The recent increase in COVID-19 cases is showing up in the data in different ways, in different regions. Royce describes why inflation surprises shouldn’t be taken at face value, while growth surprises aren’t as concerning as the bond market is suggesting. Ian walks through his expectation for the FOMC meeting next week, and provides a framework for thinking about how the Fed’s taper will impact bond yields. Both Ian and Royce do a deeper dive on the recent communications from the Bank of Canada, and discuss why quantitative-tightening (QT) is an elegant solution for the BoC in the coming hiking cycle.
Disclaimer: Disclaimer: The materials disclosed on this podcast are deemed to be sales desk literature and subject to our client communication policy and code of conduct as well as IIROC rules.
Royce Mendes: Are you sure Bill White worked at the Fed?
Ian Pollick: I'm pretty sure he did. I mean. Oh, did he work at the Bank of Canada and then he went to the OECD.
Royce Mendes: I think that sounds more right.
Ian Pollick: Thank you for fact-checking Royce.
Royce Mendes: All right. Let's talk about the Bank of Canada.
Ian Pollick: Ok, Royce, I want to highlight a little scenario for you, and I want to hear what your big, beautiful micro brain has to say about it. Ok, so just just play with me for a minute. Ok. Sure. Ok, so you walk into a bar and obviously you're on the patio because I know you're a little bit nervous about the pandemic and you sit down and a 10 year bond comes and sits down next to you and you look at it and say, Well, why the long face and the 10 year bond says, Listen, Royce, I have a couple of things on my mind. I'm very nervous about the elevated level of prices. I know that there's going to be some moderation in the acceleration of inflation. But what if this higher price level restricts consumption? And what if that restrictive consumption slows down growth? That's why I think I've been rallying. That's why I think that real interest rates are so low. And that's also why real rates have fallen more than inflation compensation has risen. And you look at him and you look him square in the eyes and what are you going to say to him about that? Because ultimately, you know, the reason I'm saying this low scenario is because that's what's happening in the bond market. That's what's going on in terms of people's expectations of the Delta variant. So talk me through. How should we be thinking about prices that are falling from a rate of change perspective, but a price level that stays high? And how does that relationship interact with consumption and therefore the growth profile?
Royce Mendes: I don't buy that narrative. First of all, let me say that in Canada, the level of prices is only zero point four percent above what it would have been if inflation had run at two percent during the pandemic. In the U.S., it's higher than that. It's about one and a half percent above that level of prices that would have prevailed if the Fed had achieved its two percent PC inflation target. Now, sure, that's a little bit higher, and it is costing people more to go out and buy, particularly goods. But usually your theory would be correct on higher inflation restraining consumption. But just take a look at the bank accounts of Canadians, Americans and households in developed countries around the world. They are extremely bloated. Excess savings is a major factor that will play into any forecast of spending moving forward. The reason we are concerned about spending at the moment is because of the Delta variant, not because of inflation.
Ian Pollick: Ok, so that's what I wanted to hear from you. And it's, it's something that I have heard many times over the past little bit, and it's not something I totally buy and that's inconsistent, as you know, with some of our forecasts. But listen, we have changed our growth forecast a little bit and I've had to change the rates forecast. Let's just walk through some of the changes that we've made on the growth outlook.
Royce Mendes: So look, the Delta variant is impacting what we're expecting for the fall and winter. We've trimmed our forecast for GDP growth both in Canada and the U.S. I know in Canada we're sort of in much of the country still not seeing the types of cases that might warrant large scale shutdowns. And we don't expect large scale shutdowns. But what we do expect is cases to rise high enough that households, Canadians are concerned enough that they start to limit some of their interactions with other people, which limits the economic activity that we can expect to see during the colder months in this country. In fact, we're already starting to see signs of that in the U.S., which saw the emergence of the Delta variant earlier than in Canada.
Ian Pollick: We saw it in the retail sales data yesterday, right? We saw spending receipts at restaurants were basically flatlined during the month. What else are you seeing?
