Two types of easing cycles

Ian Pollick: You know, the dollar is doing one thing, but then you have risk assets that are generally the biggest contributor to easier conditions.

Jeremy Saunders: But also conditions are kind of a vibe. Yeah, the vibe. The vibe was easier than the numbers.

Ian Pollick: I agree with that. I agree with that.

Ian Pollick: Okay. Well, happy Monday, everybody. I hope everyone had a great weekend. It was a week, let me tell you that. I’m joined again by Jeremy Saunders. How you doing, man?

Jeremy Saunders: I’m good. You’re going to have to get me a Curve Your Enthusiasm mug or a t shirt.

Ian Pollick: I’ll get you a t shirt.

Jeremy Saunders: Yeah.

Ian Pollick: There’s going to be some swag. Open up some merch shops after this. Listen, I was doing a bunch of reading, and one of the things that the literature says is that if you ask someone a pop quiz, it gets their creative juices going. We have a lot to talk about. So let’s start this episode with a little pop quiz. Are you ready? I’m an engaged parent, that’s what I do. Okay. So true or false? Number one, and you just got an answer. Okay? True or false? Vanilla Ice and “Weird Al” Yankovic both dated Madonna. True or false?

Jeremy Saunders: False.

Ian Pollick: True. 99% of all watch advertisements have the dial set at 1015. True or false?

Jeremy Saunders: True.

Ian Pollick: Why?

Jeremy Saunders: It makes the dial look nicer.

Ian Pollick: Yeah, it looks like a smile. Look at you. You’re good. Number three. Katey Sagal and Steven Seagal are actually brother and sister.

Jeremy Saunders: I’m saying false.

Ian Pollick: That’s a false, that’s a false. Okay, last one before we go on. 2s5s can only flatten?

Jeremy Saunders: True.

Ian Pollick: True. Okay, good. Did you feel more creative?

Jeremy Saunders: Yeah.

Ian Pollick: Okay.

Jeremy Saunders: I think I’m more creative

Ian Pollick: So let’s just jump into the obvious and let’s talk about the Fed last week. You know, for me, I’m a very big believer that the, courage is an output, and courage comes in the absence of fear. And the way that Powell was talking about the right hand side of the inflation distribution effectively being gone was quite courageous. And so he did not seem as scared as he had been in prior meetings. He heard a very similar rhetoric from the Bank of England, from ECB.  What’s the number one thing you took out of the Fed meeting last week?

Jeremy Saunders: I don’t know that the Bank of England and ECB really quite said the same thing as the Fed, actually. They’re dealing with two different sets of problems. From the Fed’s perspective, they had a hard time characterizing the incoming data as concerning, and in his defence on a number of indicators that they are watching, it has gotten incrementally better for them. I mean, if you look at shorter term measures of inflation, like three month, three month annualized, those have turned down core services ex shelter, which I know some people have take umbrage with, calculating inflation ex everything that’s going up. But nevertheless, the thing that they said they’re most focused on is 

Ian Pollick: It’s moderating.

Jeremy Saunders: Yeah, it’s 2%. He definitely seemed much more data dependent, much less set in his path. And that’s partly of

Ian Pollick: That’s just timing and what location is, right?

Jeremy Saunders: Exactly. I think the reaction is fairly outsized compared to. 

Ian Pollick: Well, the presser. The presser was a bit weird, right? I mean the discussion on the way that you can characterize I am less concerned about inflation because it’s doing what it’s supposed to is very different than saying there’s disinflation appearing in various indicators. That is a heavy way to say what you just said. And so I think the market got a little bit spooked. And then when he was asked about the symmetry of the policy response, of course you can cut rates if things get really bad, but he didn’t characterize it in such a conditional way and I think that’s why the market did what it did initially.

Jeremy Saunders: You know, last time we spoke, which was last week, I think that they think about their policy rate in real terms and it’s reasonable if inflation comes down in a way that they think is durable and sustainable, that they could lower nominal rates and still be at the same level of restrictiveness. And they’re the sap and the dots do have that embedded. And I do agree it’s you know, his comments about how the disinflationary process has begun were perhaps slightly premature or gave a little too much colour to the market. But I do also think that it seems to me anecdotally, like market participants are on the whole, somewhat, let’s say, mad or annoyed that he didn’t get up there and say, I think the stock market should go lower.

