Royce and Ian have a wide-ranging discussion on the upcoming Bank of Canada decision. Royce outlines the updates the Bank of Canada will need to make to its forecasts, while Ian discusses the likelihood of calibrating the quantitative easing program. The conversation also touches on the limitations of the Bank of Canada’s purchases on the level of domestic bond yields, and how fiscal support might be leaking out of the Canadian economy.
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Ian Pollick: Hi everyone, and welcome to another episode of Curve Your Enthusiasm, I'm your host Ian Pollick and I'm joined by my co-host Royce Mendes, Executive Director and Senior Economist at CIBC Capital Markets.
Royce Mendes: If virus case counts don't move lower in the next few weeks, as a result of some of the restrictions that have been put in place, provincial governments are going to have to be more heavy handed and that's going to be a worse outcome for the economy. That's not our base case. But, you know, it's something that we should understand about the risk.
Ian Pollick: Royce, how was your weekend?
Royce Mendes: My weekend was good, you know, getting a little bit cold over here, so sitting outside is not as comfortable, but I bought one of those firepits so you'll have to come over and see if it keeps you warm.
Ian Pollick: I would love to do that. And do you have any exciting plans for Halloween? Are you and your roommate putting candies out?
Royce Mendes: We're not allowed to, actually. So unfortunately, in Toronto, we're not really supposed to be putting candy out. So unfortunately, we won't be doing that. But maybe some spooky drinks in the backyard will have to do.
Ian Pollick: That was a test. And you passed with flying colours. You adhered to the standards. Now listen, I want to kick off the show today by taking a step back to last week. We got a bunch of data in Canada, CPI numbers, retail sales numbers, probably in line with what the expectations were coming out of your group. But maybe just walk us through, is there anything that you learned from either the price data or the retail sales numbers?
Royce Mendes: Well, I would say the inflation data, it just keeps confirming what we already think is true is that there are no upward price pressures at the moment. And the Bank of Canada really needs to be worried about downside risks to the economy and of course to CPI. In terms of the retail data, actually, it was a little bit weaker than we had anticipated. So both for August, it was roughly half the growth rate that we had penciled in. But more importantly, it was that flash estimate that we received for retail sales for September, which suggests that there's virtually no growth that we saw in Canada. In terms of what that means for the overall GDP outlook, you know as you pointed out on Friday, we received some additional flash estimates of manufacturing and wholesaling, which were on the whole better than what we saw in retail sales. But I would still argue that when I look at all of the activity data sort of together, we're not getting as good a handoff to the fourth quarter as we had hoped, maybe even just a week ago. So that's a little bit of a downgrade. And of course, we've tempered expectations for Q4 and Q1 of 2021 because of the surge in virus cases. But, you know, moving on to this week, we do have GDP out on Friday for August. But again, we'll be really paying attention to that flash estimate to see maybe did we get the sort of growth that we had penciled in? I'd argue that the likelihood of that is low and we're looking for something for September that is less inspiring than we would have hoped for. But of course, we have the Bank of Canada out this week on rates. We don't really expect anything, right? I mean, they've said for a long time now that the effective lower bound is twenty five basis points. On QE, we don't expect any material changes that would alter the effect on the economy. But maybe you can talk about is this the time that maybe they will implement the quote unquote, calibration they've talked about?
