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Ian Pollick: When we circle that back to the market response again, you know, it leaves you scratching your head a little bit, but, you know, you just triggered something.

Royce Mendes: So Let me. 

Ian Pollick: Nope.

Royce Mendes: Let.

Ian Pollick: Nope.

Royce Mendes: Let, let let.

Ian Pollick: Hey, everybody, and welcome to another episode of Curve Your Enthusiasm. Royce, how’s it going?

Royce Mendes: Good after a busy week. How are you doing?

Ian Pollick: Good. It has been a busy week. Well, we had the Fed two days ago, so let’s jump right into it. I want to just take as a very headline way to think about the meeting. We heard the Fed talk down the virus, slightly talk up the taper and provide an important definition of what transitory means. Were there any contours of the statement of the presser that made you question our forecast or that caught your attention?

Royce Mendes: I thought it was optimistic. They mentioned progress towards some of the goals that they’re trying to achieve. As you mentioned, they didn’t really talk up the virus. They certainly had the opportunity to kick the can further down the road on tapering or rate hikes. And they didn’t do that. They basically said, look, things are moving along as we had expected. There are still challenges ahead, but things are healing. Something that maybe was interesting was Jerome Powell comment on bond yields. He said even he’s scratching his head. So I want to ask you what you thought of not only the market reaction after the Fed, just what you think about the general level of yields,

Ian Pollick: Come be a strategist they said. Super easy job they said. Listen, I think that there’s definitely hints of hawkish innovations in the meeting yesterday, removing some of the words mark to marking, some of the context of the economy. It was a frustrating day, to be sure, because I think when I look at the reaction of the market after the Fed, whether it was the statement or during the presser, even if you weren’t a hundred percent committed with the idea that the Fed’s going to taper, and even if you are not 100 percent committed on the idea that they could ever raise rates, the fact that the level of yields relative to the pace of growth is so disconnected, I would have expected yields to rise a bit. It was very frustrating, as I said earlier. And, you know, I’ve spoken to a few investors ex-post and a lot of investors tell me that what they heard was Jerome Powell say, we think inflation is running hot, we think the economy is good. We are nowhere close to raising rates. That’s not what I heard. I heard that there was more focus put on the labour market because he basically said, listen, we are putting a checkmark next to the inflation part of our mandate. And now the labour market becomes very hypersensitive data. And I’d be curious before I go further into what I think is going on the bond market, would you agree with that assessment? Is that what you heard, that they’re OK with the inflation side of the mandate, but the labour market is where the healing has to come from to achieve substantial further progress?

Royce Mendes: That was my takeaway. And I actually mentioned that earlier today to someone else, that it seems like they’re comfortable with the inflation trajectory and what’s happened with inflation and, and that they have basically achieved sort of average two percent inflation. You know, it’s the inflation rate in the US right now is five point four percent. It was well below average at a point the two percent average last year. But if we take that overall, the level of prices is actually higher than it would have been if they had just grown by two percent during the pandemic. So the level of prices is actually more than made up for any weakness that we saw last year. So I would agree, he didn’t want to answer the question in the press conference about whether the committee believes that the price objective has been achieved. But I would say that if you had full employment happen sooner than they expect, they’re not going to wait to let inflation remain high for a little bit longer just to achieve some extra inflationary pressures. I think at this point, inflationary pressures, at least in my mind and I think in their mind, could be stronger than maybe they hoped they might have been. And so I think they are well within their right to believe that the inflation part of the mandate has been achieved. Now, the focus is just employment, employment, employment.

