Ian and Royce discuss the recent bond market selloff and the ongoing debate regarding the US fiscal package. With volatility increasing in both fixed income and equity markets, the arguments have moved from the ivory towers to the real world. They also touch on the implications of all this for the expected QE taper by the Bank of Canada.
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Royce Mendes: So first of all, I'm really happy to hear that capital deepening is something you're thinking a lot about, you know, on the weekends, I'm sure you're thinking all about how we can get more capital deepening in Canada. But you're right. You're right. Real rates matter for capital expenditures, more than nominal rates.
Ian Pollick: So Royce, it is our 31st episode today. And I have a little trivia for you. Are you ready?
Royce Mendes: I'm ready.
Ian Pollick: What chain of food accommodation restaurant was known for having 31 flavours?
Royce Mendes: Baskin Robbins.
Ian Pollick: And why did they have 31 flavours?
Royce Mendes: I don't think that that's a question that's allowed.
Ian Pollick: Well, I'll tell you the reason just because you don't know. It's because if you loved ice cream so much, you could go in there every day of the month and get a different flavour.
Royce Mendes: Is that real?
Ian Pollick: That's actually really, yeah. Speaking of flavours, I want to talk about some of the tension we're feeling in the market right now. And obviously that tension is resonating in the bond market. It's starting to spill out into risk assets to a certain degree. And the basis of the selloff really has just been this idea between how much stimulus does the US economy need relative to the growth numbers that we're seeing it generate? Maybe we can just take a little step back and start with kind of the catalyst this past week, which was the retail sales numbers. Why don't you tell us a little bit about that, how you're thinking about it?
Royce Mendes: Ok, so those retail sales numbers were monster numbers. And what we realize is that the people who are getting a lot of those six hundred dollar cheques went out and spent them almost immediately. And the question now is, what does that mean for the next round of stimulus, this one point nine trillion dollars that we've been talking about, there's another fourteen hundred dollar lump sum cheque that's going to go out. We have some pretty big name economists, Janet Yellen, Paul Krugman on one side of this debate, not really worried about running the economy hot, believing that there are strong macroeconomic reasons to run what Janet Yellen, I think, in the past has called a high pressure economy. It brings people who were discouraged back into the labour market. It helps repair some of the damage done during the recession to the hardest hit sectors. But then on the other side of the debate, we have people like Larry Summers or Olivier Blanchard worrying that this is too much for the size of the output gap that is left or the size of the shortfall, economic shortfall that's left to repair. And what they're worried about is that it overheats the economy too much and that generates inflation. Now, the Fed is not really worried about inflation. They'd actually like to see a little bit more inflation. But what Summers and Blanchard worry about is that if you start to see inflation creep up too quickly or maybe too much, that the Fed reacts in a way that is negative for markets and financial stability. And I think, you know, we're sort of seeing some of that play out in the bond market at the moment and in equity markets, too, which are selling off at the moment.
Ian Pollick: Well, I agree. And I think, you know, the story of the bond market is really twofold. One is, listen, they understand what a high pressure economy is, although we've actually never really seen it. And the problem is that these growth numbers that are being eked out are so strong that this idea that, yeah, maybe you can just blow through full employment sometime in late 21 or early 22, it's becoming a real possibility. So the problem, though, is that the market has been of the view that inflation is coming back as priced by whether it's inflation swaps, whether it's breakevens. And what that means is that incrementally the selloff is being driven by an increase in real interest rates. And that is a type of move that is associated with pulling the Federal Reserve forward rather than pushing it out, which is really been the case in prior cycles. So for context, right now, the Fed's priced to begin hiking rates in August 23. At the start of the year, we were still talking about a 2024 lift-off. So as you start to bring the Fed forward, you're forcing this growth narrative into the bond market and that's raising real interest rates. That's raising the real cost of capital. So I wonder from the perspective of capital deepening, which is something I do think a lot about, will interest rates just mean that for us to deepen the capital stock, it's going to cost more. So what I think about a country like Canada, let's just bring it back domestically for a sec, Royce. What does that mean in terms of moving away from our export led recovery if business investment has to be incrementally more too soon in our recuperation phase because the US is growing gangbusters?
