When the circus comes to town

Ali Jaffery: I actually think that the people that have entered the job market from this surge in immigration are more employed on average than the existing pool of workers because they’re filling vacancies in blue collar type jobs.

Ian Pollick: Good morning everyone and welcome to another episode of Curve Your Enthusiasm. I am joined today by Ali Jaffery in our Economics department. Ali, how you doing?

Ali Jaffery: Good, how’s it going, man?

Ian Pollick: I mean, compared to last week, this seems much more calm. What about you?

Ali Jaffery: Yeah, it’s more relaxed. I think the dust is settled. We kind of know how things are shaking out.

Ian Pollick: Well, let’s just talk about it, right? Like it was absolutely manic one week ago today. I think where I’d like to start talking this episode is really just US macro. You had this, obviously this massive reaction to what was seemingly not a terrible series of events, not great ones, but I guess the first question to ask is, is the health of the US economy so much different today than it was two weeks ago, whether it’s on the household side, business side or labor side, that we really need to be talking about a deep and imminent recession?

Ali Jaffery: No, I don’t think it is. So the US economy is definitely slowing, but it’s not eminently going to see a recession anytime soon, in my opinion. If we just take a step back and look at the latest GDP data we saw, that told us that domestic demand is fairly healthy at 2.5%. That’s a slowdown, of course, from what we saw in the second half of last year. But we don’t really see a very visible sign of the consumer pulling back a lot. Granted, that’s sort of looking back, what we saw the first half of this year. We could see a slowdown coming ahead. That could be bit more stronger than what we expect, but the real issue is the labor market and whether or not the labor market is going to start to tank quickly. And a lot of that centers on the fear of the unemployment rate rising a lot. And the unemployment rate has come up, you know, almost a percentage point from its lowest point over the past year and a bit. But I think there’s a challenge in putting so much weight on the unemployment rate itself, because the other range of labor market data that we have, the payrolls, the JOLTS data, all of that suggests that the labor market is probably moving around balance. That vacancy to unemployment ratio is around 1.2, could drift down to one, which is fairly balanced. Payroll job gains are very solid. And a lot of that reflects an increase in labor supply and strong population growth, which is missed in the household survey. That’s a big part of this worry that the market has and they’re not adjusting for the view that we have a very strong labor supply from population that probably isn’t fully reflected in the household survey. And what I put a lot of weight on and the attention is the difference in employment in the two surveys in terms of growth. So typically, if you look at year over year growth between the household survey and payroll survey, they track closely, but right now there’s a huge gap. Payroll survey is telling us that employment growth year over year is a little under 2%. And the household survey is saying it’s close to zero. And the household survey is probably not capturing that flood of undocumented workers. And some research suggests that these workers are getting jobs quickly. We’re seeing that where do we see strong population growth? Labor markets are a little tighter. So I tend to place less weight on the household survey in this environment. And my guess is that the markets are putting a bit more. And so that’s why I turn to you and say, why are they doing that? Why are they reacting this way?

Ian Pollick: Before I get there, I want to dig down on something a little bit more. You know, when I looked at this last non farms report, to me, one of the things I saw was unavailable to work for bad weather was up like almost 500,000. You kind of see this in the jobless claims data to particularly in some regions like Texas. I mean, isn’t that by itself kind of this false signal because you had the hurricanes? I don’t understand why A, economists didn’t pick up on this when they should have. But B, you know, that kind of sullies this interpretation of a labor market that’s materially softer than the Fed suggested it was, when in fact, in the Fed meeting two weeks ago, they actually talked about they downgraded their characterization of labor market.

Ali Jaffery: There’s certainly some temporary forces that showed up in that report. And it takes a bit of time to sort all of that and assess. You have to go to the microdata and see, where are those layoffs? Are they in those hurricane-affected areas? And I think some economists have said that we don’t see a ton of evidence, actually, that it’s happening in those hurricane-affected areas. The layoffs are in Eastern states. So that’s one view. I look at the payroll survey and see the trend in job growth being very solid. And that, I think, the Fed places a lot more weight on. And they were right to kind of re-characterize a little bit their view of the labor market. And it’s just that drift up in the unemployment rate and the triggering of the Sahm rule that I think has got people worried. 