Ian Pollick: Yeah. And I think within the context of the market move, you know, what did the market do right yesterday? Well, the curve flattened and I fully would have expected the curve to flatten, you know, initially was a bare flattener. But then it kind of turned into this kind of weird, twisty, almost both flatness rates started to rally a little bit. And one of the reasons I’ve heard cited is that Powell more and more sounds like it’s not average inflation targeting, but it’s flexible average inflation targeting. And it kind of undermines the premium associated with AIT in the very short end. But, you know, increases in the long end. I also think there’s a bit of short-termism in markets right now. You know, the move lower cut a lot of people by surprise over the past four weeks. I think that’s hurt a lot of people’s and by extension, I think people are a bit more gunshy to leave positions on for longer or seek very small profits, instead of trying to make 15 basis points. People are looking for three to five basis points. Then we can’t forget that there’s one hundred and twenty billion reasons per month why bank portfolios need to go by duration. You put this all together and I think net/net we still are of the view that durations overbought. I think the curve view is still, as we’ve said for a long time, like a flutter curve, but I think that there’s a lot of tension right now. Lot of tension Royce, and tensions between whether or not the virus breaks in such a way that you have is more pronounced deceleration in growth that really restricts the pace of the Fed beginning to taper and therefore beginning to normalise.

Royce Mendes: Look, I’m not sure if some investors are missing this, but when we look at the U.K., which reopened much earlier than us here in Canada and has seen a rise in virus cases to levels that are consistent with prior waves, we have certainly not seen an increase in deaths that has been consistent with prior waves. And I think, you know, if you think about what that means for government policy and a reaction in other parts of the world, particularly the US, to another wave of the virus, it means that you might have high virus cases, but maybe not the same level of shutdowns you would have had in prior waves.

Ian Pollick: Well, that’s the thing. You don’t have the containment risk that you did associated with the first couple of waves. And I think the chair said that yesterday, didn’t he? Said something to the extent that there’s evidence that each successive wave is having less of an impact on broader economic activity?

Royce Mendes: Actually, that’s a separate point, but it’s a good point. So what I’m saying is that this time we have this defence of the vaccine that we did not have in prior waves.

Ian Pollick: Totally.

Royce Mendes: And we might need to use some extra masking again at some point or targeted, very targeted shutdowns of certain types of services or even potentially something like a vaccine passport or proof of vaccination.

Ian Pollick: Easy, big brother, easy, big brother.

Royce Mendes: I don’t see governments shutting down the economy completely to avoid some of these more targeted measures. I think they use these more targeted measures first. But the other point Powell made, which you were alluding to, was that each successive wave of the virus seemed to have less of an impact on the economy. And that’s actually true even here in Canada, where each successive wave of the virus required shutdowns and we saw shutdowns. But even with those same level of shutdowns, economic interactions were more able to happen during later waves. And that’s because I’ve been saying this for a long time. Businesses, governments and households all kept adapting every time to the new wave. And by the third wave, you know, it was sort of old hat to go into a lockdown, but still be able to get all your groceries, get all, you know, whatever you want to buy off off of the Internet.

Ian Pollick: So I’m going to stop you there. What is old hat?

Royce Mendes: I don’t know. You’re older than me, so.

Ian Pollick: Oh, my God, you’re an older soul. So clearly. Listen, let’s bring this back a bit more and more tangibly just to our listeners. One of the things that I heard repeatedly through the Fed a couple of days ago was this idea that when someone asked him, what is your definition of transitory, he said it’s not necessarily direction. It’s more the process.

Royce Mendes: Yep.

Ian Pollick: I.e., that the inflation making process has not changed. But that doesn’t mean that producers need to take their prices back.

Royce Mendes: Right, I think it’s an important point. It’s one that we’ve tried to hammer home. That transitory doesn’t mean that the price level is going to come back down. It just means that future price gains are not going to happen at the pace that they have over the past year. So when we look at the price level, it’s still going to remain elevated. And that’s what the Fed is expecting. And that seems completely reasonable to me. The price level will be elevated for some time as as a result of some of these price increases. But the inflation rate, the year over year inflation rate is going to cool off.

