The band’s back together

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Ian Pollick: Hi, everybody, and welcome to another edition of Curb Your Enthusiasm. My name’s Ian Pollick, executive director and global head of Fixed Income, Currency and Commodities Strategy at CIBC Capital Markets. I’m very happy to be rejoined by my co-host, Royce Mendes, executive director, senior economist and CIBC Economics. Royce, It’s been a while since you and I have done this show together. How are you?

Royce Mendes: I’m good. I need a little bit of a break from you.

Ian Pollick: I understand it happens all the time. Did you have a good break?

Royce Mendes: I did. I actually ended up moving. I’m one of the people who moved out of a downtown condo into a bit more space because I’m working and living at home. So I moved to a house.

Ian Pollick: That’s great. And so far, everything is going good. You and your roommate are having a good time.

Royce Mendes: This is true.

Ian Pollick: Good. Listen, it was a pretty busy week last week. I think we should start off just talking about the Bank of Canada, you know, at face value, somewhat hawkish in nature. But you take a step back and you realize that it’s really just a mark to market characterization about the faster pace of growth in Q3 versus a statement of a faster recovery ahead. There really wasn’t any mention that the bank is more optimistic that forward output gaps will improve at a much faster pace. But there are some other interesting subtleties in it, now we can get to the part about QE in a moment. But what I want to ask you about is generally what was your interpretation of the statement, which most people thought was pretty benign, but in particular in the very last paragraph, how much should we be taking into consideration that they removed that statement that was there in July when they said that they would be prepared to provide further monetary stimulus as needed? Why was that left out? And I guess what are your broad thoughts?

Royce Mendes: Well, first of all, let me talk about the GDP projections and the assessment of GDP, which they used, as you said, it was maybe marginally hawkish, but realistically, they were just telling us that the fall in GDP was not as great as initially expected and the rebound has been faster than expected. But at the end of the day, we’re sort of hitting a ceiling faster. That’s all that’s happening. With the virus still among us. We can’t open the economy to the extent it was in February. So there is that ceiling that is capping the level of GDP and we’ve just reached that sort of faster than previously expected. So as you said, when we look at the output gap 6, 12 months from now, it looks very similar probably to the Bank of Canada, as it did in July. I think in terms of the addition of further monetary stimulus at this point, interest rates are pretty low across the curve. I think the understanding from the bank is that maybe they can’t do the heavy lifting anymore. It is really up to fiscal policy makers to be the swing factor here moving forward and support the economy right now while we’re in this phase and stimulate the economy after a vaccine is widely deployed and the economy is able to completely re-open. You know, I think the governor didn’t say it in as many words. He was asked the question by a reporter in the press conference after his speech. But you can see what they’re trying to do here is allude to the fact that fiscal policy is really going to be the key driver moving forward.

Ian Pollick: So when you think about what the Bank of Canada has told us in terms of the order of operations, that you start off in the reopening phase, then you move into the recuperation phase. Are we still in this reopening phase? It wasn’t clear to me how they characterize it because they did say the recuperation phase would be long, uneven, choppy. But to the degree that we’re not fully reopened, we are in the midst of people going back to schools. Potential flare ups are still a likelihood. What phase would you characterize us in right now?

Royce Mendes: So at this point, we’re probably past the reopening phase. That was the phase that was characterized by the reopening of businesses and the pulling back to work of many employees to those businesses. This recuperation phase is indeed going to be very long and it’s going to be winding. You can already start to see it in some of the economic data that is going to be released next week. Retail sales, wholesale sales, manufacturing. Retail sales in particular is going to post a gain, but a very meager gain. And, you know, from there on out, it’s unclear how much more progress, something like retail sales, which has made a very sharp rebound to this date, can make as we pass through this recuperation phase, there’s really not a lot more, though, that the bank can do other than monitor the situation and keep its foot firmly planted on the gas in terms of, of course, guiding the market into understanding that the overnight rate is going to remain very low for a very long period of time and keeping longer term rates low through its QE program. Now, they did introduce some language about potentially calibrating monetary policy stimulus to support the recovery and achieve the inflation objective. A lot of commentators took that to mean that they might be making some tweaks to the QE program. Maybe you can take that and explain to us what you think it means in terms of the large scale asset purchase program.

