Shakedown street

Ian Pollick: And what Deputy Governor Gravelle said was really interesting. And he said, look, we are not ending QT anytime soon. We still believe that the forces that were driving CORRA away from target had nothing to do with QT itself. I’ll come back to that in a moment because I vehemently disagree with that. But they did provide some important learnings.

Ian Pollick: Alright, happy Friday everybody. It has been a crazy week. I am joined today by my good buddy Ali. Ali, how you doing?

Ali Jaffery: Good, how are you man?

Ian Pollick: I’m okay. I actually had hernia surgery a week ago and so it’s been a bit of a slow week. Super awkward to turn around. I’m terrified to sneeze.

Ali Jaffery: Ouch.

Ian Pollick: Yeah, it is ouch. But I’m getting better.

Ali Jaffery: Good, good. That’s good to hear.

Ian Pollick: Getting old sucks. Let’s just talk about the week that was because this has been the most divergent macro week that we’ve had in almost two years. You had a Bank of Japan hike, an SMB cut, a Fed that was dovish and hawkish at the same time, a Bank of England that was dovish, Bank of Canada mainly just said nothing. QT updated which was not what people were expecting. And so there’s a lot of fat to chew on here. I think to start the episode, my simple question to you is this: are we still in an environment where the macro narrative is linear? And what I mean by that is, ending 2023 coming into 2024, it was a very linear message. Rates were going to go down. The economy is going to contract. You have this very classic end of cycle behaviour. That’s been disrupted several times in the past quarter. What are your thoughts?

Ali Jaffery: I think mostly in that narrative is still intact. It’s not perfect. There’s going to be a lot of bumps on the road, but I think it’s still mostly a sensible base case scenario. And I think the main reason for that is the most nonlinear piece of the cycle that we’ve had are the supply shocks. And not only have they faded, and we have some material evidence of that, but their impact on inflation expectations from a central banker point of view, that is either normalized or started to normalize. And we’ve seen a lot of data that has shown that excess demand is being sap. You know, monetary policy is working. And also something we’re not talking about as much is fiscal policy is not really getting in the way as much. Fiscal policy setting has not necessarily become neutral fully, but at least it’s not becoming more stimulative in other parts of the world and in other places. It is actually becoming more neutral to contractionary. So when you go down the list, the case for monetary policy easing, in terms of having less restrictive policy, I think it’s still sound. It makes a lot of sense given the data flow. But of course, what are the wrenches that can disrupt this story? And I think one of those things is where we’re supposed to go. Where are we going to end up? And I think central banks are still figuring out what’s that anchor for monetary policy? What’s our star? I think that debate is coming up. So it will be linear, but maybe the slope of that line would be a bit different.

Ian Pollick: It’s a shallower pace, right? That segues into our next topic really nicely because in a world where we’re no longer talking about an urgency of easing and we’re talking about calibrating the resting spot of policy, all of the sudden you have to talk about our star. And in small open economies, we need to include FX star. And so, you know, the Fed did a great example of this, this shallower pace of easing. in the dot plot. And so let’s just start with the Fed, right? Like to me, it was never a question that we’re going to get an actual move this week. What was not on my bingo card was an adjustment to the 2025 dot. I didn’t think that the 24 dot was going to move, but I thought that was explicitly tied to the out years. And so, my question to you is this, I want to understand what your view of the Fed is, what you heard versus what did he say. And in particular, let’s just provide a little bit of context here. When I look at the survey of economic projections, what my eyes see is when I look at the distribution of all of the central tendencies, you know, if you put that into diffusion index, it seems that more of the FOMC is worried about upside risks to growth, upside risk to inflation, as opposed to downside risks stemming from the unemployment rate, which is by itself inherently somewhat hawkish. And then you look at the actual distribution of the dots and what you see there is your right hand side of the distribution is effectively locked off. It was an extremely close call for 24 not to buy it because there was one person still below current level. And so the press conference was much more dovish, right? And so I want to understand from your perspective why such a dichotomy? What are they trying to tell us?