Royce Mendes: So first of all, I'm really happy to hear that capital deepening is something you're thinking a lot about. You know, on the weekends, I'm sure you're thinking all about how we can get more capital deepening in Canada. But you're right. You're right. Real rates matter for capital expenditures, more than nominal rates. And the higher real rates are going to impede the demand for fixed business investment. And what that means is it's going to impact sort of the way we get back to a fully healthy economy. We know during the crisis, one of the weakest parts of the economy has been these businesses not investing for the future. And higher real interest rates are going to impact the pace at which that starts to normalize. Now there is another component to this, because Canada is a small, open economy. It means that the currency matters a lot here, too. And business investment decisions don't just happen in isolation with only myopically focusing on real interest rates. The competitiveness of a business operating in Canada versus another jurisdiction matters. What's the easiest way to make it cheaper to operate in Canada? It's having the currency depreciate a little bit from where it is now. Our own research suggests that you have to be at about one thirty five dollar CAD to get any traction in non energy, business investment and exports. That's something that needs to be taken into account when we're looking at the overall outlook for business investment. Now, I do want to ask a question about this backup in yields here. We're expecting the Bank of Canada to taper its QE program in April of this year. We expect that to happen because they're starting to own too much of the bond market in Canada. And if they continued on this path, you know, they'd get into a situation where it's going to impact market functioning. But the backup on yields adds a little bit of a wrinkle, because, you know, if yields were very low heading into April, then we could say, you know, it's almost a no brainer that the Bank of Canada tapers its QE program because it has to for financial stability reasons. But now with potentially yields being higher than we had anticipated heading into April, does that change the thinking at the Bank of Canada on the QE program?
Ian Pollick: So I don't think it does. I would say that, Royce, because when I look at the behaviour of QE and how it's been channeling itself through the bond market, we can see very clearly that the term premium suppression caused by the pace and stock of purchases was really how QE has been transmitted to the broader economy. What we've seen, though, in the past three weeks is that term premia have actually started to unwind pretty meaningfully. And just to throw some numbers out there, if we think about 10 year Canadian term premiums, you know, at the depths of QE, we were talking about 10 year term premia at, call it minus eighty five basis points, and by depth of-
Royce Mendes: Sorry to interrupt, do you want to just explain what term premium is?
Ian Pollick: Sure. In the most simplest sense, it is the extra compensation an investor requires to own a longer duration asset like a 10 year bond, as opposed to buying a three month bill and rolling it over to mimic the sequential cash flows. So if I'm going to buy a bond that's going to have a lot of interest rate risk attached to it, I need to be compensated for it versus taking a three month bill and rolling it over four times a year for 10 years.
Royce Mendes: Right. But sort of oddly enough, at the current juncture and for maybe some time, we've seen that term premium actually move into negative territory.
Ian Pollick: Exactly. And the reason that it's been negative is for a couple of reasons. We know that Canada is a market that takes a huge amount of spill-over and sensitivity to global rates. And most of the G4 markets are markets have been living with QE for a very long time. So it's very natural to see that this lower term premia globally has impacted Canadian yields. The other thing, too, is that Canada structurally has been a market that's been chronically undersupplied in terms of its duration. There's more demand from our LDI community than we've ever had issuance. That's no longer the story in Canada, and that's really a function of the fact that we now have, despite QE, we have larger issuance programs at the back end of the curve. So your oversaturating demand. So to get back to your initial question, Royce, the fact that premia have started to reverse course and started to widen to me suggests that a lot of the pressure that could have been cooked on the back of an April taper is actually now reduced. I would say I feel more comfortable believing that a taper April would produce less disorderly conducts in markets than it would had we not had this backup in yields.
Royce Mendes: That's interesting. I think that's a good way to think about it. Of course, it's unknown whether or not that's the way it'll actually play out, though we're guessing at how the market will react to less interest in bond purchases from the Bank of Canada. So I do want to move into something slightly different here. You've been talking to me and asking me the question about QE potentially in Canada, you know, even if it's taper in April, but it'll still be present after that. Is it running too long? And could it impact the normalization in future years? What exactly is the crux of that question?
Ian Pollick: This is what I was kind of thinking about. You know, one of the things that we're seeing in Canada right now is, I used to call it the macro mirage. And I called it a macro mirage because if you knew nothing and you looked at what Canada is pricing for the Bank of Canada, it seems to be saying, listen, we think the Bank of Canada is going earlier than most and we think it's going to end up at a lower terminal rate. And, you know, that kind of makes sense within the context of an economy that has a central bank that has a flexible inflation mandate, but not one as stringent as average inflation targeting. So relative to the Fed, I understand why the market is pricing the bank to go sooner. We can talk about that in a bit more detail. So, no, you don't agree. But what I'm thinking about financial stability, that's one of the things that we haven't often talked about within the context of the QE program, because we know that housing activity has been so dramatic and that dramatic amount of housing activity is one of the reasons why Canadian swap spreads are so high, which is the proximate reason why our forwards look the way they do. But in five years time, 2026, 2027, does keeping interest rates too low through QE increase the likelihood that we end up in a onerous situation where policy is trying to get normalized over the next three to five years, i.e. when you start to raise interest rates, are you about to put too much pressure into the system because you have so much mortgage activity relying on extremely low interest rates today?