Royce Mendes: Well, you saw that online spending for goods surged again, and that tells me that more people were staying at home. And so when we get a broader estimate of services spending not just what's in retail sales, which is just restaurants and bars, but services spending on everything from haircuts to hotel stays, we'll see. I think the economy started to drift away from the normalisation that had begun earlier in the summer.
Ian Pollick: So I just want to highlight a couple of things. The first one is, you know, just to put a nail in this. You do not believe in this demand destruction idea coming from higher prices, restricting people, going out and spending. Rather, you just think it's a temporary reduction related to just pandemic dynamics. Is that correct?
Royce Mendes: That's right. If you look at again the bank accounts of Canadians and Americans and households around the world, the excess savings will provide ample supply of funds to finance purchases that are just slightly higher than they would have been if inflation had just run at two percent over the course of the pandemic.
Ian Pollick: So on that, obviously we got a relatively high inflation print once again in Canada coincided with a very large CPI print in the United Kingdom. And in fact, you know, U.K. rates have started to melt down a little bit because the market's now expecting the Bank of England to hike as early as February. But. Talk to me a little bit about some of the dynamics that you were seeing in the latest inflation, and what I really am looking for here is not just the headline level, but I really care about the breadth. What are you seeing in some of the shorter term annualised trends? And then last thing I would ask you is how long do we now expect inflation to run towards that four percent level relative to that three percent level we've been talking about for the past few months?
Royce Mendes: So let me first acknowledge that we and the consensus did miss the mark on the headline inflation print. It was roughly two ticks higher than what we had all expected. But let me be clear that the drivers of inflation are the same as they were before, and they largely look transitory. First of all, base effects. Second of all, supply chain issues and third resurgent demand for previously unavailable services. Those are not long term drivers of inflation. That is not the tight labour market, fully healed economy type of inflation The Bank of Canada would typically lean against and, nor should they lean against this type of inflation because it is supply driven, not demand driven. And really, the Bank of Canada can only influence demand. Looking at Canada versus the U.S., Canada is clearly lagging the U.S. in its progression into the wave from the Delta variant. So in Canada, we continue to see prices rising in August for restaurants and bars, for hotels, the types of high contact services that clearly generate more demand when virus cases are low. In the U.S., we already saw a deceleration from those in those categories in August. I fully expect that Canada will start to see a deceleration in prices in those categories come this fall. Given that we are now in the midst of a fourth wave,
Ian Pollick: Are you talking about an annual deceleration or a monthly deceleration like our price is going to start turning downwards? Or are we just talking about tough year comps are pulling the year over year down?
Royce Mendes: No, no, no. I'm talking about a monthly deceleration.
Ian Pollick: Ok.
Royce Mendes: And when we look at the months to come, particularly in the case of base effects, we should start to see the annual rate of inflation start to fall. A lot of the base effects that we talk about are gasoline prices this year being compared to very low gasoline prices last year. If gasoline prices just remain around where they are, the annual rate will start to fall and that will drag the annual rate of inflation lower. So that's why I've been saying that this seems like the summit of the mountain for inflation in Canada, and we'll probably start to see the annual rate head lower over the course of this year. That doesn't mean that we're going to hit two percent anytime soon. It'll take some time to get from above four percent down towards the Bank of Canada's target, but I expect to see it begin that descent in the months to come.
Ian Pollick: So at what point, you know, listen, I think we all know that the inflation making process, i.e. the expectations process, takes a very long time to disrupt in either direction. How long in your estimation, and I'm going to, you know, I'm not going to hold you to this, but how long do you think it would take for the average Canadian to look at these inflation prints before they start to un-anchor their expectations a little bit? Essentially, that's what the bank cares about.
