Canada, not just this one report, but over the last few months, there are still signs that the labour market is looser than it was. I do think some of the strength that we saw in the latest labour force numbers, that 90,000 increase. This is partly due to the fact that the labor force numbers are playing catch up a little bit with the population growth that we’ve seen over the last couple of years. The population numbers within that labor force survey, they have been strong, but they’ve been nowhere near as strong as those quarterly estimates. And they’re still kind of catching up a little bit with that. So I think really what we need to focus on isn’t so much the 90,000 being well above what anyone was expecting. But the fact that employment is still rising actually a little bit slower than the population is increasing, that ratio is coming down, and the unemployment rate was still held at 6.1%. So it was certainly stronger than expected, but I do think the labor market is still looser than it was three or four months ago.

Ian Pollick: So let’s just talk about that a little bit. Because I think, you know, you and I often don’t agree, but I happen to agree that despite the eye popping headline number of 90,000 or whatever it was, there were details in the report that suggests to me that to your point, the tightness isn’t just there. It’s not there to the degree that the headline number interpretation would suggest. And you look at the three month trend, it actually hasn’t moved. It’s been 40 to 45,000. And you can’t ignore exactly your point, population growth during the month was 110,000. And so you’re in this environment that’s very consistent with a lot of the themes you and I have been talking about, which is supply side growth, non inflationary, this type of labor market absorption. When you have this growth in the population and an unchanged unemployment rate, that doesn’t seem very inflationary to me. And so maybe what I’d like to do is just walk through, in your mind, we know that the bank of Canada has loosely begun to look at the unemployment rate as a proxy for the output gap. So how are they going to be viewing this report?

Andrew Grantham: Well, I think also what’s been key in recent Bank of Canada communications is that they’ve talked a lot about employment relative to population, that it’s been lagging population growth, even when the employment numbers have been strong. So that kind of makes me think that the Bank of Canada maybe internally expected some strong employment numbers and kind of got ahead of that a little bit, starting to talk about that employment to population ratio. And they’ve also been for a number of years now, we think, kind of through and just after the pandemic, have been using the unemployment rate as a little bit of a guide as to slack in the labor market. Because, you know, we’ve talked about this before that, you know, you have supply issues and demand issues. It’s very difficult, you know, from an output gap perspective to judge whether GDP is above or below potential if the short term potential is changing. So that’s why we think that they’ve been using the unemployment rate and other labour market indicators as a little bit of a guide as to slack in the economy. And even after the strong April employment number, we are still at an unemployment rate that is more than 1 % higher than the trough that was recorded just coming out of the pandemic.

Ian Pollick: Now, it’s not a big deal and it was a very light move, but you and I have often talked about some of the underlying momentum in the labor market. One of the things that we have been looking at just for our listeners to understand is the unemployment rate of people who have been unemployed for three months or more. And that actually ticked down by a tenth in this report. You know, the trend on a year -over -year basis is still lower left to upper right. So there’s still deterioration. How do you think the Bank of Canada looks at some of these supplementary unemployment rate numbers and can you advise any of our listeners on what they should start to be looking at?

Andrew Grantham: So one of the reasons that I personally like to look at the kind of more longer term unemployed in Canada, particularly if we’re judging our labor market relative to the US, is that here in Canada, we tend to have a lot more short term unemployment than they do in the US. That’s because the definition of what is classed as looking for a job in Canada isn’t as strict. So people can be unemployed rather than out of the labor market. It’s also because we have, or at least we used to have, this thing called winter, which meant that there were a lot more seasonal jobs than there are today. Today there are a lot more desk jobs than there used to be, like five, 10, 15 years ago. So what we’re seeing is that short-term unemployment in Canada is actually less, but that’s structurally less than it used to be, which is why I prefer to look at these numbers, the unemployed for more than a month or more than three months.  And you’re right, that improved a little bit this time around, but that’s been flashing warning signs for longer than some of the headline numbers have been kind of deteriorating for now.