Royce Mendes: So it's a good question. First of all, I think we have to recognize this is the way monetary policy works, right? It's pulling forward some demand from the future. Right now. Times are very tough. We should expect come 2026, 2027 that the situation is going to look much better. So the economy should be able to handle higher interest rates at that point. Now, we have to also recognize, though, that maybe the Bank of Canada is contributing to red hot housing markets across the country. And thus far, the Bank of Canada has sort of ignored that in public communications. We've heard them say there's not a lot of speculative activity and just acknowledged that this is the way monetary policy works. So they expected the housing market to respond to lower interest rates. But you're right, at some point, the risk is not only so important because the risk at any point in time is so important, 2026, 2027. It could be important at that point, but it's immediate enough, it's in the near term enough that maybe they have to worry about financial stability. Usually you would think that the central bank should respond to the crisis that is immediately present and sort of put on the back burner a risk that could materialize sometime down the road. Now, in this case, the crisis that is immediately present is the effect of covid-19 on the economy. Of course, we need stimulative financial conditions to repair our way back from that. But the housing market, every day we see mind boggling numbers on the housing market and maybe that's pulling forward the potential risk that it becomes more immediate emanating from the housing market. And that's something that they need to take into account in some of their upcoming communiques at the least.
Ian Pollick: I mean, I think that's going to be a challenge, right? It's going to be hard to communicate why they are pulling back at a time when obviously the economy needs stimulus. But, you know, for all intents and purposes, we talked a little bit about growth in the US and how we are likely to upgrade our Q1 forecast, full year growth looks a bit higher. I get it. But for Canada, let's talk a second about the starting point. We had a deeper hole. We have much slower vaccine process than our neighbours to the south. But when we look at kind of Q4 growth numbers relative to the bank, they nearly double Q1, unlikely to be negative given the information that we know right now. Talk to me a little bit about the growth profile in Canada. And then what I want to challenge you on, to use a polite word, is why you still think the Bank of Canada has to go after the Fed?
Royce Mendes: Well, I think you hit the nail on the head. First of all, we're starting from a much deeper hole. So even though Q4 is looking a lot better and certainly a lot better than the Bank of Canada had envisioned in the last MPR, and even Q1 could look a little bit better than our last set of forecasts. It's still a hole that is deeper than the US and we're not going to get to the point where we can reopen the economy as fast as the US simply because of our vaccine rollout. I still think the government's timelines seem correct and our forecasts take that into account. And that's why we have the Canadian output gap closing after the Fed and we have the Bank of Canada staying on hold.
Ian Pollick: Does the US output gap close in 2021?
Royce Mendes: I think towards the end of 2021, yeah. You're going to see the output gap closing. The question is, are we going to close it and let the economy simmer above maybe full employment or potential GDP or are we going to see it boil over and spill everywhere? And that would be the Summers Blanchard concern that the Fed will have to follow this with too many or too quick rate hikes.
Ian Pollick: So let's talk about rate hikes for a second. Right now in our forecast, we have, I think, two hikes from the Federal Reserve in 2023, I think we have one hike from the Bank of Canada. If you're leaning on the side of risks, more or less.
Royce Mendes: We'd be leaning on the side of more at this point, particularly for the Federal Reserve, but potentially for the Bank of Canada as well. The US numbers are looking like, again, the money that is being handed out via fiscal stimulus to households is being used. And of course, my spending is your income and your spending is my income. So when people go out and spend in the economy, that increases GDP, that gets you to full employment faster, that heals the economy faster.
Ian Pollick: I don't know what you buy, but it's definitely not my income, dude. Before we break, I think it's been a great episode. We've kept it relatively tight. I think we've hit all the main salient points. Is there anything you want to talk about before we go away for the weekend?
Royce Mendes: I mean, you're sounding a little bit sad, is there anything I can do to cheer you up?
Ian Pollick: I don't know, man. It's pretty snowy here. I would love to see you. It's been over a year and a half. Maybe next time, you know what we should do? Why don't we, the next time we have our podcast, can we FaceTime on mute just so I can see you?
Royce Mendes: We can do that, we can do that. We can actually do it in the system we use for the podcast. Let's try that next time. Maybe you'll sound a little bit happier.
Ian Pollick: Ok, listen, thanks everyone for listen to our podcast. 31st episode. We appreciate everyone who's listening. And remember, there were no bonds harmed in the making of this podcast.
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