Ian Pollick: Let’s talk about that for a second. All I’ve heard about the past couple of weeks is the Sahm rule. Obviously, we understand what it is. It is more of a data-fitting observation than one that is truly, truly predictive, I think. Here’s what I want to get your opinion. Implicit in the Sahm rule, which is where everyone’s focus is on, is you have to have some reality based in Okun’s law you can be this environment where you have the Sahm rule triggered, but the Okun law coefficient actually may be lower, which is just the relationship between unemployment and GDP. And so walk me through why aren’t people talking about that relationship? And do you think there’s any reason to believe that coefficient is very different today than pre-pandemic?

Ali Jaffery: That’s a great question. Okun’s law, this relationship between GDP and output that typically we think is stable, but it’s not really stable. That relationship actually, if you estimate that in a time varying sense, it moves around a lot. I don’t know exactly where it is today, and it’s tricky to do that with the unemployment rate right now, especially when it may not be capturing a lot of people who are employed. So and I think that’s the reason why I think the Sahm rule breaks down, that it’s missing people that not only are, you know, this big chunk of population that’s come on, but I actually think that the people that have entered the job market, from this surge in immigration are more employed on average than the existing pool of workers because they’re filling vacancies in blue collar type jobs that were really needed. So their employment rate and their participation rate is probably a lot higher. Now, whether or not this is going to translate into large changes in output than normal, because the Okun law is different, I don’t think that makes a huge difference right now. And the reason for that is I think what’s happening in the US economy more broadly in terms of spending is we’ve seen big preference shifts that people are willing to spend more out of wealth. They want to consume a larger flow of goods. And those are forces that I think are very powerful and not going to change too much. They’ve been very resistant to higher rates. So that’s also why I’m in the camp to think that the economy is not going to tank aggressively. It’s going to slow down. Real rates around 3% for this long is going to-

Ian Pollick: It’s restrictive, right? And I don’t think that, you know, I’m not saying by any means that when you start to dimensionalize or contextualize Sahm within the context of Skun, that it obviates the slowing in the market. But I think you have to realize, you know, there’s a lot of these automatic stabilizers through EI programs that look very different today than before. And so I think it’s another way to push back against what the market’s assessment was immediately after that non-farm.

Ali Jaffery: Yeah, I’m very puzzled by the market reaction about how aggressively it shifted and that it has the sense that the Fed is seemingly radically behind the curve. Especially when you think that the Fed hasn’t decided where neutral is, how quickly it needs to get there if neutral is much higher. It supports the Fed weighting of it more and easing more slowly, but I’m still very puzzled by how sticky that market response has been.

Ian Pollick: I listen, it’s really interesting because relative to where levels were right after the Fed pre-employment and let’s say 10 years versus where they are when we’re doing this podcast right now, it’s virtually unchanged. And so you’ve had this very, very dramatic bout of volatility that’s been unwound very, very quickly. And I do think though, if you do a kind of holistic type of forensic view on what happened, it’s not just one thing. You know, you had this flight to safety triggered by concerns about a slowing. You had a few data days that were just not very good. You had a Bank of Japan somewhat surprisingly raise interest rates triggering, you know, the appreciation of the yen was triggered or repricing of leverage. Whether you want to choke that up to the death of the carry trade is up to you. But there is evidence when you look at speculative shorts in dollar yen, you know, you saw a dollar yen shorts move from 250,000 contracts basically to zero in the past two weeks. And so there’s evidence that that was a market aggregator in terms of propagating the move elsewhere. And I can see it in the futures data for bonds to you know, you had a huge amount of shorts unwound in Canada, let’s call it almost 800,000 basis point of shorts are unwound in that very long period of time. And you’re dealing with summer liquidity. So I don’t think it was one thing. You had pre-existing vulnerabilities from stretch valuations, whether it’s in tech, whether it’s in credit. And I think at the end of the day, the market needs guidance and you’ve had very little macro guidance. You know what the direction of travel is, which is lower rates, but where the question marks have been building is in the speed and the speed of that travel ultimately was catalyzed by all those events that we just talked about. But I guess that moves me into this next question is when we think about the market looking for speed. Let’s just talk about our new Fed forecast, but let’s also talk about the case for fifties. Like that is the most interesting lingering byproduct of this market volatility is that from a level perspective, the level of yields doesn’t actually look that much different in the long end. But you do have some residual non-standard size cuts being priced in. maybe just introduce what our new Fed forecast is and let’s talk about fifties.

