What to expect, when you’re expecting a cut

Ali Jaffery: I’m in the thesis that the US economy is structurally stronger, neutral is higher, you know, so they don’t need to bring it down aggressively unless we’re talking about a-

Ian Pollick: A shock. Like in a vanilla type of slowdown, I think your base case makes sense but like in a shock scenario I mean you’d go below neutral anyways. All right, welcome to another edition of Curve Your Enthusiasm. I’m joined today by Ali Jeffery in our Economics department. Ali, how you doing?

Ali Jaffery: Good, how are you man?

Ian Pollick: I’m okay, dude. We got a big week coming up. So let’s just start with the obvious. Bank of Canada rate decision, Monetary Policy Report. It feels like it’s been a very long time since we’ve gotten some updated forecast, a little meat on the bone, as they say. Obviously this has been a very non-linear data cycle since the first cut back in June. And it’s been dicey, right? But it seems like the stars have aligned and our forecast seems to be okay. But why you start off walking through, I guess obviously the decision is probably the least important part of the meeting or least interesting I should say. But what are you thinking?

Ali Jaffery: So I think it’s a pretty clear case for a cut in July. It’s been dicey, as you said. The May numbers really were a bit worrisome, but everything before that and after that, I think, has calmed everybody’s nerves. And it probably will with the bank as well, that it was just a blip, but we’re in this regime of inflation shocks having an impact on the psychology of central bankers and them worried about inflation expectations and other second order risks, as they say. So I think that was the dicey nonlinear part. But everything else has shown that the Canadian economy is in some degree of slack and inflation progress has resumed so that has all cemented a July cut. Now for the forecast, and that’s important because the bank has this kind of outcome-based guidance view that they tie decisions of future rate of the path to where the economy is evolving and that’s kind of where the forecast is. So I don’t actually see a ton of reason to expect huge changes to the MPR forecast. You know, the GDP side, we backed out where how GDP has evolved relative to the April MPR forecast, pretty much bang on in terms of the level of GDP, I think, in a little bit lower, about like point 2%, if we assume our GDP tracking is right. So I don’t see, you know, reasons for the GDP forecast to move too much unless they’re thinking about the impact of other risks or they change their view on the US economy, but I expect that to be largely the same. Inflation forecast too, I don’t think will move too much. Now there’s a bit more room for that to move because inflation has come in a bit lower than what they had in the April MPR forecast, but this is really the important fudge factor for the bank. If you keep saying that everything is based on how things evolve relative to the MPR, well then the forecast for inflation is a really important strategic choice. And I think they don’t want to set that bar too high that they can’t meet it. So I expect that, yeah, inflation forecast will come down a bit just because of the data has shown that. But I don’t think there is going to be much more aggressively getting back to target because they want to keep some room for certain surprises. We’ve seen telecoms being a bit wonky and obviously shelter has been volatile. So I think that we are still on inflation. We shouldn’t for tactical reasons see a big change, you know, more confidence of getting back to target more quickly. It’s too early for that. But the big thing I’m thinking about for the meeting is the guidance they gave on September and the rest of the cycle. You know, do they stick with this outcome-based view and data-dependent vibe that, you know, they’ve been really strongly, you know, supporting? Or do they kind of talk about, maybe at some point we need to pause and assess how things go and-

Ian Pollick: And this is the right question, right? Because as you say, if you look at the forecast, like really you just have a mark to market of some of your Q2 numbers, we’ll get the introduction of Q3. But that I think, like I said, like the cut itself is probably the least interesting. And I think for markets, what matters here is we haven’t gotten a lot of guidance. We know what the stance is, they’ve included or incorporated kind of those three preconditions to maintain the cycle that they’re looking at. Are we too early in the cycle to expect any type of forward guidance or is it going to continue to be, well, we’re just going to see how the data rolls in?