Ian Pollick: So and that’s where I think it’s tripping the market up a little bit because most of the investors I speak to have a broad understanding of transitory meaning. You go from five percent inflation to one and a half percent inflation as base effects fall out. But that’s not necessarily the case. And the Fed isn’t just targeting what the annual pace of inflation is. They have to be mindful in the back of their heads of what the price level is, if it’s resulting in this new equilibrium is much, much higher.

Royce Mendes: I disagree, actually.

Ian Pollick: You think so? OK, tell me why.

Royce Mendes: That’s exactly what he was trying to push back against, was that the Fed is going to focus on a one time level shift in prices. If you go back years. You and I have sat in meetings where the currency has moved a significant amount. Let’s say the Canadian dollar has weakened and there has been a one time level shift in the prices of Canadian goods because it becomes more expensive to buy stuff from other countries. And I always am in those meetings saying this is a one time level shift and the central bank will look through that. This is the same thing. The Fed is going to look through a one time level shift in the price of cars, for example, or in the price of reopened restaurants, and when they have to take into account more PPE or higher wages or something.

Ian Pollick: But what he did say was that the risks are skewed to the upside. And he.. He hated saying it, but he did say it. So when we circle that back to the market response again. it Leaves you scratching your head a little bit, but, you know, you just triggered something. 

Royce Mendes: So let me.

Ian Pollick: Nope.

Royce Mendes: Let.

Ian Pollick: Nope.

Royce Mendes: Let, let, let. Let’s talk about that. We should talk about why the risks are skewed to the upside. I published a paper a few weeks ago showing that the supply chain issues happen almost every time after a recession draw down on inventories – We saw that this week and some of the GDP numbers. And as demand starts to increase again, they’re caught with very low inventory levels and they have to put in big orders and in the supply chain get sort of messed up. We call that the bullwhip effect. This is the bullwhip effect on steroids, because during the pandemic, everyone was buying goods.

Ian Pollick: Yep, and not consuming services.

Royce Mendes: In the early part of the pandemic, we shut down factories and the factories drew down on inventories. And then after that, the factories sort of reopened, tried to reopen as well as they could during Covid. And certainly different areas of the world had different issues with Covid. But goods demand surged way past pre pandemic levels. And even though we have global trade at the level it was pre pandemic, we still haven’t caught up from that. And that’s going to take at least another 6 to 12 months to work itself out. So that’s why for supply chain issues, they’re going to be a boost to prices for some time. Resurgent demand is another one. We have no way to know how long this resurgent demand will put upward pressure on prices in areas of the economy, like hotels, airfares, restaurants and bars. We’ve never been in this situation before.

Ian Pollick: Let’s talk about that, because this past week we had the Canadian inflation data out. Remember, this is the inflation data had the new wavings, which to me, I still don’t understand the justification for, because remember, for those listeners who aren’t aware what happened, basically Statistics Canada said, OK, the consumption baskets inconsistent with what consumption patterns were for most of the past year, we’re going to re-rate the basket as if most people were still in containment. And to me, tell me if I’m wrong Royce, but it almost introduces a bias where the areas where demand is about to surge are being underrepresented.

Royce Mendes: The way I describe it is using the overused saying of Wayne Gretzky sort of in reverse. You know, instead of skating to where the puck was going, this was a case of skating to where the puck has been.

Ian Pollick: Exactly. So you agree with my kind of view that it’s not going to accurately capture where that demand is coming from, just consistent with what you were saying.

Royce Mendes: However. However, I will say that generally speaking, changing the weights makes very little difference to the overall rate of inflation and the overall path of prices.

Ian Pollick: Its just relative prices.

Royce Mendes: We did a little bit of modelling and we, we used the new weights versus the old weights and we looked at what inflation would have done over the past year or so and it really didn’t change anything. So I don’t want to make too much of a big deal of the weight change. It does seem odd and we’ve received a lot of questions on it and understandably so. Why would you use 2020 expenditures when it’s such a skewed year?