Ian Pollick: Well, you said something I want to pick up on, and I think given the theme of divergence, which is all the rage, let’s just compare and contrast a little bit some of the labor market reports that we’re seeing about Canada and the US. We got the jobs report, we got the Canada report, opposite direction in terms of expectations. Wage growth in Canada actually seemed to be kind of okay, but when you look at the two economies, and in particular you look at the two labor markets, what is standing out in your mind as that key metric for divergence?

Andrew Grantham: So I do think it’s the unemployment rate and it’s the unemployment rate of people who have been unemployed for longer than three months. That has been trending upwards for much longer and much more in Canada relative to the US. The headline unemployment rate in the US has moved up from its trough, but very modestly compared to what we’ve seen here in Canada. And I think the good news that we saw from the US with the slowdown in payrolls, but also the slowdown in wages as well. It does seem that wage growth in both countries is starting to decelerate a little bit. And that’s obviously good news in terms of getting inflation, not just touching 2%, but sustainably back to 2%. It’s those wage figures that are very helpful in doing that as well. But overall, I do see a little bit more slack in the Canadian labour market than the US at the moment.

Ian Pollick: One of the things I was noticing in the last labor market report in the US is if you look at the year on year percentage change of full time positions, it sounds negative in the US. And I don’t think people appreciate that that to me is at least one channel of potential labor market weakness. So it’s not like this divergent story is US is amazing, Canada is really, really bad. I think it’s that the US is just less bad than Canada. Or would you characterize it as something totally different?

Andrew Grantham: I wouldn’t say bad for the US. I think it is slowing in a controlled manner. The concern I have in Canada, maybe before the April numbers, was that some of the slowdowns seem to be a little bit less controlled. And particularly if we think that, my personal view is that the labor market in Canada is maybe even weaker than the headline numbers suggest because the group of people who have seen their employment prospects deteriorate the most over the last year, which are newcomers to Canada, so immigrants less than five years and non-landed immigrants, we do know that they are undercounted in the labor market numbers. It takes a little while for these LFS numbers to catch up with that population growth, and so I suspect that the actual unemployment rate in Canada is maybe a little bit higher than the official numbers suggest.

Ian Pollick: Interesting. Okay. And so like, I mean, that is an important channel by which the two economies are diverging. But I think the point that I want to make to all of our listeners is the house view that we have here isn’t Canada bad US good, both bad one worse than the other.

Andrew Grantham: Both slowing down, but I think slowing down certainly less in the US relative to Canada. Now, in terms of, we talked about the labor market divergence between the US and Canada, how has that been reflected in terms of market pricing at the moment? And do you think where the markets are priced in, particularly after the surprise April LFS is kind of fair at the moment.