Ali Jaffery: I think we’re probably still too early in the cycle. I’d put 70% probability on them at this point not giving any forward guidance and pausing and things like that. But 30% of them saying, OK, maybe we do need to do that. Because a lot of things have evolved, right? The labor market has been pretty weak. Inflation progress has resumed. And the international situation is also supportive. And the bank likes to move fairly incrementally and they’ve got a lot of great news. So I don’t see a strong case for them to shift strategy at this point, but that doesn’t mean that we won’t see that shift later this year, you know, at the October MPR or a bit later in the year. But my gut is that there’s no real shift in strategy at this meeting.

Ian Pollick: I think so. I know I still think that our forecast for September skip probably makes the most sense here. But let me just back up a second because when we look at the April MPR, you know, they always talk about the changes to the base case. And for Canada, there was really three main ones. One was obviously the increased kind of GDP and potential just given population growth this year. They lowered it for next year, given what the government did on the inflow of immigration. And so not much has really changed there. Number two, and this probably matters the most is just given their upside view on foreign demand, they kind of increase the contribution coming from the export channel. But as you rightly say, the international situation is a bit different. You’re very lopsided coming out of Asia. US is decelerating. So how do you think they’re going to characterize some of that weakness that we’re seeing in foreign activity?

Ali Jaffery: I think they’re going to recognize it as some downside risk to Canada. I don’t know if they’re going to focus on that in their statement or the presser, but it will certainly show up in the MPR. They’ll say that this is going to impact Canadian exports, it’s going to be a slightly weaker impact on demand and inflation. Canada will show up in the output gap a little bit. I think that they’ll talk about it. It’s the things that they likely won’t say and we’ll see later in the minutes is that their confidence about the US inflation coming down is actually the biggest thing that they were worried a little bit about the US experience that we saw on Q1 happening in Canada. And I think the last few data releases in the US are giving them confidence that, you know what, we might see some volatility in our own inflation numbers, but there isn’t really an enduring trend happening globally of inflation picking up. So I think that’s the most confidence they’re going to get from the international story.

Ian Pollick: And so outside of the actual cut, how do we characterize this meeting in your gut? You think we’re going to be dovish? Is it going to be somewhat neutral?

Ali Jaffery: I think it’s going to be what we’ve seen in the past few meetings, going to be a little bit dovish. They have to keep the door open to further cuts. If the economy slows more than what they expect, they’re going to have to cut in September. But they’re going to not be obviously incredibly dovish because they don’t know how things are going to evolve. So it’s going to be slightly dovish, emphasizing the same risk that they’ve done: mortgage renewals, population, geopolitical, housing, all of those themes are going to show up again. And they have different signs. Some are saying high inflation, some are saying low inflation. So I think they’re going to be slightly dovish overall. 

Ian Pollick: So slightly dovish, slightly non-committal. And so that kind of leaves the market to do some of the heavy lifting in terms of the guesswork for the path.

Ali Jaffery: Yeah, so what do you think what do you think what the market view is? Does it look reasonable? Where are the opportunities?

Ian Pollick: We’ve done a lot recently, obviously, you know, coming off the business outlook survey, coming off of CPI. And so as it stands, as we do the podcast right now, you have roughly two and a half cuts priced for the rest of year for Canada. You know, you’re still above 4% by the end of the year. And so it’s a little bit above our own forecast. You know, you’re fully priced for July. You have, let’s call it 15 basis points for October and December. So, you know, I don’t think that’s a terribly bad path, right? I think that, given the fact that we don’t have any forward guidance from the Bank of Canada, markets are really assigning the highest probability to the front meeting. And thereafter, there’s just this higher probability of an ease, but we’re not fully there yet. You know, when I think about what’s priced, I always do it within the context of what’s priced relative to the US. And here, you have a very strange profile, and I think it’s partly reflective of the fact that US data is starting to deteriorate. You now have a lot of commentary on a potential third cut this year from the Fed. Because as it stands, you know, the Fed is fully priced for September and December. November is not really there. And I think that’s just a function of the election. But let me just paint a picture for our listeners. So, U4, U5 is 30 and a half basis points positive. Z4, Z5 is 18 basis points positive. M5, H6 is one and a half negative. And so what that means is that the market’s saying that, you know, the relative pace of easing, or really over the next kind of that six months, six month forward period is that the bank is just going to do less than the Fed. And so by the time you get to Q3, 2025, the market’s pricing in an overnight differential between the bank and the Fed of let’s call it minus 41 and a half basis points. And that compares to a spot, which is kind of minus 53. And so there’s really no assignment of a factor that the Bank of Canada around this time is going to have a higher probability of easing. And so, you take a step back and say, well, where’s terminal price? And so we always proxy the endpoint of policy using the forwards and like that three or one year point is as good a point as any. That’s at minus 56. And so in effect, when you think about that silhouette, the market is saying that there’s going to be no difference between the differential today and by the end of the both cycles in 2026, 2027. But the path there is going to be a bit variable. And I think that the best trades are one that take advantage of the distributive nature of what is likely to come. And so the problem is U5. By time we get to September 2025, you have a very big kink in those boxes. And so I do think that there is an opportunity here when you look at something like U4, Z5 or U4, U5 to flatten that out. But I think that is probably the most interesting part of what the market is priced in. And it’s like you said. If you’re not going to get forward guidance, then it’s very hard to trade the later meetings because they’re just going to trade like broader duration.