Ali Jaffery: Yeah, sure. So we’ve added another cut to 2024. So we have 75 basis points of easing in 2024 and another cut in 2025. So a total of about five cuts in 2025. So we think that the Fed is going to move a bit faster, but in still a gradual pace, not deploying 50s over the course of the easing cycle. Now, obviously the market is thinking very differently, having some 50s baked in this year. Now, why would you want to do a 50? So I think it depends on what you think is going to happen in the US economy. If you think that if the economy is going to slow very rapidly, which perhaps the market thinks, you want to rush back to a more neutral policy setting. And so that may make sense in that world. But the tradeoff then is that if you’re uncertain about the direction of the US economy, yes, there’s a possibility to play some positive probability on a sharp slowdown. But then there’s a possibility that it doesn’t slow that way, that you still have a gradual easing of the economy and you have a fairly comfortable soft landing. Then if you do go with a 50, you look like you sort of lost control a bit. And that will weaken the Fed’s credibility, similar like what we saw when they raised rates very quickly. I think that had an impact on the Fed’s credibility. People were questioning why they weren’t ahead of that, why they changed track so aggressively. I think that the Fed is going to put a lot of weight on its credibility and doing 50s now after standing up in July and saying, look, we didn’t need to move today. We think the economy is rebalancing and that there’s need for gradual easing was kind of the implicit subtext of that last FOMC. So I think they have to weigh that credibility angle, also they have other tools. You know, they have a dot plot, they have forward guidance. And I think that’s one of the advantages they have that if they just signal a future path of easier policy, then I think that achieves a 50. If they do that, you know, in and around what our forecast is. So market will receive the, okay, the Fed is clearly on a more automatic easing path. They’re comfortable about their price stability mandate. They’re very worried about their labor mandate. So I think that does it. And that’s probably more effective than doing a 50.

Ian Pollick: What I’m hearing you saying is the alternative to doing a 50 is come the September SEP, you indicate a much more dramatic or less shallow profile of rate cuts into 25, yeah?

Ali Jaffery: Absolutely, yeah, I think that’s a better way to do it. I think that’s what they’re going to do.

Ian Pollick: What you said was super interesting because the market pricing 50 is very much a past tense impulse. It is not necessarily a forward looking assessment that the economy is tipping over. It’s looking backwards saying, well, you missed July. Clearly you screwed up. And so September, you got to take some of this back and you need to ease again, which is very interesting because when you look at the market footprint of what actually happened, it’s very evident that there is a repricing of growth expectations. But this was the first really bad data point in the US in the past year where breakevens actually declined. So in every period, whether you go back to the Fed’s pivot last December, you go back to the first really bad CPI report this year where you missed to the downside. Every one of those instances, you had a situation where 10-year breakevens actually widened on the idea that the Fed easing would promote faster inflation. But this time after NFP, you actually had this dramatic under performance in real yields, which is consistent with this idea that on a go forward basis, you screwed something up and it kind of corroborates that past tense move, which to me, that is not a very convincing move for a 50. But let’s take the counterfactual here. Why would they do 50 in September?

Ali Jaffery: I think they do 50 if you get more really bad data and they become convinced that the downside risk to inflation are now much higher than they thought in addition to the labor market risks. That’s when if I’m them like, oh, we need to get ahead of this. We need to rush back to neutral territory.

Ian Pollick: But let me ask you this. Sorry, like I hear you. But what I’m thinking about here, that’s really interesting, right? And so you get to the SEP, you do the dot plot. Do you think that the Fed in of itself is ready to say that they screwed up because it gets back to this whole credibility issue?

Ali Jaffery: They definitely won’t say that. Having worked in a central bank, that’s the cardinal rule. You never admit that. But to be honest, I don’t think they think they screwed up. I think they still see a lot of time on the clock. They saw the last GDP report, which you talked about, and they’re probably skeptical of the household survey a bit for the reasons we mentioned. You know, the Fed is putting a lot more weight on JOLTS on this kind of framework that Waller laid out and the beverage curve, they’re putting more weight on that than kind of plain vanilla unemployment rates. And I don’t think that’s totally wrong either. And we’ll get more view of that in the retail sales data, you know, this week, but they definitely won’t say they screwed up. And I don’t think there’s a strong reason for them to say that either.