Royce Mendes: That's right, it's difficult to say because this situation is so unique. The high inflation prints tell only a small part of the story, right? We have to think about not only where inflation is today, but where it was last year. It was very low last year. So low inflation didn't materially change long term inflation expectations last year, and high inflation this year has yet to materially change inflation expectations this year. I do expect if, for example, let's say, supply chain disruptions or resurgent demand for unavailable services after this fourth wave lasts for longer than we expect. We could see upward pressure on inflation expectations. But by that time, I would expect that the economy as a whole will be closer to what we would term fully healed and the Bank of Canada can start to take away the Punch Bowl. Look, they've already tapered asset purchases a number of times. You know, I think they're further down the road to towards controlling inflation than the Fed is. And maybe I can ask you, we have a Fed meeting next week. What do you expect on, on the commentary regarding tapering? Why, when, when will they start and how will that affect the curves in the U.S. and Canada? Because as our research has shown, the U.S. QE purchases have a far greater effect on the Canadian curve than the Bank of Canada's QE purchases.
Ian Pollick: Absolutely. And you know, I think the main message coming out of the meeting next week isn't really going to be around the taper. You know, I think for me and for most market participants, what we're watching for is is that introduction of the 2024 Dot, which will be unveiled for the first time. And there's a lot o f speculation what it will look like. And I think a very conservative estimation is to say, well, where is the long run dot? Where is 2023 being anchored from? And if you just do an Interpellation, I think we could see a one and a half percent twenty four dot and that in itself is relatively hawkish, so I don't necessarily think that the Fed needs to double down on normalisation or the path towards normalisation or the path to tapering. You know, we've changed our call, as you know, and we don't think that the Fed will announce anything next week other than they're getting much closer to signalling it. Officially as a house view, we think that they'll unveil tapering in November and they'll start in December. And I think the way we have to think about it is relate it back to the 2013 experience, and there's enough differences to me that suggest you shouldn't have too large of an impact relative to what we saw in the original taper tantrum. And that's because if we calibrate some of the variables, there's enough differences and let me just highlight a couple of them, Royce. The first one is, you know, I've been using that Bill White paper since 2014. And for those of you don't know, Bill White used to be at the New York Fed and he was really, really wrote the gospel on the quantitative impacts of QE. And the rule of thumb that I always have used is for every one percentage point of GDP that bonds are reduced by, it's worth about one and a half to two basis points in the level of 10-Year yields. And if you kind of do that math and you kind of say, Well, I think the Fed has one hundred and twenty billion to go, let's say they start off at a pace of around fifteen billion a month. Now it's worth about 10 basis points. And that in itself is not a very huge number, but that's obviously quite theoretical. The other big difference that we have to be mindful of is that in 2013, when the Fed stopped buying bonds, the transmission of supply away from the central bank towards the private sector was much, much larger than it's going to be this time around. You know, we know that given some of the improvement in tax revenue to use in the U.S. and some of the messaging coming out of the Treasury, that coupon sizes are going to be cut likely in November. So the amount of supply that the private sector has to absorb isn't as large or as punitive as it was in 2013. It still is quite large, but there are some estimates floating around that it could actually decline. So I think when you relate that channel, coupled with the fact that this has been such a well telegraphed reduction in purchases, you may not get all that big of a move. That being said, we do expect bonds to sell off. That's fully consistent with our rates forecasts. The other thing I would say is if I'm wrong about the potential magnitude of the move, it's coming from the tips market. And I say that because when we look at the proportion of tips that the Fed owns now, which is about twenty five percent of the market relative to what they owned in twenty thirteen, you know, it's such a big difference that I get nervous that you could have this movement in real interest rates that at the same time, given the inflation story that you just told us, would coincide with lower market based inflation compensation, which net net means nominal bond yields have to rise. So then you say, Well, what does it mean for Canada? And I think it's important to understand the timing here, because the October meeting from the Fed comes after the October meeting from the Bank of Canada. We heard a couple of weeks ago from Governor Macklem himself that when the Bank of Canada tapers next, which we do expect in October, that kicks off the start of reinvestment. And what we've learnt from every successive round of tapering is that the cross market elasticity or the pass through from U.S. rates into Canadian rates gets larger every time we buy incrementally fewer bonds. So I think that you could end up in a situation quite perversely where you could actually see Canada underperform the U.S. on a taper tantrum or just a reduction of bond purchases. And so I think too, in terms of what that means for the yield curve, I could generally see a steeper curve as a result of that.