Ali Jaffery: And Ian, what’s going on with CORRA recently? We’ve seen some divergence from target. What does that mean for QT and can we expect any implementation changes?

Ian Pollick: Oh boy, this is one of my favorite topics. And again, for the eight people listening to this podcast that really care about it, I’ll do a little bit of a deep dive for you. Look, we have been in a situation for a very long time. CORRA has deviated from the target rate. And just remember that monetary policy is transmitted through the broader economy through borrowing rates. And it’s the shortest of short rates that ultimately matters. There’s really three reasons why recently we have seen this divergence get stretched back to around that five basis points above target level, which is traditionally the level the Bank of Canada has felt uncomfortable with. The first one is that remember the Canadian bond markets moved to a T+1 settlement system. And so what that’s really done is that a lot of activity that would have been a lot of assets that were financed in the Tom Nex market have been transitioned to the overnight repo market. And you can see that in the trimmed volume of trades eligible for CORRA, you know, it’s gone up by a factor of two. And so that’s just a technical way to say that there’s a lot more assets that need to be financed than we did two months ago. On top of that, you have this very peculiar situation in Canada where T-bill auctions occur on a Tuesday, but they mature on a Thursday. And so the street investors need that one day bridging gap to finance, you know, 25 yards kind of every couple of weeks, which again is kind of exaggerating that T+1 problem. And finally, something that we’ve talked about for a very long time is that you are now operating monetary policy in a floor system in Canada. And by definition, that floor system believes that every participant has an ample amount of non-borrowed reserves. The problem is that that’s not technically true in Canada. You have a very lopsided ownership of those reserves. And so too few people own too many reserves, you end up having some cash hoarding. And the combination of these three things is really leading to this divergence, like I said, between CORRA and the target rate. And so the question is, how do you fix it? You know, there’s two ways. One of them obviously is UNQT. You just get done with it. say we’re out. We don’t need to do this anymore. On the other hand, you may need to think about doing something a bit more draconian, which is maybe tiering the system. And so effectively penalizing cash hoarding by offering them the overnight rate less X. That’s a pretty dramatic move. And so I don’t know if either of them are fully on the table for the bank. I think that they would look to some of the non-QT issues like T+1 really driving this problem. But at end of the day, we have seen the Bank of Canada now open up their overnight repo operations for the first time in quite a long time. They’ve been in the market every single day, sometimes twice a day over the past week. But you know, to borrow a phrase from Benny Tal, it’s like putting a humidifier and a dehumidifier in the same room and hoping for a different result. It’s nuts. Like you can’t be an activist on one thing and a pacifist on the other and so the bottom line here, Ali, is I don’t think the bank is ready to do any implementation changes. I think they’re very ready to continue tweaking it on the sidelines. But we still think that unlike what the Bank of Canada has communicated to markets, that QT will ultimately end a bit earlier than 2025. But let’s take a step back from there, because I know that is pretty technical. I want to talk about the Bank of Canada within the context of the Fed. We’ve had a lot of new information on the US economy. In particular, like you said, we found that the scare of a reacceleration inflation in the first quarter seems to have been abating. The controlled slowing seems a bit less controlled. How are you thinking about your new U.S. forecast? And let’s tie that back into the Fed.