Ali Jaffery: So a couple of things here. First is the press conference. I put more weight on that than I do necessarily the dots. The dots are a point in time view. Now there’s some tactical element to that. But I think the dots are meant to kind of give markets a bit of a bone that we saw the data flow and the economy has been strong. Inflation has ticked up a bit. The labor market rebalancing has continued. So you know, on average, the cursory view would be, okay, monetary policy needs to be a bit more restrictive. And so to do that on the outer years versus the current year, you know, it gives that sense that, okay, we need monetary policy to be more restrictive, but it also resets the focus for everyone that, hey, we care about the, you know, this gradual disinflation and we don’t want to disrupt the labor market at the same time. So I think that was kind of the broad logic of the dot plots. But Powell, I think, said some really important things. One is that he poured cold water on the two very hot inflation prints that we saw in January and February CPI. He attributed a significant portion of that uptick to seasonality. And he also said something quite interesting, where the first half of the year typically exhibits higher seasonality. So it gives a little bit of leeway to the Fed to say, look, we may see more bumps along the road, but it doesn’t necessarily mean that, you know, we’re going to substantially adjust our policy stance. So the Fed, I think, is now in a different regime where they don’t need to be as ultra reactive to data. You know, they’ve seen a tremendous amount of progress and their framework is kind of resting on some things that, you know, they’ve relied on for a very long time. You know, those are sort of three main things. So one is that the Phillips curve in the United States is flat. That is the link between slack and inflation isn’t very strong. So making adjustments here and there, particularly in the near term, isn’t really going to get a lot of juice. It’s not really going to bring inflation down quickly. So I think they recognize that. The second is the interest sensitivity of the economy is also fairly low. We know the story about 30-year mortgages, but also firms. Firms are optimizing their balance sheets as rates fall, and borrowing long, and taking advantage of the curve as it adjusts, particularly when there’s a dovish signal. So they recognize that they’re also not going to get a lot of juice from these changes in monetary policy.

Ian Pollick: I would also just add that the composition of the US economy is very different. Like from an industry perspective, you’ve less capital requirements like you did 30 years ago with the big manufacturing sector. Tech just doesn’t need that. So for any given level of policy, you have less capital deepening and therefore you have less sensitivity, right?

Ali Jaffery: Absolutely, right? The share of business investment capital stock, you know, isn’t necessarily rising and we have a change in the structure of investment economy for sure, happening over the last 10 years and more. I think that they recognize that. And also, what Powell’s been saying for the last three, four meetings straight is the supply side has done such heavy lifting on bringing inflation down. And he’s talked ad nauseam about labor supply and the expansion of you know, labor force participation and productivity. So he recognized that there are other forces going on that are supporting disinflation. And monetary policy is one element in this, but he doesn’t want to be disruptive to that either and to recognize that and ride that wave. So I think that’s a balanced Fed. I think what they put wrote down makes a lot of sense. And, you know, they don’t want to overdo it on any aspect because they have time on their hands. The economy is not weak by any stretch of the imagination. Yes, there’s some worries about labor demand that Powell expressed, and I think that’s sensible, but the labor market isn’t cracking either. So I see this as a nice balanced position for the Fed. And it’s not necessarily a full-on dovish signal, as some interpreted it. Like you said in the beginning, there’s some hawkish elements, some dovish elements, but this is their patient, and I think they have a lot of time on their hands.

Ian Pollick: Yeah, I think people largely, and by people I mean the market, underestimated the result they have in waiting to see what happens. And really, it wasn’t until Powell made the comment that they could actually have confidence to start easing monetary policy, even with the labor market being relatively strong. I think that comment threw a lot of people off. And so the ultimate question here, and really what matters for the bond market, is there does not seem to be a tradeoff anymore between growth and inflation, which is the trade off that markets had been banking on for the past really three months. And so walk me through why you think he made that comment on the labor market. Like why would he be willing to say that confidence can be reached to start normalizing rates as the labor market stays strong? Is that just him saying that they don’t view policy needing to go through neutral and therefore add stimulus? It’s more of just an operational adjustment?