Ian Pollick: Okay, so let’s just take this a little bit further. I think one of the really big implications of us talking about a faster Fed, which whether 50s or not, for those listening, we don’t think 50s for the Fed in September, but the implication of a faster Fed is what it means for the Bank of Canada. And so you had this period of time where the Bank of Canada had this first mover advantage. The narrative really for many months has been this Bank of Canada Fed divergence, which now seems pretty uninteresting., right? This is not an interesting story if the Fed is moving all that much faster. And you can see it in the way that the market forwards have been preserved. You don’t really have more than a 55, 60 basis point differential at the end of the cycle, which is not materially different than where it was six months ago. And so for all the talk about this divergence, there doesn’t seem to be a lot. But let’s work through the math here. Let’s just say the Fed goes faster. OK. And by faster, we mean they get to neutral in one clip. There’s no pausing. There’s no quarterly pause as you just go. What does it mean for the bank? And let’s just start that off with talking about our current bank forecast.

Ali Jaffery: So I think what it means is that the Fed starts to do a little bit of the lifting for the bank. It makes it easier. So that if you have the Fed easing more, that means financial conditions globally and particularly in Canada will be a bit easier. So that will spill over into Canadian yields. That will bring mortgage rates down in Canada a little bit more. So the Bank of Canada will welcome that to the extent that they think that the Canadian economy is weak and that monetary policy doesn’t have to offset more restrictive global conditions. So that’s good. But it also may obviously reflect the fact that the US economy could be weaker. And that would also have impacts on the Canadian economy, making the bank handlers job a little harder. So there are these different channels, the foreign activity, you know, how the US economy affects the Canadian economy, and how US financial conditions affect Canadian financial conditions. So I think on balance, doesn’t radically change their strategy, but it probably means that they don’t need to cut as aggressively. And particularly in my worldview, where I think financial conditions from the US, Canada are very important, perhaps more important than the other channels. So it doesn’t mean that the bank needs to cut faster. It probably gives them more time, particularly in 2025, to pause at some point and slowdown, which is what we think they’ll ultimately end up doing. It just takes a little bit of pressure I think overall off the Bank of Canada not to have to deal with any divergence, not to deal with-

Ian Pollick: You don’t think that necessarily this provides cover for a faster bank rather you think this provides a bit more of assessment period that they can do what they’re doing right now. They get some benefit from spillover from the yield channel not so much from the currency channel. I mean that’s the other aspect here but realistically we’re talking about very, very small passthrough. What about a Canadian 50? Talk to me about that.

Ali Jaffery: Canadian 50, you do that when and if you don’t think the economy is responding enough. We clearly see the Canadian economy in excess supply. The Bank of Canada definitely does that around minus 1% or a little bit more. That if you’re not seeing the economy respond to rate cuts, you might have to move more aggressively and you might have to move below neutral. And so if you think that getting below neutral is what you need to do then, a 50 is a very reasonable way to get there that you start just move there more quickly.

Ian Pollick: So how far below neutral? Because our new forecast for the Bank of Canada is we have the bank reaching 2.5 % by the end of next year, which is arguably at least 25 below the midpoint of their neutral investment. But that’s probably not enough, at least given the math that we’ve been doing, to materially change five-year mortgage rates from where they are today. Like not materially, obviously a bit lower. So how much further below neutral are we talking about? Is this 2%? Is this 175?

Ali Jaffery: I would think you’d want to move around that 50 to 75 basis points to really get yourself in a stimulative position. The monetary policy will start to add to the economy more. I think that’s a reasonable guess if you wanted to get there. But again, if the US starts to ease more, you get a little bit of juice from there. I think central bankers as a whole are very cognizant of the ELB, the effective lower bound era, and they don’t want to get there unless they absolutely have to. And right now it’s very clear that the bank doesn’t really necessarily want to get there. Nobody’s talking about the need for stimulative policy, and the Fed I think is absolutely the same. And so they’re not going to bust that out until they absolutely need to. And they think they can probably get there by just dialing down the restrictiveness of policy. And I don’t think that’s unreasonable. There’s a lot of forces that could support growth in Canada by 2025. We a fairly material pool of precautionary savings. Population growth will probably slow materially. Demand and supply have a path to meeting each other over the bank’s projection horizon, our projection horizon. So right now, I think it’s premature to think about getting below neutral in 50s but you know that’s not a radical scenario either by any means. It’s just not my base case.