Ian Pollick: Well, I think this is something that we’ve talked about really for the past two to three months. And it was this recognition very early on that the scaling of the LSAT program in Canada was a bit too large relative to the outstanding Bond Market. And if we go back to first principles and just ask ourselves, what’s the point of QE? Well, it’s to reinforce any type of forward guidance, a conditional commitment, it’s to keep interest rates low across the curve and push investors through some type of portfolio, reallocation into riskier assets and therefore improve system wide liquidity, opens up credit to the broader economy. The problem is, though, if you were to look at what the Bank of Canada owns right now, which is roughly 30 percent of the government of Canada bond market, that is a very big number and it’s an even bigger number when you take into consideration this is a ball market that’s growing. And when you look around the G7, you realize very quickly that this is one of the largest proportional ownerships of the outstanding bond market. You know, really, it took the Fed almost a decade to get to the same level the Bank of Canada did. And if the bank doesn’t do anything, then not only will they own an outsized amount of bonds, i.e. above 50 percent of the bond market by the end of twenty twenty one, when you break it down from a sector specific level, we’re really talking about 70 percent of the off-the-run 2 year securities. Seventy five percent of five years, 50 percent of 10 years and 30 years. These are really big numbers. And I have to presuppose that a central bank would not want to engage in too heavy of a hand in the bond market if it has unintended consequences, like topping the signaling mechanism of interest rates, reducing liquidity or overall market functioning, so we always expected them to right size the program. I like that we’re right size more than calibrate, because calibrate feels like a big word that doesn’t actually mean all that much. And I think Governor Macklem rightly said, if you want an easier definition of the word, it simply means an adjustment. The question is, you know, where do they actually have to make the adjustment? I suspect what they want to do is when he was asked in the Presser, he said, I want to keep longer term interest rates low, like five year yields to help household borrowing rates. I think that the vernacular of our market is such that we tend to think about long term interest rates maybe in a different way than the central bank. I continue to believe that the five year point of the yield curve is where they’re going to want to focus their attention or really five years and under. And I think that does come at the expense of long-end purchases. So if you were to ask me right now, make a decision, what is this look like? I think it looks like a reduction in the overall pace, maybe away from that five billion per week towards something more manageable, like three billion, and generally a readjustment away from the long end of the curve. I think that either way, it’s very clear that if we are wrong and this isn’t going to happen, then the reason it won’t happen is because you have rising issuance risks. And I think what we’ve heard out of Ottawa over the past month or so and some stories in the press do suggest that the deficit is going to rise from already very large levels. Either way Royce, I think it’s very clear that if our base case view, which is that QE does need an adjustment and we do think that it does happen at the October NPR, if there’s a risk to that view, it’s something that’s similar to what’s likely to happen next week in the US, namely that, policymakers may want to wait to understand what the full fiscal trajectory looks like before committing to either extending or reducing their QE programs. Remember, we have a thrown from the speech in the next couple of weeks. We do get an economic update some time in November. And if we’re wrong and QE doesn’t get adjusted, I think our view and what it does to the yield curve is the same because the issuance risks in Canada are rising. And we’ve seen recent reports that future deficits could be of a similar size to the one we saw this year. The deficit this year could even grow. And if the bank didn’t do anything, then that additional supply, even though not all of it is going to come from the bond market and even though you’ll get somewhat of a revenue offset through faster GDP growth, you’re going to have higher issuance and that matters for that supply. So the way that we’re thinking about QE, is that whether it’s calibrated or not, you’re still going to end up with a very large steepening profile. Are you thinking about QE at all? From the lens of our fiscal stimulus is interacting with policy like how are you thinking about QE right now?