Ali Jaffery: I think it’s that they have a dual mandate, right? And they want the labor market to stay where it is. And they recognize, like I said, that monetary policy isn’t really going to substantially impact the economy very quickly. So it makes sense for them to gradually ease, to prevent the labor market from cracking. And we’ve seen some signs with the unemployment rate ticking up, vacancies coming down, that there are some indication that the labor market’s strength is starting to fade. So I think even though the headline indicators that everybody follows remain fairly strong and particularly the payrolls data, but that might be driven by the supply side that he’s talking about. So I think they have a very nuanced view of the labor market and they want to ensure that labor demand doesn’t fall. So even though the headline indicators are fairly strong. So I think it’s that let’s start to pre-emptively bring rates down, you know, just like they did in the 1995 cycle, to keep the labor market sort of where it is for the next few years.

Ian Pollick: Okay, so let me ask you this. This is the Ali view, not necessarily the CIBC Economics view. So I’m putting you on the spot here. Remind our listeners what your forecast is for the Fed.

Ali Jaffery: Our house view is we have four cuts for the Fed this year starting in July and another four cuts in 2025. Now, I think there’s a case for that, particularly if we see labor demand weaken, we can see the economy not as strong as what the Fed has laid out. The Fed has put a lot of weight on this increase in supply driving growth. Maybe that doesn’t have as many legs as they put in their projection and four cuts might be sensible in that world. But I see a lot of downside risk to four cuts in the sense that three cuts, like what they’re saying, makes a lot of sense too. The economy is still humming along. You know, you want to move at a very gradual pace. Four cuts might be fairly aggressive, you know, particularly if our star is much higher than we think, let’s say it’s in the three, three and a half percent range. There’s no rush to get there then. So a more modest pace of easing in that world can make a lot of sense too. And if Powell is right that the supply side of the economy remains robust, even in 2024, 2025, you have higher potential growth. That means higher R star. That means less need to cut rates aggressively. So I see a lot of benefits in that three-cut view. And we’ll be watching the labor market data to see whether that labor supply story continues to shake out and if it does I wouldn’t be surprised if we move to three.

Ian Pollick: Yeah, I would agree with that. I think that’s a very, very nuanced way to look at. And I think that’s really consistent, even the way he talked about quantitative tightening and the runoff. You know, he basically said, look, we’re in abundant period, we’re looking to be in an ample period. And the slower we go, the further we can go. And I think that that’s a testament, not just to their view on QT, but also how they’re viewing the normalization of policy as well.

Ali Jaffery: Yeah, exactly. Let me turn the tables here and ask you a question. What do you think, you know, what the Fed said yesterday means for the bond market and the curve? You know, are we clear to rally? Are we clear to steepen? What are your thoughts?

Ian Pollick: Listen, I think it was a very, very pivotal moment. And I want you to call the time of death of the flattener at 2.01 PM, March 20th, 2024. And I believe that firmly because you’re now in an environment where we had for the past six months, the market has been going back and forth between whether or not central banks do have to make a trade-off. You’re either choosing to allow growth to deteriorate because inflation is too high or on the opposite side of that, you’re doing the opposite. And each one has a very different implication for how the bond market reacts and how the curve trades. But what the Fed is effectively saying with their dot plot as well as their SEP forecast is that you’re now in a situation where you can have this coexistence of slightly higher inflation, relatively strong growth, and start to normalize interest rate policy back towards neutral. Well, then what you’re effectively doing is you are migrating any inflation volatility in any stronger growth away from the front end of the curve to the back end of the curve. And so by itself, that argues that long-term interest rates just don’t have to fall as quickly. But by definition, as you enter the easing cycle, your curve has to steepen. Now on top of that, when you are transferring that relative vol to the back end of the curve, that back end now has to absorb the increase in global bond issuance and there’s still an increased level of issuance, even with a more tempered fiscal path. You saw this pre-existing stock of bonds that has to be rolled over and issuance is still relatively large. And so I do think that it means that long-term rates will have a very hard time falling. And in particular, we’ve already seen the back end of the curve respond to this idea that our star is higher. You know, like yesterday, what did they raise the long run dot by a tenth?