Ian Pollick: It’s pretty funny because I think it’s a very natural reaction of the market, which is obviously forward looking. You see such an enormous positive forecast error and the immediate conversation is, well, June has to be dead. And we’ll get that later in our conversation. We’re going to talk a little bit more about that. But as a result of that, you had Canadian bond yields underperform. But you take a step back and really the theme in the Canadian bond market vis-a-vis the United States has just been this tremendous outperform and that outperformance, it’s been happening for about two months now. The deterioration, the Canadian data really started to increase kind of mid -February. We’ve seen term yields across the curve really outperform the US. There’s some relative cheapening recently, but more or less it’s been a very defined trend. In the short end of the curve, you have double the amount of cuts already priced for the Bank of Canada relative to the Fed by September. You have, at the end point of the cycle, let’s say three years forward from today, you have the bank that is priced to be 70-ish through the Fed. That’s not a very big differential considering we’re starting at 50 below the Fed. And so I think that this theme of divergence, as much as it’s been discussed and quite widely at that, it’s not necessarily priced the way that I would have expected it to. Now, when I think about the main channels by which this divergence has been priced, there’s really three. Obviously, it’s short-term interest rate expectations, Canada relative to the United States. The second is your neutral rate expectation, Canada versus the US. And the third is really some supply, demand, and balances in the bond market, which you could more or less proxy by looking at term premiums. And what’s really interesting is that in Canada, let’s just focus on the 10-year sector. Ten-year term premiums in Canada are actually above the US for the first time in a very long time. That speaks to the domestic growth in our bond market, in particular in the 10-year sector. When I look at short-term policy expectations, you know, people fail to realize that you do have obviously more price for the Bank of Canada this year, but you have more price for the Fed next year. And so there is room for remediation in a world where you do believe that the Canadian data deteriorates much, much further. But it’s not clear to me that given the starting point where we are today and giving some of the uncertainty around the June go or no-go decision that this level of outperformance can be maintained. And we wrote about it earlier this week. And so I do think, you know, that divergent story has largely played its course. And in particular, it looks to have played its course in the long end of the curve. Because when I look at U.S. pricing, you know, as we kind of do this podcast, Andrew, you have one and a half cuts priced for the Fed this year. It feels pretty skinny in a world where you do have potential downside surprises in your forecast. And so I think one of the ways that the market is trying to reassess or calibrate how to trade this going forward is to try and understand some of the idiosyncratic risks that Canada has relative to the U.S. And what we’ve been talking about on this podcast is I think more of a timing one. You know, you have labor market slowing and that is an issue of timing in any given market. You keep policy restricted for a long period of time, your labor market’s going to slow. It’s kind of the last thing to move. But in Canada, if we focus on some of the idiosyncratic risks, that’s obviously the leverage in the household sector. And we had the financial stability review this week. One of the interesting things that I took out of this review, because it is really meant to present the tail risks and the tail risks are very specific to Canada. And those tail risks all are around the slowing in the housing market predicated on stress in mortgagers, renters. And what I found very interesting from Macklem and Senior Deputy Governor was that they seem much less concerned about the wave of mortgage refinancing in 25 and 26 than they did six months ago. You know, rightly so. I think they focused a lot on where the stress is and lower income Canadians and particularly those who rent. But to me, that limits the magnitude of what the cycle is going to be. And so I often get asked the question, is this an easing cycle? Is this an operational adjustment to get terminal closer to neutral? And I think when you hear less concern from a financial stability perspective, then you have to lean in the view that this is not the start of an easing cycle, one that provides true stimulus through neutral. But maybe I’ll just back up and ask you, when you saw the FSR, did you have a similar interpretation? Or am I completely reading this the wrong way?

Andrew Grantham: I had a similar interpretation of the way they interpreted the numbers. I still have concerns about some of the figures that they showed because I think they’re absolutely right and we’re seeing this within the economy at the moment that households who have to refinance, whether they’ve refinanced already or whether their refinancing is coming up still, they are saving more, they are spending less and if they spend less, then that impacts employment in some kind of lower paid sectors such as retail, food accommodation, that sort of thing. And that will impact the people who work there and that will impact generally renters rather than home buyers in terms of employment prospects. And really from a credit risk point of view, it’s the employment prospects, the unemployment rates that really matter. So I think at the moment that is absolutely what we’re seeing. That’s where the stress is. It’s among kind of the lower income, the renters, the people who have seen their employment prospects deteriorate from the pullback in spending that homeowners have made either because they’ve refinanced or in anticipation of future refinancing. The one thing that worried me from that report is that you look at some of these numbers, in terms of the refinancing hit that people will still be facing in 2025 and 2026, and these are based on market expectations for interest rates. Because financial markets relative to a year ago are buying into this higher for longer scenario than, you know, more so today than they used to, some of these numbers look worse than they did a year ago in terms of the percentage increase. So you know I think definitely at the moment you know there’s maybe less stress than they thought but I’m not sure we’re kind of all clear yet.

Ian Pollick: So would you take some of that discussion and if you had to think about your medium term forecast for the bank, let’s say to the end of 2025, would you agree though that in the absence of concern of solvency, in the absence of concern of more broad based deterioration in the ability to service debt, that this is a cycle that is more about getting closer to neutral than one that is to provide actual stimulus?

Andrew Grantham: Absolutely, absolutely. I think, you know, and that’s reflected in our forecast. We have, you know, the forecast numbers that we have out to 2025 only have us coming down towards where we think a new neutral rate is. You know, we don’t see them having to dip below that yet. So yeah, this is an adjustment, but we are adjusting from, you know, rates, which is quite a bit higher than where we think that the neutral is. So that would still reflect quite a few interest rate cuts over the next year, year and a half.

