Tiff & Jay’s excellent adventure

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Ian Pollick: That’s a great idea, actually, but I’m going to have to provide you with swim trunks that I feel are appropriate.

Royce Mendes: (laughs) No chance, absolutely no chance.

Ian Pollick: No? OK, fine. I pursue my life a little bit. So it has been an extremely strange couple of weeks, and I want to start off, Royce, first of all, how are you?

Royce Mendes: I’ve been avoiding you.

Ian Pollick: I know you’ve been avoiding me. Can you tell our listeners why you’ve been avoiding me?

Royce Mendes: I lost a bet.

Ian Pollick: And what was the bet? Just refresh my memory since it’s been a while.

Royce Mendes: (laughs) It was whether CPI inflation would be above or below my forecast. You chose above and I lost. But I lost a bet where there was no monetary consequences. But I do have to run down a slip and slide in your backyard. What’s it called again?

Ian Pollick: The Crocodile Mile.

Royce Mendes: Oh yeah, Crocodile Mile, yeah. So that’s a thing that’s going to happen.

Ian Pollick: Well, listen, you know, it’s safe to do so. It’s legal to do so, so it’s hot enough to do so. So I am going to hold you to it. But you know, when I think about why you lost the bet and CPI was higher, it obviously is important that we talk about CPI yesterday because, you know, when you calibrate the move in CPI, that is the underlying narrative in the market right now. So I just want to take a couple of minutes talking about it. And, you know, obviously the number was a bit higher than expected. Within it, there were some nuances, used car prices contribute to a meaningfully large amount of the headline inflation. Year over year now is 5% in the US.

Royce Mendes: Just to be clear, we’re talking about US inflation.

Ian Pollick: We’re talking about the US right now. And all of a sudden we saw the bond market largely ignore it. We saw relative central bank communications this week start to diverge pretty meaningfully. And in retrospect, we had the Bank of Canada meeting this week. It was pretty much in line with what we said, right? Status quo. We didn’t really learn anything. And the Deputy Governor Lane speech actually, I would argue, was a bit more hawkish than I would have expected. Two things that stand out. Number one is they said that their Q2 estimation is still largely intact, which, tell me why that’s possible or how that’s possible. Number two is that they gave us a little bit of a hint that they would reassess economic strength in the coming weeks with respect to whether or not they will withdraw more stimulus from the system. That’s totally consistent with our view for July taper. But the question is, on a relative basis, is the Bank of Canada just permanently now seen as more hawkish than the Fed, given the different inflation frameworks? And is there a possibility that this pushes Canada one way or the other to actually formally adopt AIT at the end of the year?

Royce Mendes: Yeah, I mean, that’s a good question. It seems like that’s the way the market is interpreting it. It certainly could factor into the framework discussion because it’s going to affect the way that the exchange rate is priced. Tim Lane, in his press conference yesterday after his speech, said that there were differences in the frameworks and he outlined them. The Bank of Canada doesn’t explicitly target employment. The Bank of Canada is not operating under an average inflation targeting framework where they’re trying to overshoot the 2% target for a period of time. However, he did say that some of the interpretations are exaggerated, and I think he was pointing to the market pricing. What I’d say to that is that the Bank of Canada needs to do a better job of communicating why the market’s interpretation of the relative differences in between the Fed and the Bank of Canada’s frameworks are exaggerated.

Ian Pollick: So let me just pause you there just to provide a little bit of background. So right now, I think what we’re trying to say is the market interprets that the Fed has less degrees of freedom because it has an AIT mandate versus the bank that doesn’t. Therefore, the bank can be realistically priced ahead of the Fed. Is that what you’re referring to?

Royce Mendes: Yeah, that’s right. But I would argue that the Fed’s average inflation targeting framework is confusing the market as well, because it’s not really giving investors anything clear to go on. So, you know, we look at the inflation numbers from yesterday. They were hotter than anticipated for the second month in a row. Largely, we see that as transitory, but we can’t discount the fact that there could be some underlying inflationary pressures that are more permanent and the handoff from transitory to permanent inflationary pressures is maybe happening a little bit earlier, given what we’re seeing in the wage market. But the market doesn’t know how to interpret that because the Fed hasn’t said how long or by how much they’re going to try to overshoot on inflation. And that’s why I think when we look at it from the lens of the Bank of Canada, the issue is that there is a divergence in the way the market is interpreting the relative frameworks. But moving to average inflation targeting isn’t necessarily better or an easy decision because it comes with these costs of increased uncertainty that the Bank of Canada’s mandate at the moment is very clear. It’s 2% inflation. When you start to try to target things like maximum employment, how do you even decide that? That’s not something that is observable.