Royce Mendes: From our opinion, of course, fiscal stimulus leaves less of a need for central bankers to step up to the plate. And that’s sort of the mix of policy that we would seem more appropriate. You don’t want central bankers having to do all of the work. First of all, it’s sort of like pushing on a string at this point for central bankers, but also rates that are too low for too long do create asset bubbles. But I think your point is well taken, that part of the reason that quantitative easing is occurring is to help the digestion of increased issuance so they could work in tandem together where the size of QE rises or remains the same doesn’t shrink as issuance starts to rise. So I’m on the same page with you in terms of QE and fiscal stimulus for the time being.

Ian Pollick: So I want to pivot a little bit because there was a lot of anticipation last week in the rate statement that the Canadian dollar would get a little bit of real estate and in fact, it didn’t. And I had suspected ahead of time that the risk was somewhat symmetrical, because when we think about Governor Macklem’s previous role as the number two behind Governor Carney, that’s when Dollar Canada went to parity. And they used to discuss the Canadian dollar within the context of a type one, type two framework. And for our listeners who are familiar with that, and Royce I forget which one is which, but one of them was you have an appreciation or depreciation in the currency as a result of fundamental forces in the economy. The other type of response is because of broader portfolio flows that make the dollar an innocent bystander. I think what we’ve seen this year is the appreciation from the highs in the Canadian dollar have really been a function of US dollar weakness, not Canadian dollar strength. What’s your take on why they didn’t mention it? And are you worried that a dollar thirty thirty one, the exchange rate will start to impede the recuperation phase?

Royce Mendes: So obviously we’re a long way from parity or anything close to that when the bank was using some open jaw operations to try to contain any appreciation and try to maybe get a little bit of a depreciation in the Canadian dollar. What I think is a key level here on dollar Canada is 130. We’d be doing some analysis in the early results show that when dollar Canada is above 130, you can get some pretty strong traction on exports in terms of their contributions to GDP. When Dollar Canada is below 130 or the Canadian dollar is stronger, it seems like, you lose a lot of traction in exports. So it is an extremely important variable that is going to go into the monitoring and assessment of the economic outlook moving forward. I think anything above 130, though, in terms of dollar Canada, the Bank of Canada is going to be comfortable with. They’re going to have to live with it. I’m sure they wouldn’t mind if the Canadian dollar moved even weaker. And of course, that is one of our more medium term forecasts for the Canadian dollar to weaken because of the fact that non energy exports have not gained any traction over the past five years when the Canadian dollar depreciated in the face of lower oil prices. But for now, I think anything weaker than one 30 Governor Malcolm is probably going to be reticent of making any mention of it, In the official statement. He pointed out himself that new governors often get themselves in trouble by talking too much about the Canadian dollar. It will be an important variable, but for now it’s in an area that I think they’re comfortable with. Of course, you know, any strengthening in the Canadian dollar or weakening is going to affect the pace of inflation. That’s one way that monetary policy or financial conditions can quickly feed through from markets to consumer prices. For next week, we’re looking for another pretty lackluster reading on inflation. We’re looking for flat month over month, not seasonally adjusted and only zero point three percent increase over the past year. Of course, that has a lot to do with lower gasoline prices over the past year. But the monthly reading is pretty tame and it’s coming off of a reading in July, which was weak. I mean, there’s no other way to put it. It was it was ice cold, but a lot of those variables were still in play in August. You continue to see Rent prices falling. You continue to see low mortgage rates. So shelter prices overall should have remained weak. You know, we know that airlines weren’t doing a lot better in August than they were in July, so there was no reason for them to hike rates. There’s a lot of reasons to expect that CPI didn’t make up the ground it lost in the prior month. And I think moving forward, we’re going to see Canada’s inflation rate and some of the underlying measures of inflation to more accurately depict the wide output gap in this country. Early on in the crisis, we had seen some strong gains in items that really were being prices were spiking higher because of some panic buying or stockpiling. we’re no longer really seeing that anymore. You’re still seeing strong gains in things like furniture, appliances, electronics, you know, things that have to do with working from home and living at home, making it a bit easier to do both. But even that might fade over time as some of that demand wanes. You only need to really buy a desk once for your house. Overall, I think moving forward, we should be expecting some soft inflation readings over the next six months or so. After that, maybe we’ll start to see a little bit of a pickup in the economy. Hopefully we can start to build on that after a vaccine is implemented. But I think the message from the economics group for now is very tame inflation for the next few quarters.