Ali Jaffery: Yeah, so we expect the US economy to slow in the second half of the year, averaging around like one and a half-ish in terms of GDP growth and inflation to continue to come down. And the labor market to also continue to soften with the unemployment rates staying above 4% and a rise to about 4.3 on average in Q4. So we’re expecting further weakening of the US economy and, you know, and a slight opening up of slack there. And all of that will mean the Fed is going to have to ease policy which we expect them to do, you know, along the lines of what you mentioned for the market expectations September and December of this year. And we’ve been at that position for quite a while so the market has converged to that. 

Ian Pollick: We’ve had that for a really long time so kudos to you because again, that was spicier than our bank call, for sure.

Ali Jaffery: Yeah, and no, so that’s worked out very well and that’s very likely to pan out. We saw the guidance from Waller and others this week kind of confirming that. And they just want to see a bit more data before they pull the trigger in September. But if they were not comfortable, they would have tried to move the market because the Fed obviously engages in a lot of near-term forward guidance. So that removes a big hurdle for the bank in the sense that the last meeting, if you recall, the governor got peppered with all these questions about Fed-BOC divergence. And now the Fed is starting to move and they’ll likely move fairly gradually from there on out. And although the bank wasn’t too concerned about it even then, it’s even less of an issue now and we haven’t seen large movements in the Canadian dollar. So that risk to inflation seems to be small and that’s bared out well for the bank. And it just also, it gives them confidence that, everybody else is doing this. We’re all moving the same way underlying trends of inflation are fairly linked. So I think all of this is supportive for the Bank of Canada to move very gradually. They’re not going to get potentially as excessive financial spillovers from U.S. bond markets into Canadian markets. So that’s not something they have to ward against. They can kind of continue to move at their own speed based on domestic conditions. So all of this is good. All of this is going to make government council fairly happy that you’re seeing the Fed move gradually and in ways that aren’t going to limit the bank’s own degrees of freedom. We’ve thought about the amount of divergence that could be acceptable to the bank and I think 100 basis points we’ve said would be comfortable, so presumably I could do a bit more, but it doesn’t seem like they’re going to need to test that limit at all anymore. That’s at least the base case view.

Ian Pollick: And so maybe that kind of validates where that market endpoint is, right? Because, you know, the diversion story is so interesting if you have a mismatch in the timing of the start dates, right? And ultimately, the Fed does go in September. You’re really talking about a timing of three months. The bank may have gone, probably went twice before the Fed gets out of the bed. But you’re now running that same race. And so maybe that endpoint actually doesn’t look all that crazy. But here’s the question I have for you. And here’s where the new narrative is right now. For a very long time, you had this kind of idea that what this policy cycle is across the developed markets or developed world is not one that needs to be providing stimulus. is one where you are normalizing or strict policy and you are getting overnight rates back down to neutral. But you have this new thesis that’s making the rounds that says, look, the US consumer was very insensitive to rate hikes on the way up, largely reflecting the distribution of maturities of key borrowing rates in the economy. Is there symmetry in that view on the way down? And if so, do we have to put a higher probability that the Fed can or may actually try to take rates below neutral just given that insensitivity? Do buy that?