Ian Pollick: Okay. And I would just say before we move on to the next topic, it was funny to me in the FSR and just for the bond geeks that are listening to the podcast, there was a lot of discussion on the increase in reliance of term repo or repo in general and how that creates a lot of systemic vulnerability. And obviously that’s true in a world where you’re using leverage. Now you have leverage and you have surprise and you generate volatility. The one thing that I would have to dismiss is in the FSR, in the press release too, they talked a lot about the increased use of the basis trade. Well, I’m sorry, Bank of Canada. I look at the transaction level data from the Montreal Exchange. You do a basis trade, it’s tagged exactly as that at the Montreal Exchange, and we are not seeing any material increase today relative to six months ago. And actually, the overall volume DV01, the actual risk of basis trades in Canada, whether it’s in XQ or CN or CV, is almost at an eight month low. And so I’m not too sure what data they’re looking at, but I would just say that that is one part of the FSR that I vehemently disagree with. So let’s get onto the guts of this. And this is what everyone’s going to want to be focusing on. I want to talk a situational analysis between the Bank of Canada in terms of when they go and what the cadence of those cuts look like. So let’s assume that your forecast for the Federal Reserve to cut rates in September and December this year is correct. Let’s say the threshold for a June cut and tell me if I’m wrong on this, given the labor market report, not withstanding some of the dynamics we talked about, is it fair to say that a threshold for them to go in June based on the next CPI report would be something like greater than 0.2 seasonally adjusted in the core measures?

Andrew Grantham: Yeah, I think, you know, definitely the bar has shifted with the labor force numbers. We will need those core measures of inflation. Whether you’re looking at trim median or whether you’re looking at something like CPI-ex, we’re going to have to see them remain in fairly subdued, you know, and similar to what they have been over the past two months. If we do see an acceleration, particularly if we see like seasonally adjusted point three or something like that, then, you know, that probably will see the Bank of Canada wait until July and wait until they see some more inflation and employment numbers. But I think a continuation of the recent trend, I think they would still move, or they’ll still be fairly happy to move in June.

Ian Pollick: Okay, so let’s do this analysis, okay? Next CPI report, seasonally adjusted core measures, they’re point two or they’re below, and that signals a June cut. In a world where your Fed forecast is correct, talk me through what the path looks like. They go in June, then what?

Andrew Grantham: You don’t normally say in a world that your Fed forecast is correct to me.

Ian Pollick: I know. We’re in an imaginary environment right now.

Andrew Grantham: OK, fine, good. So this is just coming down to the divergence. How much can the Bank of Canada diverge from what the Fed is doing? The basic answer to that is there’s really no limit, because if the Canadian economy was weakening significantly relative to the US, the Bank of Canada would have to be forced to cut interest rates to raise inflation domestically and they wouldn’t worry about the currency from that. Now, based on our forecast that the Canadian economy will kind of stabilize, pick up a little bit as interest rates come down and the unemployment rate will do the same, so no more slack has kind of opened up within the domestic economy, then there will be a limit. There would be a limit as to how much inflationary pressure from the exchange rate they would be happy to have. So under that scenario, I think they would be happy to move two, maybe three times before the Fed, but probably no more than that.

Ian Pollick: So if we think Fed is in September, can you see situations for what I just heard is let’s say point two, they go, so they go in June, they go again in July, do they skip September and then maybe look for an October, December move?

Andrew Grantham: They could do that or they could move in September and then skip and then to one more in December. I think it would be two and then a hold or three and then a hold, but there would be that pause in there to make sure that gap between the Bank of Canada rate and the Federal Reserve’s rate didn’t get too wide and so that the currency didn’t depreciate too much.

Ian Pollick: Okay, so let’s talk about the other scenario here. Again, your Fed forecast, beautiful, absolutely stunning. It came exactly to fruition. But let’s say you get that .3 in the core measures for the June meeting, and so they skip June, they go July, do you see the same cadence, i.e. it’s sequential July, September, then maybe a skip, and then they go again? Or has your path changed in that environment?