Ian Pollick: Or even financial stability, right? Which is the so-called soft third mandate. But I agree with you, there’s not enough detail, but then I wonder if the Fed told you what their lookback window was, and they told you what their thresholds were, while it would provide a bit more certainty, would it not create a bit more confusion in terms of market pricing?

Royce Mendes: In what way?

Ian Pollick: Well, if the Fed told me with exact certainty, I almost feel like it reduces the degrees of freedom they have even further because what if you were in a situation where, you know, the lookback window is X amount of months and the overshoot is X amount of basis points and you’re just slightly below that, but there’s a lot of evidence that it’s stickier than people thought it would be. Can they break that? And if they did, would it be less credible and therefore would it blow the whole experiment up?

Royce Mendes: I mean, that’s possible, but at least you have more certainty about what the goalposts are. We don’t know where those goalposts are, so we don’t know if they need to be moved even yet.

Ian Pollick: So, listen, one of the things I wanted to ask you, because this is a question that you and I, I think we were on a client call a couple of days ago, and we brought this up, because you and I have been getting increased amount of questions on whether or not this move in CPI is transitory. And the thing that I kind of said was, well, what is your definition of transitory? And when I think about transitory, you know, it’s almost like that statement doesn’t mean anything in of itself. It’s like asking Santa Claus which way is north. If you’re in the North Pole, by definition, anywhere you point is going to be south. It doesn’t have meaning. So when I think about what transitory is, I think it is a situation where CPI is above target, not CPI that is 3%, 4%, 5%. So if I said Royce, what do you think that phrase means? CPI is transitory. What is it?

Royce Mendes: I think it means it’s really pointing to two things. The base effects, which we know are going to fade. And the supply chain issues, which we are far less certain are going to fade in the near term. The big question now for anyone looking at the inflation numbers is when is these supply chain issues going to be resolved? It’s sort of like a perfect storm. There was the covid-19 hit to production in many countries. There was the big increase in demand for goods. There was the typical what you see after any recession, this bullwhip effect in inventories during the worst of the recession. Businesses think that they should be drawing down inventories instead of building up inventories, but then demand returns, demand returned a lot quicker this time. There’s a lot of different headwinds and tailwinds happening encapsulated in the supply chain issue. So I’m not sure when they’ll be resolved, but I don’t think they’ll be fully resolved this year. And the other thing you need to take into account when you look at the rise in inflation, the recent rise in inflation, and now that prices are starting to look 2% or more higher than they were on an annualized basis relative to pre covid levels of prices, so higher than the trend. In most cases, some of the rising inflation numbers would crowd out spending, right? In other instances, you would see prices rising and people would have to allocate more money to something and they would have to reduce spending on something else. In this case, households are exiting the pandemic with so much excess cash they can buy a used car that has shot up in price, but also go out for dinner five times a week. So it’s really tough to say because we can’t use the historical experience for a lot of these upside pressures on inflation. All that to say is that for next week, and maybe you’ll take a double or nothing bet her, I think we’re going to see some strong inflationary pressures again in the Canadian numbers. So we’re forecasting 0.5% month over month, not seasonally adjusted, which equals 3.6% year over year. Used car prices should start to show up here in Canada. Gas prices, housing costs, all of those things are pushing inflation up. When will those be resolved? It’s not really that clear, but do you want to take that double or nothing bet?

Ian Pollick: I’ll take the double or nothing that it’s over,

Royce Mendes: That it’s over? OK, you’re going to take over again? OK.

Ian Pollick: Ok, but what’s the double, you’re going to like, jump twice on this slip and slide?

Royce Mendes: So here’s what I’m thinking. I’m thinking I’ll give you the opportunity if I lose this bet to videotape it and send a video to anyone who donates a certain amount of money to a charity of your choice.

Ian Pollick: That’s a great idea, actually, but I’m going to have to provide you with swim trunks that I feel are appropriate.

