Royce and Ian discuss the latest developments in the US regarding the Federal Reserve. Royce talks about how a range of employment indicators will be in focus as central bankers figure out what constitutes maximum employment, and how that will affect the timing of rate increases. Ian discusses how tapering US QE could affect Canadian rates. Ian and Royce then chat about how all of this affects the Canadian dollar.
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Royce Mendes: The discussion about rate hugs is well into the future.
Ian Pollick: Rate hugs?
Royce Mendes: I said rate hikes.
Ian Pollick: You said rate hugs, but go on.
Royce Mendes: I don't even know what that would be. But OK.
Ian Pollick: Hey, everybody, welcome to the 30th episode of Curve Your Enthusiasm. Royce, 30 episodes, buddy.
Royce Mendes: Congratulations.
Ian Pollick: Congratulations to you, too. Let's kick this off a little bit. I want to start our conversation today just looking back to the data yesterday from the US. Obviously, we got Q4 GDP. To me, it looked a bit interesting because when I looked at some of the contributions to growth like inventories, there were some signs that the build wasn't actually that big. So when I think about Q1 and I think about the growth implications, presumably it's actually OK because you can't necessarily whittle down inventories that weren't built, could be some more production. In general, what are you thinking about the numbers?
Royce Mendes: You're absolutely right on that. But I don't think people want to talk about inventories. So I will leave it at saying that Q4 GDP came in a little bit below expectations. That means there's less of a drop likely in store for Q1. So we could even see a flat reading or maybe a slight positive. In the grand scheme of things, the outlook is still the same. And we heard from the Federal Reserve earlier this week that better things are on the horizon, but the Fed is defending their position. They're talking about, well, they're not talking about winding down QE. Chair Powell was very adamant that he didn't want to get into any discussion of that. And certainly the discussion about rate hugs is well into the future.
Ian Pollick: Rate hugs?
Royce Mendes: I said rate hikes.
Ian Pollick: You said rate hugs, but go on.
Royce Mendes: I don't even know what that would be. But OK. Looking ahead at when we might start to think about this unwind. This year is obviously heavily dependent on the path of the virus and immunization. But I would argue that if all goes according to plan, the output gap in the US is going to be closing around the end of this year. That's not the case here in Canada, but in the US it could start to close by the end of this year. But the Federal Reserve is not talking about hiking interest rates until 2024 in the dot plot. So why is that? I would argue that what you're going to want to keep an eye on outside of inflation, of course, inflation is going to matter, they're going to try to get it to overshoot. I think they will get it to overshoot in 2022 and they'll want about a year of that. But outside of that, I would argue what we got from Chair Powell's press conference is that investors are going to need to keep an eye on a diverse range of unemployment indicators to make sure that the labour market is achieving maximum employment. So what do I mean by that? You know, in the last recovery, we paid a lot of attention to the unemployment rate and we tried to guess where full employment was or something like that. And we kept realizing that the unemployment rate could be pushed lower and lower because there were these pockets of weakness and slack. This time around, the Fed chair is saying we're going to focus on those pockets of slack after we closed or think we've closed the output gap. So that's talking about racialized people, women, low wage earners, all of which have been hit disproportionately by the pandemic. So I would say that if we start to see an improvement there and we get the expected pickup in inflation in 2022, we could start to see rate hikes as early as 2023. And I think when we get to the March Fed meeting, if the vaccinations are picking up and accelerating and the outlook is improving, you could start to see a few more than just a handful of dots that have hikes penciled in for 2023. But a little bit earlier than that, I want to ask you a question about the Fed and when you think they will end the QE program, because, not only because we care about what the Fed is doing and US rates, but you and I published a paper on the implications for US Federal Reserve quantitative easing for Canadian rates. And I'm wondering what you think the tapering and eventual cessation of QE purchases in the US will do to Canadian rates?