Ian Pollick: Yea.

Royce Mendes: But I do want to say that it doesn’t really change anything for the inflation story overall.

Ian Pollick: Let’s talk about what the real guts of this inflation story are, because I think if you’re an investor, a bond market investor, you’re looking at what’s priced into Canada and you look what’s priced into the United States. And Canada continues to be quicker, faster ends at a higher point. And you have a lot of people now doubting that, but are too scared to enter into the market. And I agree with that because our money market futures curve has looked like this for a very long time. BA futures scare the bejesus out of me, even at current levels. So the question is, let’s think about relative inflationary trends in regards to the reaction function of the central banks. And you and I were talking this morning and you came up with a really interesting kind of detail about the relative inflation rates while you walk our listeners through that.

Royce Mendes: Well, first of all, let’s just talk about the headline numbers. Inflation in Canada, three point one percent inflation in the US at five point four percent. There’s a stark difference there. If we’re talking about flexible average inflation targeting the Fed has more than made up for the lost inflation. The Bank of Canada is just, is above the one to three percent band, but just barely. We’re not talking about where we are in the US. And, you know, to me, that suggests that on the price aspect of each of their mandates, you know, the Fed is more complete than maybe the Bank of Canada is. Now, when we break down some of the numbers, there is a little bit of a problem with comparing them one to one, the US and Canadian numbers. There’s a lot of sort of issues. I’m going to focus on, one which is particularly important right now and ninety nine point nine nine nine percent of the time is not important.

Ian Pollick: Before you start, is this one of those things that’s going to be super arbitrary or are you going to tell me why we cannot compare directly apples to apples, the two inflation rates?

Royce Mendes: I’m going to give you a concrete example of why the Canadian inflation rates are missing a chunk of inflation. We’ve all talked about used car prices in the US, right.

Ian Pollick: Yep.

Royce Mendes: It be in one of the things Powell mentioned, he mentioned three pieces of information that seemed very odd to him and completely tied to the pandemic, used cars was one of them hotels and airfares. I’m going to focus on the used car ones because they just garnered a ton of headlines in the US numbers. When we look at the Canadian numbers in the basket weights, it appropriately weights the amount of purchases that Canadians make on new cars and used cars when we moved to the price is part of it. When Statistics Canada is gathering prices every month to calculate used and new car prices, it actually only calculates new prices. It doesn’t have a good source.

Ian Pollick: Ohhh, so it infers the used cars based on the new cars.

Royce Mendes: And new car prices in both Canada and the US are running above five percent inflation. And, you know, if you look at the US numbers for used cars, let me just tell you what it is.

Ian Pollick: Much higher!

Royce Mendes: It’s 4.5 percent inflation over the past year.

Ian Pollick: But do you know, by any chance you may not know this answer, but if you have the same car, the same model, the same trim in Can the US do you restrike the price of that based on the exchange rate? Or there’s still differences between the markets?

Royce Mendes: For used cars and new cars?

Ian Pollick: For new cars.

Royce Mendes: No, the exchange rate doesn’t necessarily change the price of a car all that much.

Ian Pollick: OK, so that’s not an explanatory factor.

Royce Mendes: No, but let me focus on the used cars here. So I was able to dig up some data and some data is not perfect data, but it’s better than no data. And this data said that the inflation rate for used cars in Canada was about 15 percent and the inflation rate for the US was about 30 percent. So it’s a little bit different than what’s going on in the US CPI. But for these purposes, it’s fine. That means, I think, the Canadian data, if we put that into the Canadian data, that 15 percent, it wouldn’t make up anywhere close to all of the difference in the inflation rates and the US.

Ian Pollick: But it explains a good chunk of it.

Royce Mendes: It actually explains a little bit of it. Yeah. So there’s something there. But even aside from that, Canadian inflation is lower than US inflation. And I think that’s something that monetary policymakers have to take account of.