Andrew Grantham: I think it would still be, again, based on the forecast that we have for the economy starting to pick up, there’d be no more slack in the economy. I would say under that scenario, you push back to July, you probably have one less cut this year than you would do. So you’d still have that skip. It wouldn’t necessarily be four meetings in a row.

Ian Pollick: Okay, but do you think it would be July, September, and then you skip the back half of the year? Or do you think that you’d have to do something like July, skip, Sep, do October, because that’s your next NPR? I guess the question I have for you is in a world where you have that .3 core, so the handoff is a bit stronger, are you more reliant on a forecasting update, i.e. do the NPRs have a premium that they don’t have if you’re in a .2 world that sees you go in June?

Andrew Grantham: I don’t think they have as much of a premium anymore because we do have the press conferences, we do have the ability for the governor to explain the actions. So I think it would be very rare to start either a cutting or hiking cycle and only do one. So I think if you push back to July, you still do two in a row and then maybe skip and then have one more afterwards.

Ian Pollick: Okay. I think for my own part, again, I can’t, I think June is a coin toss. I do not think that we will know the answer to that until we see the CPI report. Assuming that we get point two and under, my own view is that it is June, July, you skip September, then you have to see where the data migrates to and maybe you get another one this year.

Andrew Grantham: In this world, I think we’re kind of both on the same page here, that it’s not going to be a straight line in terms of this cutting cycle whenever it starts. You know, there’s going to be some periods where they pause, see how things are doing, because we’re not expecting the economy to fall off a cliff and we’re not expecting inflation to materially dip below the bank’s target. So in that world where you have this kind of fairly slow gradual path in terms of cutting, like how’s the best way to trade this in terms of markets at the moment.

Ian Pollick: Well, I think we are, you see what’s happening on this podcast, Andrew, you and I are actually coalescing around a view and this never happens.

Andrew Grantham: Which means it’s going to be wrong probably, right?

Ian Pollick: Correct, which is very special to me. I think you’re right though. We are agreeing that whatever the cycle looks like, it is irregular and it is somewhat shallow relative to what we had thought three to six months ago. And so in my view, I kind of see September as the low hanging fruit as a meeting to skip. You know, it’s kind of wedged at a weird time of the year. I don’t necessarily think that three in a row is all that realistic, barring some rapid deterioration that we just haven’t yet seen in the data. And so I don’t mind steepening some of the meeting gaps like July, Sep even June stub Sep. I think those are very good trades where the skip occurs in September. But I do think even in an irregular cycle, you may have a shift in mortgage preferences to take advantage of what could be a very near term trough in policy rates and five-year yields. And therefore I really like five-year swap spreads. I think five-year spreads are a really, really interesting way to trade an irregular cycle. I would like to start getting long around minus five, minus six, maybe dip a toe here just to see how they trade. But, you know, in contrast, when you think about the U.S., what is the irregularity that their cycle has? Because we haven’t really talked a lot about the pace of the Fed. And so maybe just before we end the episode today, and we wish everyone a good week ahead. How are you thinking about in a regular shallow cycle in Canada, just to tie this theme of divergence together and how the Fed starts to move once they start?

Andrew Grantham: So I think with the US, we would expect a fairly gradual path in terms of the Federal Reserve when they start to cut interest rates. Because we’re not seeing anything within the US data that would warrant them to cut quickly at this point in time. And we don’t forecast that within our forecast. So to your point about whether this is a real cutting cycle, whether this is an adjustment back to something closer to neutral, our forecast is that it’s more of an adjustment. Whenever that starts, whether that does start in September or whether that starts later, it’s more of an adjustment, which means then it’s going to be a fairly gradual and, again, a regular path in terms of the move down.

Ian Pollick: Okay, great. Andrew, thank you for being on the show. To our listeners, we wish you a great week ahead, a happy long weekend. And remember, there are no bonds harmed in the making of this podcast.

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