Ali Jaffery: A tenth, yeah.

Ian Pollick: Yeah, so it went from 250 to 260, I think. But market implied R star in the US is trading at 360. It’s already 100 basis points higher. And so the back end’s already really absorbed this view that neutral can be sustained at a relatively high level for a very long period of time. And so I think, like I said, call the time of death on the flattener. We’ve unequivocally entered into a trend steepening part of the cycle, but it’s not the traditional steepener that people wanted. It is not one that’s led purely by lower term interest rates. It’s one where you do have this stickiness in term premia because term premia do respond very well to inflation volatility, to increases in breakeven expectations, as well as global bond supply. And so I think, you know, based on our current forecast, I think we’ve nailed it. I don’t think that the market is a one-way rally from here. I think you can get marginally lower interest rates over the balance of the year. But to your point earlier about going slow, going slow introduces a lot of risk and they’re not just downside risk, which is really important. And I would like to talk to you in a second about what that means from the Bank of Canada so that we can do a cross-market comparison. But just to reiterate, you know, I do think that the curve can stay steeper for any given part of the cycle, i.e. any given level of overnight rate will produce a steeper curve. And that steeper curve isn’t just a function of lower term interest rates.

Ali Jaffery: Just pivoting to the bank for a second, Toni Gravelle had an interesting speech this morning. What did he say? What are the implications?

Ian Pollick: You know, this was one of my most anticipated speeches of the year. I remember that we hadn’t heard from Deputy Governor Gravelle in over a year. And so the speech yesterday was all about balance sheet normalization. And there’s been a lot going on. You know, remember that we’ve had these constant dislocations of CORRA relative to target. You had the Bank of Canada at the March meeting throw a little bit of cold water on the notion that QT itself was the cause of it. And so yesterday was always going to provide us with an outline of how the bank was thinking on a market to market basis. And what Deputy Governor Gravelle said was really interesting. And he said, look, we are not ending QT anytime soon. We still believe that the forces that were driving CORA away from Target had nothing to do with QT itself. I’ll come back to that in a moment because I vehemently disagree with that. But they did provide some important learnings in terms of how they are viewing calibrating the lowest comfortable level of reserves. And they said, look, we believe that we can take it slow. And the further we go, the better off our balance sheet will be, and so they kind of reiterated that 20 billion to $60 billion range. Our updated view on the resting spot of reserves is towards the top end of that range, so let’s call it 60 to 70 billion. What the banks said yesterday that to me was the most interesting is the way that they will manage the balance sheet once quantitative tightening ends. And in effect, they’re just saying that they want to skew their asset holding shorter. And so really what they’re trying to do here is they’re trying to better align their floating rate liabilities with floating rate assets. And those floating rate assets are term repos, they are treasury bills, and it’s really the fixed rate liabilities like currency and circulation, that will be matched by an increase in bond purchases, and so really what they’re telling you is that there’s going to be much less reliance on bond purchases going forward relative to how they manage the balance sheet pre-pandemic. In fact, they actually even laid out an order of operations. They basically said, look, we are, once QT stops, we will first start doing term repo operations. After that, then we’re gonna start buying treasury bills. And then a while after that, we’re gonna start to buy bonds. I think that makes sense, recognizing that their bond portfolio is still relatively large, but it’s a bit surprising to me that they’re still maintaining the view that QT in of itself is not the root problem of core slippage. In the speech and there was also a paper that was released alongside of it that basically said we think there’s two things happening. Number one is there’s just a larger increase of bonds from a levered community because there is more expectations of interest rate cuts. And number two is there’s more prevalence of the basis trade which seeks to arbitrage the difference between futures prices and cash prices. There is a lot wrong with that point of view. To start with, we’ve had market rallies before predicated on expectations of monetary policy pivots, and there’s been very little evidence in the past that prior rallies, which were in fact, larger and more sustaining, that didn’t have any influence on CORA. Number two is that we happen to look, daily, at the transaction level data from the Montreal Exchange. And that’s how we build up our net positioning reports. We see no indication that there is an increased level of basis trading going on over the past three to four months, that would be consistent with the view that this is the primary or proximate cause for core rising. And so I’ll just reiterate what we think is happening, Ali. When I look at the ownership of reserves, what I see is a disproportionate concentration where roughly 60 to 70% of all the reserves in Canada are now being held by two to three banking institutions. And so that is the opposite of what a floor system is supposed to be comprised of, right? A floor system is by definition a system where there is an ample level of reserves across all market participants in that system, such that there needs to be less fine tuning to get your overnight rate back to its target zone. And so this is a problem and it’s going to be a problem as you go forward because ultimately what’s going to happen is I think they’re going to be forced to NQT a bit earlier than they had thought, which they said was early 2025. And you’re going to see core dislocations all the way through, and so the immediate market implication here is very simple. You know, in a world where not only is Cora maintaining its deviation from target that undermines carry. Number two is that in this new sequencing of how the bank’s going to manage its balance sheet after QTNs, they’re just going to buy fewer bonds. And so we know that net supply is going to be very large next year, and it’s going to be even larger than we have thought because the bank’s going to rely less on the actual bond market. And so for swap spreads, that’s unequivocally swap spread narrower, and it just pours a little bit of gasoline on the notion that swap spreads in of themselves have to rise. But at the end of the day, to me what’s really interesting is that, you know, similar to how central banks are trying to anchor their monetary policy stands, they’re also trying to anchor QT. And the bank is now choosing somewhat of a hybrid approach to anchoring QT in such a way that it blends a bond portfolio on one side, which is non-board reserves, and a very small pool of liquidity through lending facilities on the other side, which is board reserves. And so that’s what I took out of the speech. And I mean, I would ask you, I know this is super technical, but is there any reason to suspect that you can not maintain quantitative tightening as the first eases get delivered?