Ian Pollick: Well, I think they haven’t. I mean, there’s a reason why the Bank of Canada has tapered so many times and they’re actually very close as we keep reminding our clients, when you get to October, we think the Bank Canada finishes its active QE purchases, interest reinvestment phase only. You know, I would argue that policymakers are acutely aware of this. I mean, if we know what, they know it.

Royce Mendes: But the point is here that the US central bankers need to do some catch up and the market needs to do some catch up in terms of because the US has to deal with an inflation rate of five point four percent. I agree with the Fed and the Bank Canada that a lot of this extra inflation is transitory. But when you think about the price level, it has risen. It’s not going to come down. Everyone agrees. It’s not going to come down. Absolutely. It’ll slow. But that price level is there and it’s made up for all of the so-called missed inflation. So the average inflation part of it, I think, is met. But I want to move on to one last topic before we go. And this is something I’m certainly going to defer to your expertise on. And these are the new repo facilities in the US. I want to talk about that and maybe in the context of a US taper.

Ian Pollick: Yes. So I think just to remind our listeners, you know, one of the things the Fed did two days ago was they announced the establishment of a domestic spending repo facility, as well as a foreign international monetary authorities facility. The former is called the SRF. The latter is called FEMA. In effect, both of these are meant to not be used. They are both meant to be backstops for the money markets during times of stress. If you remember pre pandemic, there was a period of time where repo rates were close to 10 percent towards the end of the year. Some of the details very quickly. The maximum size is five hundred billion and the cost is equal at the top end of the Fed funds range, which is twenty five basis points. And obviously that’s much higher than current market rates. And I think by itself, that is the needed infrastructure required prior to introducing a taper. And that’s simply because there’s more and more Treasury securities hitting the market just as a function of the deficit. But as the Fed starts to scale back those more of these entering the market, there’s more financing needed. And if you still have some binding constraints from some regulatory shackles, then you need this facility just in case. It’s interesting because the first thing we saw when that technical note came out was a swap spreads went very, very big, i.e., they widened out. And that’s exactly what they should do because, you know, you’re in a situation where it almost puts a ceiling towards the level of where Repo can go. I do think it’s really interesting because when you listen to what Paul said yesterday, someone asked him in the presser, Do you think that you could have active QE coincided with normalisation? And you would have talked about this within the context of the Bank of Canada sequencing that we expect. But he rightly said it doesn’t make sense to take away stimulus with one hand and give stimulus with another. So the lift off timing is inextricably linked with the taper timing, because our base case is you start off at around 10 billion a month, you speed it up to 20 billion a month, and that gives you between six to nine months for you to actually complete all your purchases before normalisation. So I think it’s a really good clue as to how the sequencing is going to look and,

Royce Mendes: Interesting.

Royce Mendes: When it comes to the market, you know, the market’s going to understand that if tapering is delayed, normalisation has to get delayed.

Royce Mendes: He sort of did the opposite of what Bernanke did in trying to break the link between tapering and rate hikes. He’s trying to make the link.

Ian Pollick: Exactly, He’s putting them back together because that’s his way of putting a path towards the market. And I think there’s been enough uncertainty in the response function as a result of AIT that, you know, this is actually pretty interesting. And I think it’s a good thing. So Royce is there anything you talk about before we shut it down for the day?

Royce Mendes: No, I just want to say thank you to everyone and enjoy the long weekend.

Ian Pollick: Enjoyed the long weekend!

Royce Mendes: If you’re getting one!

Ian Pollick: I just found out we’re getting you know, that is the best kinder surprise when you ask someone what’s up for the weekend, they say, you mean the long weekend. I actually didn’t know. Are you doing anything cool?

Royce Mendes: Heading up to Ottawa. Yeah.

Ian Pollick: Oh, nice. Listen, we hope everyone has a very safe weekend, whether it’s a long one or not. And remember, there are no bonds harmed in the making of this podcast.

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