Ian Pollick: Well, it's a great question. I think, you know, we've been teased with this calibration term for a couple of months now. And the problem is I use the word tease because we actually haven't had any details rounding out what that actually means in practice. So it's really let a lot of the analytical community in the street, as well as investors, to really be left to their own devices say, well, what does that actually mean? You know, our take on this Royce, as we've been saying many times, that as a first principle, we think the program's too large. The problem is, as you rightly say, just given some of the slowing that we're expecting in the fourth quarter, newly announced provincial lockdowns as well as the optics around potentially easing away from QE at a time where the virus case count is not doing very good, would seem to be quite odd. So what we think needs to happen is a staged out approach. And when we think about what that order of operations really means is we would be looking this week for a broadly technical adjustment, meaning that when you look at the eligible basket, that the bank conducts its purchases for the various maturity sectors every day. What's very apparent is that the author and securities in Canada are no longer being sold to the Bank of Canada, and it's nearly the same size as they were at the very start of the program. I think part of that simply reflects that there is a certain scarcity effect taking place in the market, meaning that people don't want to sell some of these deep off the run seasoned issues for fear that they won't ever get them back. So I think when you look at the data, it shows you that, in fact, investors have been selling the Bank of Canada benchmark securities. Benchmarks are the most elegant way to conduct a QE program just because that's where all the upside issuance indigestion possibly comes from. It is the most liquid complex of the entire market. So we think this week that they move to truncate the baskets to include the single, all the current and the building benchmark securities. I think that is going to have some implications for the market, because when you look around the fixed income space in Canada, what's very apparent is the cheapness of some of these benchmarks and building benchmarks in particular. So trades that we like going into Bank of Canada, which aren't necessarily macro based, is just own the benchmarks versus some of the off the run securities, but when you think about what calibration is going forward, and I'd be curious to see if you agree with me on this, we think that at some point you do get an outright tapering of the weekly purchases, say from five billion a week to something more digestible like three billion a week. And ultimately, when you do get to the later part of that recuperation phase, that's the most likely time we see yield curve control being implemented, because that just coincides with yields being at their most vulnerable to upside swings. I'd be curious from your perspective, from a more economics point of view, what do you think the Governing Council is thinking with regards to QE? I mean, we've talked a little about it before, but maybe just reiterate this. What do you think QE has been worth in Canada?
Royce Mendes: Well, there's been a lot of talk about the Bank of Canada financing the government's deficits. I will say that by our estimates and, you know, I think you agree with this, the central bank has only lowered the 10 year benchmark bond yield by roughly 10 to 20 basis points out of the, what is it, 80 basis points, it's fallen since February. More important for those bonds are the significant increase in domestic Canadian private sector savings, which are recycled eventually largely into government bonds and what the Federal Reserve is doing in the US because the long end of the Canadian yield curve is really dictated heavily by global capital flows. So, you know, I agree with you that there will come a point when the long end will be vulnerable. But I think tapering at this point shouldn't be seen as sort of the Canadian version of the US taper tantrum. This is not the Federal Reserve operating on US government bonds. This is a much smaller central bank operating in a small, open economy where its yields are heavily influenced by global rates. At that point, though, when you say that the long end of the yield curve is most vulnerable, I would agree because a lot of things will be happening. Not only will the Bank of Canada maybe be tweaking its bond purchases, but, you know, when we're at the closer to the end of this recuperation phase, all of that savings will be starting to be unleashed into the economy and that changes the dynamic. What will the US be doing? And that's why we don't have to talk about this today. But I think next week is going to be really interesting. Obviously, it's the US election, but what is the Fed going to do? We've seen long end yields drift higher. Maybe you can give us a little bit of a preview of what you think the US Federal Reserve response is to that sort of gradually grinding higher of long end yield?
Ian Pollick: Absolutely. It's a great question. I think it's one that reinforces the view that when you look at the Fed's purchases and with the weighted average maturity of those purchases are, they're almost three and a half years shorter than they were in the middle of QE infinity, you know, in 2012, 2013. The question is, you know, when we talk about yield curve control in Canada and we talk about the Bank of Canada focusing on that five year sector, the point that we're trying to make is saying that that's where household borrowing rates really are the most sensitive to. And it's quite the opposite in the United States because they have much longer term debt for the household sector. Mortgages tend to be 30 years in nature. So if you look from August today, you know, 30 year bonds in the US have sold off 40 basis points. And that does have an implication for mortgage rates. And housing is seen as a very important part of the recuperation mechanism in the US. The question is, you know, does the Fed care? And I think when you look back at some of the recent communications from the Fed, whether it's from the FOMC itself or it's from the regional presidents, we're seeing a divided line. One part of the FOMC is saying, listen, you know, QE only has a certain amount of limits, particularly those limits start to get strained when you are at the lower bound end rates. And to the degree that long bonds have sold off 40 basis points in the past three and a half months, you know, I would argue there is probably room for the Fed to extend some of its purchases. But against that, I think they really want some fiscal clarity. I think there is a desire to get a fiscal stimulus program done. So I think, you know, ultimately my expectation would be that the Fed does start to increase the size of its purchases as well as lengthen the duration. But it's not clear to me that has to happen before Q1 2021 until we get a better picture of what the fiscal stimulus package looks like, what the new or current administration will look like on November 4th. So I think ultimately that matters for a country like Canada, because in the absence of support for the long end, as you rightly say, Canadian yields take a huge amount of elasticity from global rates and particularly the United States. That just means that we should be bracing for a steeper yield curve.