Ali Jaffery: I think from a monetary policy perspective, I don’t see a big problem here because the impact on inflation, you know, is fairly modest. The changes in the yield curve aren’t going to really spill over into real activity. First of all, they’re going to be very small, and the spillover is going to take time, and the impact on price setting is going to take even longer, if at all. So my takeaway is the bank is trying to normalize the balance sheet. You’re probably right that there’s gonna be some dislocations and they might have to stop early, but they’ll live with that. Because they wanna get to normalization as much as they possibly can. To give them more space, should they need to use this tool in the future? But, I’d be interested in your thoughts on that. Are they priming themselves for that? Or is it just they wanna put this tool to bed and normalize it so they don’t have to deal with this over the medium term.

Ian Pollick: Oh, I would say unequivocally, I agree with you. By skewing the maturity distribution of the balance sheet much shorter, it allows them in the future that if they ever had to do bond purchases again, and remember they said, look, we’ve done all the analysis and we’ve done it too, QE didn’t really do much what they thought it was gonna do. It was really global spillover from the US. And what they were left with was a very problematic bond market owning a disproportionate amount of bonds that really didn’t do much. And so they said, look, if there’s a market event or external or internal that forces us to provide the quiddy to the bond market, that’s how they would characterize it. So they’re not going to do QE again the way they did it in the pandemic, but I am sure there will be some part of the future cycle where they’re going to have to buy bonds again. And by allowing their balance sheet to skew shorter, you know, the really traditional way that QE or bond purchases work is to suppress term premia. And so it provides a huge amount of bang for the buck that they were to buy longer duration assets when they need to, because that kickstarts the whole portfolio diversification effect. So I think what they’re doing is actually quite smart. So let’s wrap this up. Let’s bring it a bit closer to home, and I wanna talk real talk here. Let’s talk about the Bank of Canada. You know. we got the minutes this week and the minutes basically said, look, we are not willing to look through high shelter inflation yet. We wanna see evidence that it’s really just contained to mortgage interest costs, i.e. rents and household services have to fall, b  ut the conditions for an easer are still here. And so the number one question we get from clients is why isn’t Macklemiesing, we’ve had two back to back, relatively problematic reports showing that CPI ex-shelter is not only not above target, but well, well through target. And so I’m gonna open this up to you and ask you, number one is the seasonality that you cited to the Fed saying that they believe that there is a seasonality to CPI, is there a same similar downside CPI seasonality in Canada? And is that what the bank’s looking through? And in general, what did you hear from the minutes this week?