Ali Jaffery: Not really. I don’t because the controlled slowing and inflation in the US. Yes, there’s, you know, some non-trivial demand portion, but there’s also very large supply portion and so I think that that has been the biggest driver of inflation rising and falling and that story of US households remaining insensitive to rates at least directly is still true even on the way down. Yes, there’s impacts on durable goods consumption and things like that, but those have proven to be a bit smaller because of preference shifts. So I’m really strongly in the camp that neutral is higher in the US and interest rate sensitivity of the US economy on average is lower. Even firms, they borrow out, they’re much more tactical, they take out longer maturities when rates fall, households refinance when rates fall. So all of that means that this massive Titanic of the US economy really turns very slowly all the time. And so I don’t think the case for going below neutral absent a major shock is my base course or anywhere near that. And also like I think about it tactically too that if I’m J Powell or FOMC and the big problem before the pandemic was being constrained by the zero lower bound and you want to have rates, you want to give yourself a bit more ammunition for future crises. So all of that means I want to stay as far away from going below neutral as possible. And I think they’re moving closer and closer to a sense that, yeah, neutral could be materially higher than what we thought. The dots are going to take time to drift, but the 2026 dot is far above the long run neutral. I think there’s not a strong case for me that they’re going to need to do that. Like the labor market is soft, but it’s not cracking by any means. know, demand is not collapsing. Consumption is slowing after a very strong pull forward in 2023 and the level of consumption is still incredibly high. We’re probably at a new trend path. So I’m in the thesis that the US economy is structurally stronger, neutral is higher, you know, so they don’t need to bring it down aggressively unless we’re talking about a-

Ian Pollick: A shock. Like in a vanilla type of slowdown, I think your base case makes sense but like in a shock scenario I mean you’d go below neutral anyways.

Ali Jaffery: Yeah, of course, if I need to stimulate the economy, of course, right? Now, the other point is like, if neutral is way higher, like let’s say it’s like three and a half to 4% now nominal. Okay, yeah, that environment possibly like, you could see a little bit dip below neutral, but nothing like materially below and that’s still above where they were before the pandemic. But, you know, I’m thinking in the case of if you think neutral is like three or slightly below, then I don’t put a lot of probability on rates heading there or needing to go there.

Ian Pollick: The market kind of agrees with you. You look at what the market implied neutral is for the US and you’ve obviously been as high as 4%, but you’re really now stuck in kind of that three and a quarter to 350 world, which I think is very consistent with this notion that the whole structural composition of household preferences, of just the general speed limit matters. Here’s the risk, right? And so this is a theme that everyone wants to wrap their arms around. Let’s talk about a potential Trump win and what that means for US growth, for global growth. And then we’ll break that into what it means for Canadian free trade afterwards. But give us your sense in a world where, you know, we’ve already seen an outline of certain policies coming from the POTUS nomination. And one of the things is, you know, a sharp curtailment of immigration, a sharp curtailment of the flow of free trade. And so walk me through how you’re thinking about that relative to what we just talked about with neutral.

Ali Jaffery: So I think it depends on the extent of what they do. But if we’re talking about this 10% across the board tariff and 60% tariff on China, I think that would be a fairly material impact. that, could cause the Fed to move. But it depends on how quickly that’s laid out. And if it’s something that’s well telegraphed and gradual, then it might not be so huge. Like we saw the 2018-2019 trade war. That had fairly modest implications for the US economy. Now, this is larger than that. And so it depends on the sequencing and how radical and abrupt it is. But it’s certainly, I wouldn’t stand here and say, yeah, you know, all will be good and the Fed won’t have to respond to that. That’s going to have complicated implications. so for example, if you impose tariffs, that’s going to have it, you know, raise in the price level itself. So that cause a little bit of inflation in the short run, but it’s going to disrupt the global trading system. It’s going to raise intermediate good prices. So it’s probably going to be inflationary as well. But at the same time, it’s going to weaken GDP and there’s going to generate a lot of uncertainty. So how those channels shake out and how the Fed sees overall inflation from other forces makes it very complicated to say, okay, on net the Fed is going to have to ease more below neutral or keep rates where they are. So it depends on so many forces, but the trade war, if it’s anything like the trade war we saw in 2018, 2019, I don’t think it’s going to really radically alter the path for the Fed too much. The Fed probably over responded to the last trade war. And they’ve learned a lot since, you know, the pandemic about the sensitivity of households and the lags of monetary policy and the strength in the US economy and these shifts in consumer attitudes that if it’s like that, I don’t think it makes a huge difference, but if it’s more radical, more abrupt, more aggressive, and you have broad retaliation, which, you know, in different ways, then I think in that scenario that, yeah, the Fed might need to help out, but it’s complicated.