Royce Mendes: Let's talk about the fiscal picture, because as you rightly point out, we have no clarity at the moment on the fiscal picture. And you mentioned November 4th about knowing who's president. I mean, we'll see. It seems like more and more that the Electoral College votes are going to be heavily tilted toward Biden and it's going to be a clear victor. But there's still a possibility that because of all the mail in voting, it takes longer to actually confirm that. Now, in terms of the fiscal stimulus in the US, maybe there will be a deal after we taped this and before we send it out. But at this point, I would say that those are sort of fading hopes of a fiscal deal because from the time you agree, the Democrats, Republicans, the White House all come to an agreement, it takes some time to actually get it legislated, so getting it done, that final vote done before November 3rd, it's a very tight time frame. And I would say it's highly unlikely at this point. And, you know, after you flip the calendar to November 4th and that lame duck session begins and let's say Republicans lose the White House and or the Senate, well, are they going to be as willing to play nice? They could put up roadblocks. At this point, you know, it would really be, in my opinion, a Hail Mary from the US Republicans to try to get a deal done and sort of change the tone of what the recent polls have been suggesting may already be fait accompli essentially.
Ian Pollick: So let me ask you this then. I'm going to put you a little bit on the spot here. And I know it's not something that we said we're going to talk about on the show today, but you just struck a chord with me. And when I think about what the interest rate market is thinking about when it comes to a blue wave, a lot of it has to do with what was really missed in the 2016 election, which was what do these incumbents actual policies mean for the economy and therefore growth, therefore inflation, therefore, what level should interest rates be? Part of the appeal for the bond market to sell off and steepen into a blue wave? narrative is the idea that under Biden's economic plan, a lot of the stimulus is front loaded. So I guess, you know, my question to you is not specifically on whether or not you know what those policies are, but when you think about an environment where you have excess savings or high elevated levels of savings, and you have low interest rates, what does the literature tell us about multipliers when it comes to fiscal policy? Because if Biden does win and we do get, let's say, a blue sweep, then if you believe that you have strong fiscal multipliers, you believe that you have a fast delivery of the stimulus, then bond yields are susceptible. And it could be by a very large number, 40 to 50 basis points over the coming quarters. So what do you think when you hear about why the blue wave is so bad for the bond market?
Royce Mendes: Yeah, I tend to agree with that, except for the fact that the Senate is less of a clear cut Democratic win. So, you know, if the Republicans hold the Senate and the Democrats hold the White House, it could be like the ending years of the Obama administration when the Republicans took a very obstructionist stand. And maybe we don't get the type of fiscal stimulus everyone is pricing in. Now I would still say that that is not the likely outcome, but it's something to think about as we head into the election, is how does Congress set up and how willing are they going to be to work with the White House? Now let me switch gears and talk about the multiplier in Canada. There's a little bit of a difference here, and it's a little bit technical, but it's very interesting. So you look at the US and, you know, they produce a lot of the goods that they actually buy. So this switch from services to goods purchases by households, you know, hasn't leaked, quote unquote, as much growth out of the economy. We don't really think about this sort of stuff when the economy is operating at full potential, because if we're buying more things from outside the economy, we're actually producing something else here and that's what's getting us to full employment and an economy that's running at or near potential. But when we're this far below potential, we think about these distributional differences. So in Canada, we actually buy a lot of goods from outside of the country. And I've been sort of working on a paper, I hope it'll be done soon, that looks at how much growth is actually leaking out of Canada. So in Canada, it's not just as simple as sending the cheque out as it is in the US. You send the cheque out of the US, even if people buy a lot of goods, it gets recycled into the US economy. If you send the cheque out here in Canada and households buy a lot of goods, it gets leaked out to the rest of the world. So there maybe needs to be a supplemental policy in Canada that tries to get households to purchase more services. You know, we've talked about cutting the sales tax on services. It's just something to think about, the difference between Canada and the US and fiscal policy in each country and how it actually affects the domestic economy.