Ali Jaffery: So I don’t think there’s a seasonality necessarily in Canada, but I do think the bank has been putting a lot of weight up until very recently on its preferred measures of core inflation, Tremon median, which hadn’t budged, and thereby design low volatility, high persistence measures of inflation. And they don’t do well when there are persistent shocks to different parts of the inflation basket. They’re designed to strip out transitory big movements and inflation on the big or the downside, but not really well designed to deal with persistent shifts in the price basket. And I think they’ve kind of started to figure that out, you know, with the October NPR and the fall. And so there’s some tactical elements here that are going on that they want to be ultra sure of themselves. When they signal that, okay, we’re ready to cut rates, because it’s not just one cut. They’re gonna have to talk about a series of steps. They’re gonna have to lay out some conditions for an easing cycle, because the minute they say they’re gonna cut rates at meeting X, they know they’re gonna be asked, oh, are you gonna cut meetings at the next meeting? And so that signal is the most important thing for a central banker. They want that to be entrenched in financial conditions, and that’s what’s gonna weigh on activity and keep inflation where you want it to be. So they really want to get that first signal right. So I think that’s one part of it. The second part of it is, the bank has a certain process, which I don’t think people fully appreciate. They go through, from one NPR to the next, they go through a range of debates about incoming data, surveys, what markets are saying, and they plug it into their projections, see how that’s different from what they had last time, and they want to see the differences between one projection and another. Can they explain that? What are they getting wrong? And it takes them some several times to feel comfortable with a certain position. So, for example, if we rewind to 2023, if you look at the January NPR to the July NPR, you see growth being, you know, severely revised up, inflation being revised up. The bank basically got a bit skittish. They thought, okay, the economy is stronger than what we thought. And it took them two and a half to three NPRs to figure that out, a nd so they ended their conditional pause and they started to hike again in June and July. Now we saw a big downgrade in the October NPR, which was sustained in the January NPR. So you have two NPR saying the same thing. Their processes are kind of saying the same thing. And now we know the data that’s come out since then is going to show that the April NPR is going to give an inflation picture that’s weaker than we saw in the January NPR. So it’s going to give them more confidence as well that what they’re doing is working and that they can send that signal. And you know, the minutes, some conflicting signals in there, especially if you compare them to the past minutes and the governor’s speeches. But there’s good elements in there too. Like I like the discussion about, they’re continuing to say that, you know, we’re looking at a wider range of inflation indicators, which I interpret to mean, although they’re not saying CPIX, I think CPIX is in that midst, and they’re looking at every subcomponent possible. So they’re putting less weight on trim and median, that’s gonna help them in their decision. You know, they’re acknowledging the weakness in the broader economy. And they also think perhaps that, the labor market isn’t going to crack as significantly more. They mentioned that in the minute. So I think they feel like they might have a bit more time than markets want to give them, but I think our call for June is a good one. 

Ian Pollick: I like it.

Ali Jaffery: Absolutely, and I think that their process is going to lead them there as well. The April NPR will be a stage, they’ll set it up. They’ll talk about our start, they’ll talk about potential. So they’re talking about the long end of the economy and the long end of the curve. It’ll be odd for them not to talk about, you know, the broader strategy about monetary policy easing They’ll talk about the progress that’s been made in inflation. They’ll say they want a bit more, and I think they’re going to acknowledge the more persistent forces, you know on price setting that are going on now.

Ian Pollick: Okay, listen, I agree, but what I also want to say is that the show is getting a bit long. Ali, dude, you’re a ray of sunshine. I really appreciate you being on the show. 

Ali Jaffery: Pleasure to be here.

Ian Pollick: For everyone that’s listening, please have a wonderful weekend ahead. And remember, there are no bonds harmed in the making of this podcast.

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