Royce Mendes: (laughs) No chance, absolutely no chance.

Ian Pollick: No? OK, fine. I pursue my life a little bit.

Royce Mendes: Here’s a question I have for you. You know, we’re seeing these inflationary pressures. I recognize that the central banks are telling markets that it is largely transitory. There is more and more evidence that it is not all transitory or that the handoff from transitory to more persistent inflationary pressures will be faster. Why are markets so sanguine about the inflation outlook?

Ian Pollick: You know, I would say that it’s a great question and it’s one that’s been causing me a lot of frustration, because if you were just to look at the kind of mosaic theory of cross assets where you have oil that’s been relatively firm, breakevens that have not really done all that much, term yields that have been rallying, precious metals that have been somewhat rallying, like you have this divergence across all these asset classes, that doesn’t make a ton of sense, particularly when you think about the dollar and, you know just what the potential is for future hikes or the Fed’s terminal rate, because inflation is showing that it’s maybe not as transitory as people think it is. You know, I think the move in the rates market reflects a couple of things. Number one is broader positioning into a reflationary environment was for a steeper yield curve. And I think people are recognizing that the report yesterday was the last report where the weak year on year comps are in it. So theoretically, that’s when inflation should fall. And therefore, it’s very expensive to hold some of these steepening trades in an unlevered mandate. So every day that the curve is not steepening, you’re losing money. I think some of those trades were taken back. I think the move in broader risk assets have been relatively strong. And there is some evidence that there’s been some pension rotation locking in funding status. And then at the very front end of the curve, let’s say twos to fives, you know, to me that’s probably the most grossly mispriced, just given that obviously the inflation backdrop does portend future rate hikes. And when I think about some of the reasons being brought forth, one is that bank portfolios ahead of the stress test want to clean up their balance sheet. They’re buying some assets or the TGA wind down is creating this need to buy duration. I think every excuse in of itself probably makes a lot of sense. But at the end of the day, you know, I think that the market failed a really important test. And I think the market prematurely decided to reject the non transitory inflation debate. And, you know, that could be at their detriment.

Royce Mendes: So here’s the question for you. Does this open up an opportunity for Powell to be a little bit more hawkish here? Because the market is really not taking any of the inflation numbers and running with them, looking very concerned. He could unveil a slightly more hawkish Fed next week in terms of maybe pulling forward the timing of the first rate hike in the dot plot or talking about talking about tapering. Do you think that there’s an opportunity there to have a little bit of a hawkish surprise?

Ian Pollick: I think that relative to the level of yields, there’s a lot of risk going into next week. You know, my interpretation or my expectation is that we don’t get a IOER increase. I think there’s been some broad stability in Fed funds, and I think RRP is doing what it was designed to do, at least temporarily. I don’t think that you get a discussion of the taper in the meeting next week, although I do think you hear something quite hawkish in the minutes. So that kind of coincides with a mid-July.

Royce Mendes: Interesting.

Ian Pollick: But I do think that you’re right on the dot plot. I think we will get that kind of dot moving into a 2023 hike and relative to what’s priced in the belly of the curve, I think there’s a huge amount of risk in the market. You know, am I off base in my interpretation of what to expect next week or do you think there’s something different happening?

Royce Mendes: No, I’m on the same page as you. I think it’s the right time to pull forward the timing of that first rate hike. It seems pretty clear to me that the downside risks to the economy have faded and now the upside risks are clear. I think over the next however many years, the near future, the risks to inflation are clearly to the upside now. And I think it’s time to start communicating to the market that the Fed sees this, understands this, and will be able to control it because that’s important. We don’t want to have the Fed so far behind the curve where they’re chasing inflation and they cause a recession in let’s say 2024. I want to jump back to Canada here and talk a little bit about QE tapering. You know, the bank didn’t really say much in the statement, but in Lane’s speech, he did seem to hint that if everything goes according to plan, in the next few weeks, we’ll see another taper in July, which is in line with our forecasts. But in the press conference, he actually pushed back against a reporter’s question, which asked, is there some stealth tapering going on? Because we’ve seen the past few weeks the bank hasn’t hit that three billion dollar mark in asset purchases. And Tim Lane clearly stated that the bank has no reason not to tell the market when they’re tapering, which I think removes some of the risk. And you can correct me if I’m wrong, remove some of the risk of an intermeeting taper.