Ian Pollick: But it’s also complicated as well, just given the relative starting point, right? Like you are now in this very strange situation with China, where broader Chinese growth is contracting and decelerating very quickly. And yet the authorities there are actually very concerned about the level of bond yields because they’re so low. And so they’re very reluctant to actually cut rates to help stimulate the economy for concern about what does the real estate market. And so you can be in this very strange situation where you have a slowing China that’s now hit with new tariffs, which further slows the economy, yet there’s this reticence to actually provide much domestic stimulus. And so globally, you have this very negative shock. And so to your point, I think what I may disagree with you a little bit is that you could be in this situation where the actual trade war doesn’t look all that different, but has much worse global foreign consequences.

Ali Jaffery: No, fair enough, and so how do you think the market is understanding these differences and does the 2016 Trump trade work today?

Ian Pollick: You know, my gut says it’s a very different environment. You know, you remember when Trump first won in 2016, we were at the cusp of a globally coordinated or synchronized upturn in growth. And so the point in this cycle was very different. You had this kind of bear-steepening of the curve, long rates sold off on better growth expectations, higher inflation expectations. So breakevens widened, the US dollar was very strong. It’s not clear to me that we should be expecting that similar type of sustainable footprint in the market, even though we saw it. Like we saw it after the debate. We saw it after the assassination attempt and so remember too, that in 2016 Trump’s win was a surprise. Today it is now a foregone conclusion, but I think we need a framework to think about it. And so I always start with this idea of fiscal space. And, you know, for me, it’s this idea that is there a room for undertaking, you know, this discretionary fiscal expansion relative to what the existing plans are without endangering market access, without endangering debt sustainability. And obviously we’re in a worse place. And so the question of fiscal dominance obviously matters. And does the U.S. have that much fiscal room left? Well, I think they’ve shown that they’re, you know, what’s the deficit? Six, seven percent of GDP. You can continue to get concerns on the fiscal side of the U.S. that propagate to the U.S. bond market that obviously has spillover elsewhere. Against that, it’s exactly what you just talked about. If you’re in a world where you get these universal tariffs that is negative for global growth. And so I think that ultimately, when you look back at the last real type of fiscal episode we had, which is in 94, and you kind of study what happened in the bond market, it wasn’t this concern that you had fiscal expansion that was unfinanced. And so it was this growth of bond supply. That’s not really what happened. What really happened was capital mobility. It was the countries that had a disproportionate amount of non-resident holders of their bond market, which acted as the transmission mechanism of volatility. And so it’s very clear when you look back at what happened in France kind of two months ago, you know, 45% of the French bond market is owned by non-residents. And so when you have amount of people that are concerned about fiscal policy in a world where you do have actually alternatives like Canada, on the other hand, has a huge amount of fiscal space. I think there’s enough differentiation on fiscal policies globally right now that you probably aren’t going to get that type of bond market response, at least one that lasts for very long. And so we like this idea of fading any type of kind of Trump induced large bond market sell off. And when it comes to the currency, you know, the counterfactual here is if I’m wrong, and you do have this level of high inflation in the US, you have this kind of steepening of the yield curve. Dollar based assets don’t look that good as a foreign investor. And so I cannot see the necessary strength or the flows needed to support a strong US dollar. And I think that gets back to our dollar CAD view, which is one where we actually see the Canadian dollar appreciating quite aggressively in 2025 relative to where we are today. Okay, we’ve talked a lot. We’ve talked about the bank, we’ve talked about the Fed, we’ve gone around in circle a couple of times. Any last thoughts for people before we head out on the weekend, buddy?

Ali Jaffery: Stay the course, stick to your guns, policy’s coming down, enjoy the weekend.

Ian Pollick: I echo that. I hope everyone has a great weekend. Look forward to a very busy week ahead. And remember, there are no bonds harmed in the making of this podcast.

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