Royce Mendes: Are you sure Bill White worked at the Fed?
Ian Pollick: I'm pretty sure he did. I mean, oh, did he work at the Bank of Canada? And then he went to the OECD?
Royce Mendes: I think that sounds more right.
Ian Pollick: Thank you for checking me, Royce.
Royce Mendes: All right. Let's talk about the Bank of Canada.
Ian Pollick: Ok, so listen, you know, we've been spending a lot of time you and I offline talking about the Bank of Canada, obviously. We gotta take a step back and just say, what did you learn from the Bank Canada meeting? Because to me and we'll talk about kind of the implementation operational aspects of QE in a moment. The statement itself didn't really say all that much. I think it was.. If anything, there was that slight word change on inflation where they said, you know, inflation is expected to be transitory from a stronger version of that that we saw at the July MPR. Do you take much out of that?
Royce Mendes: No. I think all the central banks are are less certain that all of the inflation we're seeing now is completely transitory. But again, I'll go back to the point that this is not really the type of inflation that the central bank can deal with. The pandemic in general is not the type of economic shock that monetary policy as well suited to deal with. So I take the word change. I recognise that it did signal something, but I'm not sure that it actually matters for the outlook for policy. I think your point was correct what we learnt. From the Bank of Canada was really in TIFF Macklem speech on the outlook for the balance sheet.
Ian Pollick: Absolutely. And you know, I think what I took out of that speech is a couple of things, and the first thing I would say is we had written a paper going into the speech, and I think we got most of the main points correct, namely that once you begin the next tapering round in effect, you're in reinvestment. That's a little bit different than how other central banks globally have done it. You know, they've actually gotten purchases to zero and then talked about reinvestment. So it's a bit interesting that the bank is choosing to kind of, you know, two birds, one stone type of deal. The other thing that I got wrong was that I had expected that any reinvestment would occur almost exclusively in the primary market. And what we learnt is that there'd be a reduction in both primary purchases, which just means that the bonds that the Bank of Canada buys at auction, but also in the secondary market too.
Royce Mendes: That's right. Yeah. And why don't you explain what the implication of that slight difference is?
Ian Pollick: Well, listen, you know, at the end of the day, what is happening every time the Bank of Canada comes into the market and buys bonds, it is removing assets from the investable universe of the private sector. It is creating settlement balances and parking them into respective accounts held at the Bank of Canada. It's paying interest on those accounts. The impact of that is very evident in how we see repo rates trade, namely that Cora, which is the Canadian overnight repo rate. Think about money supply, money demand. The more cash there is in the system, the lower interest rates have to be to clear the market. And because there's so many excess settlement balances, you're in this situation where your repo rates have traded persistently below your target overnight rate. And that's akin to the course correcting. We've seen the Federal Reserve do with their own fed effective rate and interest on excess reserves right now.
Royce Mendes: Correct me if I'm wrong, though, that there's a limit to how low Cora could fall below the target because there is an arbitrage here where funds coming into banks in the repo market can just be parked at the bank for 25 basis points.
Ian Pollick: There is, but the problem is is that it's a relatively closed window compared to other jurisdictions. So there's only 14 members of the Payments Association in Canada. Those are the ones that are disproportionately benefiting from the Bank of Canada paying interest on those reserves. The point is is that you don't have other actors coming into necessarily being able to arbit all that much because you're at the point now where there's so much cash in the system that it's almost exceeding demand in the repo market. So in theory, yes, a financial institution could absorb cash at a rate below what they park it at the Bank of Canada. They could earn that spread, but that spread incrementally makes the problem worse because it just compounds.
Royce Mendes: Right.
Ian Pollick: You know, let's take a step back from kind of the operational minutia, and what I want to talk to you about is one of the parts of the speech where Governor Macklem was talking about potential asset sales sometime in the future. And I don't think there's enough credit being given to this idea. We've heard it from the Bank of England before. You know, remember, the Bank of England said when they reach 50 basis points, they would start to reduce their balance sheet actively.