Ian Pollick: Yeah, but it was always hard, right? It was always going be a meeting where you’re going to upset somebody because you cannot maintain a hawkish level that would have actually done something over and above what the market was doing. Right. And so he was almost always doomed to fail in terms of for the bond bears. But it was just like you look at the move in in stocks like the Nasdaq move like 3.5%.

Jeremy Saunders: Yes, so

Ian Pollick: These are big numbers, and I will just say that the day before last Friday was the single largest call volume day of US equities in the history of life ever.

Jeremy Saunders: Branching out from a fixed income here.

Ian Pollick: That is crazy to me. It’s just crazy to me.

Jeremy Saunders: So let me ask you a pop quiz. In the spirit of pop quizzes, what do you think was the change in US five year SOFR yields between the day before the December meeting and the day before the February meeting?

Ian Pollick: Oh, I think they’re unched.

Jeremy Saunders: Yes, that’s right. Good for you. Do you work in fixed income?

Ian Pollick: I do watch the screens once in a while.

Jeremy Saunders: So one of the comments that I think got people really agitated was his comment that financial conditions were broadly unchanged and it doesn’t feel like that at all.

Ian Pollick: And the charts do not show that. The charts quite literally show this massive easing of conditions.

Jeremy Saunders: So the charts show an easing through the fall of last year and then a tightening from the December meeting into January 1st and then actually back to the same level. Broadly speaking, that there are

Ian Pollick: I think we talked about this. You’ve got to rip it up into components because there’s outsized components that are making this easier. And to me, when you look and you just aggregate it, you know, the is doing one thing, but then you have risk assets that are generally the biggest contributor to easier conditions.

Jeremy Saunders: But also conditions are kind of a vibe. Yeah, the vibe. The vibe was easier than the numbers.

Ian Pollick: I agree with that. I agree with that. And speaking of numbers, the worst thing that could have happened to this market from a clarity perspective was the numbers that we got last Friday. You look at the jobs numbers, the ISM numbers, they were absolutely ridiculous. And so I think one of the things we talked about going into Nonfarms, I was particularly nervous about the benchmarking revision data and I was nervous to the downside. And what we found is that the benchmarking from March 21 to March 22 added half a million jobs. And so you look at that in conjunction with the prior two month payrolls and this whole idea of a missing two 3 million job workers, a third of it’s been found.

Jeremy Saunders: So an interesting question is that is that helpful to the Fed or worrisome for the Fed? I think 

Ian Pollick: It’s worrisome.

Jeremy Saunders: I think there’s an argument to be made that it’s helpful. It suggests that the NAIRU is declining because the matching process is working and that perhaps that’s a way of easing pressure on the labour market because more people are finding jobs, so

Ian Pollick: It sounds a bit like square in round hole-ish.

Jeremy Saunders: Maybe. I don’t know. I think there’s a lot of seasonality in today’s data and the revisions can be caught both ways. And the thing they were most focused on was Avadel earnings and that’s the one piece of data that 

Ian Pollick: It was fine. So I’ll tell you what stood out to me. What stood out to me was that as part of the benchmarking revisions, they actually change their assumptions on the working population. And yet, even though it grew, your unemployment rate fell. That is very important when your participation rate actually didn’t do much. And so you now have the third lowest unemployment rate ever. And so in your definition, right, if you think that short run NAIRU is higher than long run NAIRU, then the gap is that much bigger and as the unemployment rate continues to go lower, I would argue that’s more worrisome than helpful.

Jeremy Saunders: My point is that the fact that 800,000 extra people got jobs for the given set of wage data and inflation data suggests that the short run NAIRU is actually lower than what it was previously.

Ian Pollick: So it is coming down. I would agree with you on that, because the frictions that were associated at the start of the pandemic, they’re not really there anymore. Right. And ISM, I mean, I looked at the components. Obviously, yes, it was directionally a beat, but what was really important is that it came from everything other than prices and some of the reopening components like when I looked at it, you know, business activity was screaming, exports were screaming, new orders were ridiculously in the delta. It was like a 15 percentage point delta. And so that is firm, and that’s the bigger part of the economy. You know, I feel kind of dumb because, you know, you saw the Nonfarm data and you’re like, okay, that jives with the JOLTS data. Maybe I’ll wait an hour and a half to see if this was legitimate. I was like, oh wait a second, of course the server side is ripping. Should known it, you could’ve sold the mark away.