Ian Pollick: That's really interesting, actually. I mean, I think it's one of those things where when you break down, why does the bond market care about a blue wave, when you think about the mechanical transmission of what that stimulus actually does, not just the timing of it, but the multiplier effect, I think it's really important because it helps us gauge what that ceiling could look like in terms of the rise in yields. And the only things I worry about that I haven't really heard is the commensurate impact that higher yields would have on, for example, equity markets. And, you know, it's not that the right level is very high, Royce, it's more that potential rapid speed of a sell off could begin to disrupt some of the other parts of the market. So it's not clear to me that we want to be expecting yields to rise materially and sustainably, but I do think that we're supposed to stay a little bit defensive on duration.
Royce Mendes: You mentioned 50 basis points. I think you're saying it just to be clear, probably in isolation without the Fed stepping in, which it likely would, and try to, as you said, maybe implement some stronger yield curve controls.
Ian Pollick: Well, not yield curve control, but more just lengthen its purchases to just really recognize that where the parts of the curve that need stimulus are the ones that are probably the most vulnerable. So I think we're in agreeance here. Now one of things I have, a question for you. It's a bit tinfoil of me, but I'm going to put it out there anyways. If you are sitting in the governing council and you're a fly on the wall and you're listening to deliberations which begin, I believe, tomorrow or today and tomorrow and culminates on Wednesday, what are the things that you think that they're talking about that they can't necessarily say, i.e., is the data good enough that they could sound hawkish in the absence of the second wave that we're seeing? Or is unequivocally when we take a step back and say, well, listen, we're still in a very long, protracted, highly uncertain environment. There's really nothing good that we can parlay out of what's happening right now. What do you think that they want to say that they're not going to, if anything?
Royce Mendes: You know, I don't know what exactly they wouldn't want to say, but I will say as a rule, it's sort of an unwritten rule for forecasters, is that you don't want to move wildly from one side to the other. And you will remember that in the last NPR, they were seemingly very downbeat on the Canadian economy and very downbeat on the global economy. And, you know, I don't want to criticize here, but that was a big swing and a miss because they were more downbeat than I would say the consensus of private sector economists was and now they're going to have to revise those. So we see growth in 2020 more like 5%, whereas, you know, they were growth contracting by something like 5.5% as opposed to they were calling for a decline closer to 8% in the last NPR. I don't think they can be overly hawkish because it would be such a dramatic turn in the tone from the central bank. At this point, the risks are still heavily skewed to the downside, right? Like how much of an upside risk could we have? Well, you know, you get a little bit of better growth, but you sort of get that near-term ceiling because we're not getting tons more airline traffic in the near term. We're not going to get people going back to packed movie theaters, sporting events or conventions. Those types of things just aren't happening. So you can get a little bit more growth. But there's a lot of downside here, right? If virus case counts don't move lower in the next few weeks as a result of some of the restrictions that have been put in place, provincial governments are going to have to be more heavy handed and that's going to be a worse outcome for the economy. That's not our base case, but it's something that we should understand about the risk. So I would say they really don't want to sound hawkish or be perceived as sounding hawkish. One thing I will say is they might have to address is this question of independence. We've seen, you know, I've been asked a number of times because I think there is some messiness here between fiscal policy and quantitative easing. The bank is seemingly financing the government. But as we talked about, it's not really adding that much pressure to yields, I mean, in the grand scheme of things. And it's not, you know, there is, I mean you can correct me if I'm wrong here, but there is appetite for government of Canada bonds, highly rated, a long track record of fiscal prudence, sort of. So I would argue that that might be something that they have discussed and they want to figure out a way to communicate that independence that the bank is operating in its, under its mandate to achieve 2% inflation and nothing else. And I'm sure if they don't come out and say it, someone will ask that question at the media scrum.