Ian Pollick: So Royce, what I took out of that, which was a lot of good stuff. Thank you for that incredible detail, was that the trajectory of inflation thus far has not really kept pace with the V shaped recovery in some of the growth rates of the higher activity indicators. Is that just something that as it converges, it reinforces why this recuperation phase is going to be long and protracted?

Royce Mendes: Well, let me unpack a few things there. So first of all, as GDP fell or, you know, GDP measured by expenditures fell, so did the supply side of the economy. So the output gap wasn’t equal to the drop in GDP. So that’s one thing to keep in mind. But the second factor is that consumer prices tend to be somewhat sticky, so it takes time for the momentum in inflation to wane. So I’m not surprised that the drop in GDP initially didn’t really show up, but is starting to show up and the rebound in GDP is not really showing up as a rebound in inflation because, of course, now we’ve seen supply also increase again. So we’re starting to see a more accurate, I would say, picture being painted of inflation and the output gap as we move through time. There were a lot of weird and funny things going on at the beginning of the pandemic, which affected the way we would usually think about movements in GDP and their relationship to inflation.

Ian Pollick: Well, from my perspective, what we’ve seen, at least for the last two CPI prints in the United States was that the numbers were OK on the surface. But when you drill down a little bit, the numbers last week were really just a function of used car sales and prices improving. The month before that, I believe it was insurance contracts. The prices went up because everyone got a relief because no one was driving during the lockdown. But as these one off start to dissipate again. That’s probably a good indication that it’s consistent with your view that you start to get a normalization between activity indicators into the growth numbers, into the inflation data. Now, I just want to link this inflation discussion that we’re having back to the Canadian dollar for a second. And I think we need to talk about the move by the Fed to introduce an average inflation targeting framework. The fact that Canada is in the middle of its own renewal is great. We’ll talk about that in a second. But if you’re in an environment where the Fed is now an average inflation targeter, the bank does not formally adopt that average inflation target, then by definition that does suggest that the Bank of Canada could hike at a faster rate than the Fed or divert from zero before them. That’s what the market has priced right now. OIS markets have Canada raising rates in June of 2023. That’s literally a full year ahead of the Fed. Does that short rate differential matter for the Canadian dollar if the Bank of Canada does not formally adopt an average inflation target?

Royce Mendes: It does matter for the Canadian dollar, and maybe that’s one of the reasons it’s proven so resilient, even aside from the broad based weakness in the US dollar, because, as you know, over recent days, oil prices have looked pretty weak, but the Canadian dollar really hasn’t weakened in consequence to that. I will say one thing, though. The Bank of Canada’s forward guidance, I believe, is being somewhat misinterpreted by the markets. The governor and the governing council have said that they are not going to raise the target for the overnight rate until inflation is sustainably at two percent, that is very different than prior expansions when central bankers around the world have tried to get ahead of inflation and raise interest rates ahead of actually reaching their target, or, in other words, seeing the whites of inflation’s eyes, what that means is in Canada, while there is no formal adoption of an average inflation targeting framework, we are basically committed in this country to an overshoot of inflation. Now, for how long? We don’t know. 

Ian Pollick: But that’s consistent with any central bank that’s giving forward guidance or conditional commitment. That’s by definition. You’re running hot, right?

Royce Mendes: Well, no. In the past, conditional commitments have been either calendar based or they’ve been based on a certain economic variable reaching a certain threshold. So, for example, unemployment, to my mind, I can’t remember a time when a central bank has said that they’re going to not touch the overnight rate from the effect of lower bound until it actually reaches the target, because we know monetary policy works with a lag. So you’re not going to get the full effect of a rate hike for six to eight quarters into the future. So if you don’t start raising rates, you’re committing to an overshoot. Now, we don’t know how much that overshoot is in Canada going to be, but we also don’t know all that much from the Fed just yet about how it’s going to implement this average inflation targeting framework. So I am somewhat surprised by the way the market is interpreting the Fed versus the Bank of Canada at the moment.