Ian Pollick: You know, in my heart of hearts, part of me thinks that you may get still an intermeeting taper. I think that what he was referring to was we’re not going to pretend we’re not doing something when we’re actually doing it. And I think, you know, there is some analysis floating around there that’s, in my opinion, not done very well, that looks at what the bank has been buying on average, saying that it’s falling short of the three billion per week. Well, obviously, the thing we have to remember is that we had a shortened holiday week. We also had an RBB buyback, which by definition is smaller than others and on average, the misses that these people are talking about, we’re talking about one hundred or two hundred million. And I think what that reflects more than this bunk notion of stealth tapering is the idea that there is scarcity starting to creep into the bond market where not everyone is willing to sell these bonds to the Bank of Canada. And that is kind of the central part of our thesis that this bank has slowed themselves down, but the program’s still too big. That’s how I would interpret it

Royce Mendes: I philosophically disagree with the idea of having an intermeeting taper. I think it’s a monetary policy decision. There are fixed announcement dates for these monetary policy decisions. They should be on the announcement date. So, you know, I’m not disagreeing with you that there’s a chance, but I’m disagreeing with the underlying rationale if it does.

Ian Pollick: So you’re saying there’s a chance.

Royce Mendes: (laughs) Last thing on the QE tapering, Tim Lane did identify the reason that the Bank of Canada has actually started tapering so much earlier than some of the other central banks around the world. And it’s because, as he pointed out, the Bank of Canada entered the pandemic with a very small balance sheet relative to its global peers. It really ramped up purchases very early on. We went to from zero up to a large share of the bond market or a share of GDP very quickly. So, you know, they’re sort of just, I guess you said before, they’re right sizing this. Is that the way to look at what’s happening? Not really that they’re tightening monetary policy faster than their peers, it’s that they ease so much faster first or there’s coming into speed that’s roughly equal.

Ian Pollick: I would disagree that it’s a function of the rapidity of the policy actions in the crisis. I think it’s more what you said earlier is that we came into this crisis owning 13% of the bond market, and that’s just the amount of bonds that we bought at every auction, because traditionally the balance sheet growth was all liability driven with currencies in circulation. So you look back at most of the narrative or the academic literature since the 2008 crisis. And it’s pretty widely accepted that QE works best through the stock effect, not the flow effect. But Canada had neither stock nor flows. So I think you had to have a very fast flow to build up the stock. So I don’t mind this deceleration of the flows.

Royce Mendes: Let me just say something to that on the academic research. So the stock versus flow effect, it’s not really clean research because the stock, the QE announcement in the beginning, were all stocks. The US Federal Reserve told the market how much they were going to buy. And you got a big reaction. The latter rounds of QE were open ended. So they were more flow effect. But as you also owned more of the market or had conducted more QE, you might have just had less of an effect because you had already done so much. So I’m not so clear that one is better than the other.

Ian Pollick: We’ve shown through some research that every sequential round of QE just has diminishing returns to scale. Your term premia impact is just smaller every successive round. That’s why I actually think the bank did a really good job at what they did. Like they came out very fast, very hard. They did a good job at actually trying to acutely target the term premia. But the problem is, is that Canada’s a small bond market and we take a lot of elasticity from abroad.

Royce Mendes: Exactly. Canada’s issue was not that it was stock versus flow or even though the first round of its QE purchases, it would mean it would have a large effect. The issue was, is that it’s entering a market that is largely dominated by international moves in bond yield. And so the Bank of Canada buying bonds, as we’ve shown in research together, is not going to do all that much. So tapering is not going to do all that much either. I do want to move on and talk about one last topic, which is one that is a favourite on this show, which is the Canadian dollar. There has been almost no mention of the Canadian dollar this week by the Bank of Canada in either the policy statement or Tim Lane speech. Very interesting, given that it is at very strong levels relative to what we would say is needed in this country to keep exports, non commodity exports competitive. And a reporter pushed Tim Lane on this and asked him, what’s the deal here? His response was sort of curious. He said if it goes too far, meaning if it appreciates too much, it could become a challenge to manufacturing exporters. But, you know, that’s sort of what they said, Governor Macklem said a few weeks ago. So it’s moving the goalposts on it. I think the whole point here is that they really don’t want to have anything to do with trying to talk down the currency. They don’t want to be in that business for whatever reason. I don’t know what the reason is. They just don’t want to be in that business. And over the next few years, it’s not really going to affect the economy because the economy is going to be ramping up based on consumer spending. Where it will, or you know, very well could have an effect, is a few years from now where, if today we’ve missed out on opportunities to attract business investment and export capacity, when we’re back in a normal economy, we will be again overly reliant in another cycle on housing and consumption. Is that sort of the way you saw it this week, that they just don’t want to get into the business of trying to talk down the currency?