Ian Pollick: There’s a really perverse implication to all this, right? In a world where we are talking about a faster Fed, in a world where we’re talking about a faster Bank of Canada, if you think about the underlying micro dynamics in the market, how the market actually will change is you are bringing forward your neutral, which currently, it used to live in the three year forwards, now it lives in the two year forwards. If we’re really talking about a faster central banking response, your neutral gets pulled into your one year forwards. And at a point in time, it gets so low, then we have to realistically start to re-extend it back out. And so it pushes into the near, the medium term, which is how your yield curve steepens. But that’s ultimately what undermines the move in five-year yields. Because if you told me the bank was going to 2% tomorrow, yes, we have some more repricing to do, but then the probability that you have to get back up to a much more restrictive stance over the next two to three years, ultimately undermines that initial move in five years. And therefore I cannot see a world where five-year mortgage rates stay low for a stable period of time. And so a consequence of going faster is that you are pushing where your neutral lives on the yield curve back out. And that is the mechanics of steepening. But what it also does is it restricts the level of yields from falling all that much.

Ali Jaffery: That’s going to be a big problem, especially for Canada. And if you’re right that it’s very sticky and mortgage rates don’t come down enough, then that’s a world where you can see them bringing policy into a somewhat more stimulative stance. Or the bank could use a different tool for guidance, which I don’t see why they don’t use that and why they stick to this outcome-based guidance based on the NPR, which is a crude way of doing it, but I think they could achieve it that way. So there’s other paths to this, but I think that’s a great risk you flag here, which leans towards stimulative policy or alternative tools to support the economy.

Ian Pollick: For sure, because there is a consequence of going faster. I mean, you’re just ending the cycle too quickly. And unless you are signaling to the market that you’re willing to maintain rates here for a very, long period of time, you end up in this situation where you have to reprice some part of your curve. And so you lose any stimulative benefits from an FCI channel relatively quickly.

Ali Jaffery: So Ian, we’ve talked a lot about the macro implications and central banking paths. How do we trade this?

Ian Pollick: You know, we were very clear when all this was happening and really it was, you know, after that Monday where you had the big wipe out that this really made the case for strategic flatteners. Yes, we’re in an easing cycle. Yes, easing cycles are consistent with a steeper yield curve. But you’re now at the point when you look at the front end, the bias to be received the front end is much less convincing today than it was two weeks ago. And in particular, it’s because when you look at where market implied neutral rates are relative to academic R star. You know, in Canada, you’re below it. You’re below the midpoint of that target threshold range the banks talked about. In the US, you got exceptionally close to that long run dot. You’re now below LeBoc Williams. And so what it suggested to us was two things was about to happen. In a world where we were talking about 50s, we were talking about a faster Fed and did materialize, then you were already priced. And so your risk reward was to be for an unwinding of that very aggressive policy pricing and that was transmitted through the belly of the curve. So we put on some fives thirties flattening around 20 basis points trading down all in Canada all the way down to 16. I ultimately think that goes back to kind of pre Fed levels around that 14 basis point level. These are very interesting strategic flatteners. But outside of that, I think the next iteration of all this is this idea that if you are pulling neutral closer into the forwards, then implicitly you are talking about re-steepening your terminal neutral curve that ultimately hits five years. And so you still have five year weakness, but I would suggest it’s more of a twos, fives, tens type of response. And so from all the macro that we talked about, it really gets back to this belly weakness versus some of the longer dated assets. And so I think we’re very close to taking profit on our flatteners. More granularly, again, this is for my now 13 people who love CORRA and want me to talk about it on the podcast. Obviously, CORRA continues to move higher. It’s just completely collapsed two year spreads. I think that this is a bit of something that’s going to continue for a while. There’s some upward drift in the level of the distortion in CORRA. So we still like being short two year spreads, but I like wrapping against about something a little bit longer. That right level of yields does suggest you could get some corporate paying. So a steeper spread curve is how I like it. Listen, we have a big week ahead. We have PPI today, we have CPI tomorrow. Any lasting thoughts for people listening to the call today?

Ali Jaffery: Stay the course, stay calm. You know, we’re going to see gradual slowdown, but don’t panic, everything will be okay.

Ian Pollick: You heard it here first for folks. Do not panic. And remember there are no bonds harmed in the making of this podcast.

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