Royce Mendes: Right
Ian Pollick: To me, if you're going to enter into a hiking cycle, you would want to be able to transmit policy just as effectively as you were if you're in an easing cycle. And therefore, wouldn't you not want to try and normalise the any gap between repo rates and the overnight target rate? And therefore, I like this idea of quantitative tightening because not only does it introduce some normalisation, but I think it actually slows the potential pace of the cycle and potentially even introduces a mid-cycle pause. What do you think about that?
Royce Mendes: Yeah, I like your idea that it allows policy transmission to work more efficiently. I'd also add to that. And let me ask you a question. Tell me where on the curve does the Bank of Canada own the most government of Canada bonds?
Ian Pollick: Well, I mean, listen, notionally it's obviously going to be in the front end, but can't look at it from a notional perspective. You have to look at it from a risk perspective. So, you know, the average kind of devo one sits in that kind of seven to eight year bucket, just given how much they own of the long end, as well as the short end. But on a national basis, it's two years and five years.
Royce Mendes: Yeah. Let me ask you a rhetorical question, which is the part of the Canadian economy that has been running so hot that many commentators have been concerned about it.
Ian Pollick: Well, I would have to say it's the housing market, my friend.
Royce Mendes: That's that's absolutely right. So if you can tighten policy in the part of the curve that is most directly impacting borrowing conditions in the housing market, that sounds like a good idea to me.
Ian Pollick: It sounds like a pretty terrific idea. And you know, I think it's one of those elegant solutions because you and I talk about it all the time. Monetary policy is a blunt instrument, and it cannot be all things to all sectors of the economy. And therefore, if you can have an unconventional policy like quantitative tightening that allows floating rate debt to rise at a much slower rate, but you can acutely attack that one problem sector of the curve that has a build up of financial vulnerabilities. Why wouldn't you do that?
Royce Mendes: This makes sense to me, and I'll also add that quantitative tightening makes sense such that the bank wants to avoid looking as if it's politicised. And with the balance sheet growing exponentially at the same time that deficits were growing exponentially, there was some muddling of monetary policy and fiscal policy to sort of deal with that. The bank can let some of these bonds roll off the balance sheet and show that, you know, this was a short term policy that was meant to deal with the crisis alone, not do anything like finance deficits, which I don't think it was doing. But some people thought it was doing.
Ian Pollick: But you raise a good point. You raise a good point because remember, this is a paper that you and Avery had put out before. But the main message of that paper was, Listen, there is a misunderstanding of how the government of Canada has gone through a very large maturity transformation. And yes, on the one hand, they have termed out the debt that they issue at all. Yeah, but that debt has been effectively converted into very short term liabilities to excess balances. So by doing quantitative tightening.
Royce Mendes: Let me explain that point in simpler terms. The maturity transformation that you're talking about is when the central bank buys a 10 year bond and instead issues a settlement balance to one of the financial counterparties. What it is doing is it is taking the long duration liability of the government out of the the public market, and it is issuing into the public market a short duration liability. And because the federal government is responsible for any losses that the Bank of Canada incurs as interest rates rise at the short end of the curve. The federal government will have to essentially pay that interest rate.
Ian Pollick: Listen, I agree, and I think one of the solutions of QT again is that you can actually legitimately lock up and provide kind of a reverse maturity transformation where the government of Canada, who will experience incrementally higher borrowing costs as a result of the hiking cycle as a result of you are moving a huge amount of an even larger amount of supply away from the public sector into the private sector. It helps them just lock in longer term debt. I think it's a great solution.
Royce Mendes: Right? It's just more true to the spirit of what the government is trying to do in extend its maturities.
Ian Pollick: Ok, listen, we've talked enough. I hope that everyone might listen to our podcast. Today has a wonderful weekend ahead. And remember there were no bonds harmed in the making of this podcast.
Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s), except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.