Ian Pollick: For sure. And listen, one of the things, before we wrap this up, I have a question for you, and this is a theoretical question, but what we've seen over the past, really couple of weeks, is this flurry of mergers and acquisitions. A lot of M&A activity is culminating in Canada. We're seeing broader consolidation in some of the service sector, in the energy sector. The question I have for you, is there any academic literature that says when you have elevated M&A activity just a result of all the cheap assets and cheap funding out there, what does that do in theory to productivity? And do we need to start thinking about a shift in potential growth in 2021, 2022, if we do get this rapid consolidation in some of the larger, more inefficient industries?
Royce Mendes: It's a good question. I haven't read up on that. I would assume it probably increases productivity. But maybe I'll try to answer that one with some reading I do in the following week, I'll try to answer next week.
Ian Pollick: I think I smell coauthored report here, buddy. I think we should think about this a little bit. It's an interesting topic. Lastly, I want to say, you know, we get the dual GDP numbers in North America this week. And I think, you know, you highlighted this earlier. But what we're seeing is particularly for the US, when you look at some of the higher frequency activity indicators for Q4, it looks like a very similar pattern in North America where you had pretty decent Q3 growth that looks to be petering out in Q4. Is there any reason not to expect that to be the case on a go forward basis?
Royce Mendes: Well, I mean, let's say we got a fiscal deal and we got that money into the economy. Look, I think there's scope to outperform because at this point, what these households who are receiving this additional unemployment benefit and have not been recently, you know, they've been drawing down on savings. You can only do that for so long. I said in a meeting earlier today that it's almost like Wile E. Coyote running over the side of the cliff, only to be suspended in air for a few seconds before falling back down to earth. At this point, we've seen household spending continue to advance, but how much longer can it do so without those additional unemployment benefits? And that's why I think it's so important. That's why the market's been paying such close attention to this, whether or not we get a deal in the next twenty four or forty eight hours and we can get it done before the election and that lame duck period.
Ian Pollick: That's a good point. And finally, I don't think we actually gave numbers. What are we expecting for GDP in August?
Royce Mendes: So we're looking for GDP in August to be 0.8%. It's a little bit less than that flash estimate that came out from Statistics Canada in the last GDP report. And then I'll tell you for September, you know, we had originally penciled in 1.5% because there was such a strong employment report. It still could be the case. It's just that when I look at all of the flash estimates of retail, manufacturing and wholesale and put together with some of the other numbers we have for things like oil and gas production, I sort of come now to the conclusion that it may not be 1.5%. We could be lower. And that's going to, of course, lower the Q3 number. But what it really does, it impacts the handoff to Q4 and it reduces the starting point for where we're moving forward and we know it's going to be a very difficult period for the economy. So I would say that's the key to watch on Friday. The August number is sort of baked in. It's really what happens with the September flash estimate that I think will move markets.
Ian Pollick: Yeah, I would agree. I mean, someone asked me this morning, what was the piece of data outside the bank that matters this week? I said, well, it's actually the flash estimate for September that's going to give us our handout for Q4, which is what arguably we need to start thinking about. Listen, I think this has been a great episode, Royce. Thank you for taking the time. I hope you and your roommate have a wonderful Halloween this week. Next week, we're going to be back. We'll talk about the Bank of Canada. We'll talk about anything that we've heard in a bit more detail. So I hope everyone has a great week ahead and remember-
Royce Mendes: We could do another episode this week, couldn't we?
Ian Pollick: Do you want to? I mean, we should probably update everyone on what we learn from the bank. That sounds like a great idea. We'll update everyone after the Bank of Canada. Royce and I finally agreed on something which is fantastic. And remember, no bonds were harmed in the making of this podcast.
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