Ian Pollick: I would agree, and I think I would just tell all of our listeners to the call, Royce and I are putting out a piece tomorrow, a little FED preview. So check it out. But one of the things that we talk about in there is there’s a very big expectation that the Fed does announce this week either an extension to its asset purchases in terms of the weighted average maturity or an outright increase in the size. And again, I think we have to recognize that this is a very damning narrative for the steepner, because when you go back to QE Infinity in 2013, 2012, the weighted average purchases by the Fed were close to 13 years. Right now, they’re only about seven and a half years. If the Fed does decide to extend its purchases, then it does really start to hurt that steepening narrative. Now, as most of you know, I’m not a big fan of the “reflationist” narrative. I am a fan of the steepner for more technical reasons relating to swings in that issuance, swings in potential QE tapering. But I would definitely have steepners on in Canada versus the US going into it. Now, Royce, for your part, you don’t think that we get a fuller explanation of the details, the windows, the mechanics of what that average inflation targeting looks like? Correct.

Royce Mendes: I’m not sure that we get a more fuller explanation. Hopefully we do at some point because it’ll help set expectations. But what I think is an interesting facet of all of this is that we’re talking about monetary policy and the US being more aggressive to reach this overshoot of inflation. But if you look at some of the longer run forecasts in the summary of economic projections, which will be released alongside the statement on Wednesday, you might find that the longer run Fed funds rate projection actually rises a little bit. So why is that? Well, the whole reason for a central bank adopting an average inflation target to try to raise inflation expectations is that in the next expansion, interest rates can actually rise a little bit higher, further away from that binding effect of lower bound. Obviously, in this recession, we saw the Federal Reserve only able to cut interest rates roughly by half of what they’re used to doing in the face of a normal recession. And this was nothing like a normal recession. What they’re trying to do is be able to get that funds rate a little bit higher. It has nothing to do with the neutral rate, which is defined as the real neutral rate or R Star. It only has to do with the nominal neutral rate, the one that is projected in that accompanying table. It might be interesting and a little bit difficult to absorb immediately, but it’s something maybe we should be mentioning to clients that could happen.

Ian Pollick: So I think it’s a really good point. And, you know, we’ve already been talking about it within the context of identifying what the first principles are of a yield curve that steepening. Because if I take your definition of why they’re doing it, which is completely clear, the gravitational pull of the lower bound when you try to leave it is very, very strong. But if you raise that average inflation target, and you make no statement about productivity or about labor absorption, then you’re implicitly saying there’s no change to our star. Therefore, the nominal terminal rate on average is going to be higher over a variety of cycles. That should be priced into the long end of the curve as opposed to the short end of the curve. That’s what we’ve really been telling investors, why they should be paying attention to the steepner, not just because it’s a reflation theme, but when you drill down, if you believe that on average, the next three cycles will have a higher nominal terminal rate than longer data rates are supposed to rise into that environment. Royce, do you have anything else you want to talk about before we kick it off for the day?

Royce Mendes: No, I’ll just say I think it’s going to be an interesting week this week with the Fed out on Wednesday and a bunch of data releases here in Canada. 

Ian Pollick: Don’t forget to, we have the Bank of England. We have the Bank of Japan. And just to summarize, for all of our listeners on the call today, we do think that the Canadian economy continues to operate at a slower speed than being telegraphed by some of the recent data. Don’t pay too much attention to the word calibrate from the Bank of Canada. You’re likely to get some type of inertia waiting for fiscal policy to unveil what it’s going to do. Royce has a new roommate, a new house. He’s very happy. I’m very happy because Royce is back in the studio talking to me. Our favorite trades continue to be anything that speaks to five year of performance. We really like five thirty steepening, especially this week, because we do think there’s a little bit of disappointment for the Fed. I hope everyone has a great day. And we’ll speak to you next week. And don’t forget, there are no bonds harmed in the making of this podcast.

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