Jeremy Saunders: Yeah, the JOLTS data is very interesting too, because under the hood the split of where jobs were, openings were coming off was all information technology which yeah, that’s well socialized. But against that was all the service sector areas had significant increases in jobs. So I mean I do agree with you, all of this data paints a picture of an economy that’s very hot and labour market 

Ian Pollick: Hotter than they thought.

Jeremy Saunders: Yeah, and was hotter than they thought. But nevertheless, the reason why they care about that is because it informs wage pressures which inform inflation. And those two things have moderated substantially.

Ian Pollick: So that’s the thing. So let’s take that to the next step. Right? So you’re right, because you haven’t had this uptick in wages despite an even stronger labour market, you’re not getting your prices paid doing anything other than moderating. And so that leaves your real growth indicators as growing. And so this is, and I hate to say this, this is very indicative that that soft landing narrative is actually coming to fruition. And so what do you do in that environment?

Jeremy Saunders: I’ll tell you another word that people hate to say that it may be, it may have been transitory.

Ian Pollick: Oh my God. So I’ve heard a couple of transitory words coming back or the use of it. I don’t want to bring it back. I don’t like it. I’m against it.

Jeremy Saunders: Fool me once.

Ian Pollick: But I do think that you could have this situation where the coordination of cross asset prices needs to put a bit more probabilistic outcome that you are entering at least a near term soft landing.

Jeremy Saunders: Which well, they have. And I think that’s reflected it partly in Jer Powell’s appearance, and really what he’s saying is we don’t really know, Right. We’re much less sure than maybe we were three months ago about what all the signals are telling us because we have a model based view of inflation. And the underlying drivers of that model based view have turned up again. But, meanwhile, the output of that model has turned down. And let’s not forget, up until the pandemic, for the previous four years, the models all didn’t work very well. You had an increasingly tighter and tighter labour market, on the face of it, with no significant boost in wage induced inflation. So they have to have some humility and say we don’t have really a super firm understanding of the inflation process. And at some point the actual output of low inflation will start to have more weight than their concern about what they view as the underlying drivers, just to tie it back to

Ian Pollick: So, earlier in the week, you and I were at my desk and we were looking at time series of CPI and wages and the two obviously track each other very, very well. And total wages like the wage pie and total CPI. And so I think you’re entering this really weird part of the market where you have almost this cap to front end yields, which are still too low but terminal is baked, right. I’m not terribly worried about how much more they have to tighten. I think following the prints last Friday, May moved up maybe four basis points, maybe five. It’s more about does the back end of the curve deserve to be where it is in an environment where growth seems to be somewhat less concerning than it was? And I don’t think it does. I think it’s hard to sustain it here. But one of the reasons I wanted to bring you back on the show, other than I like your company and the only person that wanted to do it, was that podcast capital had a pretty good week over the past week. A lot of the themes, all the trades that you and I had discussed two weeks ago worked out well. So let’s just start off with kind of the SOFR Butterfly that we were talking about two weeks ago.

Jeremy Saunders: Yeah, so that has worked quite well. And today particularly we’re pushing out the first cut from the, call it, Q423 a little bit further, you know, two yields in Canada. Also, to your credit, have cheapened substantially against the US

Ian Pollick: Yeah, I know, right?

Jeremy Saunders: Yep.

Ian Pollick: But then to your spreads to your earlier point.

Jeremy Saunders: Parts are much lower. Yeah.

Ian Pollick: And I don’t see that move into your spreads stopping anytime soon.

Jeremy Saunders: Well they’re still quite high. So I mean the older component, the FRA-OIS component 

Ian Pollick: It’s moved. 

Jeremy Saunders: Has, has come down quite a lot. But if you look at a longer time series of that longer, you can only go so far back because the world has changed, call it, 2019. But I think a fair value for that is somewhere in the low thirties type of area and so we’ve gone from much higher to that than that to getting closer to that. So that move probably has some more to go and markets generally overshoot, but that’s no longer the most compelling part of the trade.