Ian Pollick: I think so, because I think fundamentally there are some factors that are beyond their control. And I think you nailed it right? Number one is that it’s a weak dollar story. Number two is commodity prices are rising. That obviously impacts the dollar. But, you know, the other side of it, too, is that when you look at the traditional flow of funds, you know, you tend to have in general a big underweight on the TSX relative to other global indices from very large structural investors. And the TSX has outperformed the S&P 500 by two hundred basis points this year. I think people recognize that if you really are in a commodity upswing, then there is this broad based underweight relative to where they should be on the TSX. So some of the suppliers of Canadian dollars and FX market just aren’t there. And in turn, foreign investors are also coming into our domestic equity market and we’ve seen that flow. But I don’t think this is something that the Bank of Canada, through jawboning is going to be able to do much about. So what I heard from you is really interesting because we’ve talked to clients about this before where maybe in the first part of this cycle or the recovery period, because we’re relying more on domestic consumption, you don’t need that export led growth. But, Royce, the question I have for you is, is it foolish to think that the stronger Canadian dollar allows the domestic manufacturing sector to buy really expensive pieces of machinery that make our economy more productive, then maybe that offset some of the scenario you’re talking about in the future years or no?

Royce Mendes: Well, you have to have demand for whatever product that you’re selling from that machinery. And, you know, if the end product is too expensive because relatively speaking, the Canadian dollar is strong, which is making your wage compensation higher in this country, well, then you may not buy that machinery even though it’s a little bit cheaper. So that’s the way we tend to think about this. And, you know, it’s flowing through what we’re thinking about overall production costs, not just one part of production, which is capital. And in some cases, you know, there’s not a piece of machinery. It could be a service export. It could be a head office deciding to locate here. So it’s a lot of labour compensation. And when the Canadian dollar strengthens, it makes it more expensive for international companies to locate a head office here.

Ian Pollick: Unit labour costs are just generally more expensive in Canada to begin with, aren’t they?

Royce Mendes: No, actually, if you look at going back to, let’s say, 2000. In the big run up during the commodity supercycle, we did see Canadian relative wages increase. It priced in US dollars because, of course, the Canadian dollar was strengthening. 2014, they start to fall because, of course, oil prices fell, the Canadian dollar weakened. And we were narrowing it, but now that we’ve seen the Canadian dollar strengthen again, you widen out again. So it is a function of the Canadian dollar and that’s what we keep hammering home. And we published a paper last week about looking at the commodity prices and, you know, acknowledging that it’s good news for the Canadian economy. The bottom line, it’s good news for the Canadian economy. How long will it last? Well, other than the commodity supercycle, a lot of these spikes in commodity prices are sort of temporary and they seem to fade as more supply gets brought online. It’s not always very quick, but it does happen. And what you’re left with may be a few years from now is that commodity prices are back lower and we don’t have a lot of non commodity export capacity because we weren’t competitive during this period where I think there’s a lot of movement in economies around the world, we could be trying to attract some of that capacity here.

Ian Pollick: Ok, I think that’s a good point. And I also think that it’s time to shut this down. I think when we look ahead to next week, it’ll be interesting because, you know, I hope that Chairman Powell starts to converge more along the lines of Governor Macklem and really open up a bit and be a bit more honest about the characterization of the economy and what they need to do.

Royce Mendes: It’s just being more realistic, right?

Ian Pollick: Yeah, exactly. So, listen, I hope everyone has a great weekend. Royce, I can’t wait for you to double down and I can tape it and show it to everyone who’s listening.

Royce Mendes: We’ll see, we’ll see.

Ian Pollick: But remember, there are no bonds harmed in the making of this podcast.

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