Ian Pollick: I agree. I agree. I think I wrote about something last week and one of the things I want to write about is what we’ve been talking about effectively the past two weeks, which is does what is priced into the market from an easing perspective makes sense. And I think it does. And I wanted to do some work to show that this is not look very different than the average amount of easing that’s priced in before it eases you know 200 basis points. When I wrote it, one of the things we did to kind of animate it was I plugged in the bank’s forecast our forecasts into five different policy roles. Taylor 99, Taylor 93, An inertia rule, a forward looking rule, a low weight on the output gap rule, and then you kind of average all these things out and it says that by the end of 2024, the overnight rate in CAD should be something closer to, you know, to 45 to 50. And so you say that’s roughly what’s priced into the market right now. There’s not that much wrong with that. It’s the timing of that first ease to your earlier point on what we’re seeing in the Fed and similarly to the Bank of Canada, things are being pushed out. Right. And so it’s these micro eases that are priced into the OIS curve that on a cumulative basis, when you add these things up, they actually amount to a lot for the front end, if you start to push them out.

Jeremy Saunders: Yeah. Where do you think these first eases come off? Let’s assume the forecast come to fruition. And remember, there’s a risk management principle at work here. And I mean, what’s your view there?

Ian Pollick: Well, listen, I think you kind of said it earlier, right? Like you can be in a situation where restrictive policy isn’t just a nominal term, Right. It’s a real term as well. And so you have a situation where all of a sudden, once CPI is below Fed funds or it’s below the bank rate, you start to get this movement in the real policy rate right, that leaves you almost unched. And so you kind of say, well, where does the bank impute this to the end of this year? It’s kind of like one six. I think the Fed’s like one five. It really starts to turn positive at the end of Q two. So I realistically think if you have the real overnight rate that turns positive in Q two, given the lags they’ve talked about and they look at things on a quarterly basis and with data lags that, you know, maybe you get to the December meeting, realistically you could start talking about easing, but that means you still have about 18 basis points starting in June that you have to get rid of. Right. And the other thing that I think is interesting is that you look at what’s priced into boxes for the bank next year and it’s not so much that you have a cut at every single meeting that’s priced, it’s that you have a uniform distribution of those easing. There’s no non standard size cuts, which I think is crazy. Like, I don’t know why you believe a central bank would take rates up high would have to ease, and do it in 25 basis point.

Jeremy Saunders: One interesting thing is I think that there’s two types of easing to be priced into the forward curve. One is the type of easing we’ve been talking about, which is the lowering the nominal rate to keep the real rate the same type of easing adjustments, let’s say. And the other is

Ian Pollick: Course corrections, if you will.

Jeremy Saunders: Yeah. And the other is something’s gone wrong and we need to lower fast. And it does seem reasonable to me that the first type is becoming more dominant in what’s price and that is a more uniform process. And the second type is becoming less dominant as people get more confidence

Ian Pollick: But then how do you reconcile if we really are pricing on just this, we are keeping the real policy unched and we’re moving from a nominal role to a real world. How do you reconcile that against the level of yields? That is where I have a hard time, because when I look at where tens are trading, it is telling me that it is the second type of easing that I don’t know long and Trader thinks is being priced.

Jeremy Saunders: Yeah.

Ian Pollick: Quick question for you. We look at the week ahead, not a ton of data. There’s a lot of fed speak. We have Tiff on the mic. Really there’s not much this week I should say. What do you think coming after last week is the dominant move this week?

Jeremy Saunders: I think it’s going to be talking central bankers, Right. You’re not only going to have Powell on the wire on Tuesday, you’re going to have Williams on the wire on Wednesday. You’re going to have Tiff. I’m sure you’re also going to have various representatives from the ECB and the Bank of England speaking

Ian Pollick: And we have the minutes as well.

Jeremy Saunders: The minutes, that’s what we’ll be, should be interesting.

Ian Pollick: I can’t wait. I cannot, actually cannot wait for it.

Jeremy Saunders: It’s like the Super Bowl for you.

Ian Pollick: Yeah, I cannot wait. It’ll be amazing. Listen, we’ve talked a lot. Jer, thanks for coming. I hope you had a great weekend, and everyone who’s listening, we hope you had a great weekend, too. And remember, there are no bonds harmed in the making of this podcast.

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