Ian Pollick: No, it's a good question, right? And I think, you know, just going back a few minutes, you know, you hit a very important topic right now. And when you kind of look at what OIS markets are pricing in and you look at the level of longer term interest rates in the US, there is a tug of war where the market is implicitly more hawkish than the Federal Reserve. So what are the things that's ultimately going to catch up with either side of the narrative is, well, time is going to progress. We're going to find the binary outcome of vaccines or no more vaccines. Are they working or they're not working? And as time gets closer to this mythical 2024 for liftoff, these questions are going to get louder. So I think right now, you know, we did the work and basically we looked at 10 year yields in Canada, 10 year yields in the US versus when the implied first hike would be coming into the market, priced in by the OIS curve. And what we found is that in Canada, you know, every time yields sold off in Canada by 10 basis points, it was worth roughly sixty five days in terms of bringing the Bank of Canada forward. Whereas in the US it was a much larger number, it was closer to ninety five days, meaning that, you know, every 10 basis points, almost, the market moved three months forward to price in the first Fed hike. That's pretty important when you think about the level of yields, because what it implicitly says is there is a ceiling here to the amount that yields can sell off in the very near term without the Fed budging on its narrative. So when I think about QE, I've tended in the back of my mind circle, well, you know, the US doesn't have a similar problem in terms of its big footprint in the market like Canada does or the Bank of Canada does. So, you know, early 2022 is kind of what I think when I look at your macro forecast. It makes sense to me for them to start dialing back a little bit. But I think one of the things that Chair Powell said over and over again was we learned our lessons from 2013. We're going to overly communicate this. So I get back to this realization that it's not actually the event of tapering. It is the expectation and the announcement that you will taper. So is it possible or probable that, come the summer, you're in a better situation with the economy, a better situation with the vaccine rollout. The Fed does start talking about tapering. Do we get that reaction immediately? And I would say we probably do. So it's almost moot when we think they're actually going to do it versus when they're going to announce it. And I think it's, go back to first principles. This is a Federal Reserve that is buying a tremendous amount of bonds. One hundred and twenty billion a month. As they take the foot off the gas while the economy is improving, you're going to see an unorderly move higher in yields. Now, hopefully, it can be contained to a certain degree and by extension, Canada rates are going to go along for the ride. One of the things that we've been very adamant about and what you and I wrote in our paper was that once you get past really the belly of the Canadian curve, the amount of spill-over from US rates is nearly 85, 90%. So it's very hard in isolation for Canada to go at it alone unless you're in a very different part of the policy cycle, a different part of the economic cycle. But we share such a similar macro DNA that that's very rarely ever going to happen. And I'd like to know your opinion on this. I don't think the timing, when they do it matters. I think it's the timing to which they start announcing or suggesting that they're getting closer.
Royce Mendes: I tend to agree with that, although the research suggests that these more open ended types of QE, where there's not a fixed dollar amount announced in the beginning, have flow effects as well. So I would tend to agree that you're right, a lot of the market movement is going to occur earlier than when we actually see the Fed start tapering. It's going to happen on the announcement effect. But some of it and I don't know if you agree with this or not, but this is what the empirical economic research would suggest is that there's still going to be some flow effects.
Ian Pollick: I think so. But let's take a step back and think about that, right? You have North America. Let's talk about Canada, the United States, leaving Mexico absent for a minute. When you think about QE, obviously the flow matters much more for a market like Canada because this is the first foray into quantitative easing for the bank. And that's one of the things that we were talking about. When you kind of look at the spill-over from QE purchases into term premia, it was very, very large at the start of the program. So call it April to really the start of Q3. That flow really mattered. But more and more as QE continues, it's really the stock that starts to matter. And I think that's something that the Bank of Canada flagged a couple of weeks ago, NPR vs. the US, where I would argue it's not a flow based QE narrative anymore. It's more just the stock. And that stock is very large, perhaps for the more illiquid parts of the market, like TIPS, certain pockets of MBS that flow matters. But I think for treasuries, it's that stock and that stock is going to remain very high for a very long time. So I think that's just a new twist on what was an old academic view, because QE has been going on for so long, it's much larger than it was before. But what's curious is QE and currencies. You know, traditionally-
Royce Mendes: Well, actually, want to stop you before you get into the currency, because the elephant in the room we're not talking about when we're talking about stocks of QE is what the issuance profile looks like in the US. At this point, there's a material amount of uncertainty about what the stance of fiscal policy is going to look like in the summer. You know, Joe Biden has presented a case for one point nine trillion dollars of additional stimulus. Whether or not that's the deal, it's highly unlikely that that's going to be the deal. But a lot of this, I would argue, is going to hinge in addition to the stance of quantitative easing on the stance of fiscal policy. Would you agree with that?
Ian Pollick: I think starting points matter. So I'm going to slightly agree with you. And what I mean by that, Royce, is that even if we were to half that fiscal stimulus program, let's say it comes in at nine hundred billion, a trillion. The starting point for bond issuance in the US in the current year is one where you see this massive net supply build, so you go around the G7 or the G4 wherever you want to look, you say, well, what's that supply look like in various markets? And in Europe, there's basically no supply. The PEP is very big. They expanded the PEP. it's likely to happen again. Versus the US, where you have this very dramatic net supply build. You're going to see a very similar net supply build in Canada, too. So I would argue that even without these fiscal stimulus programs coming online immediately, you're still in the situation where you have less incremental support from the bond market. And if you do get this passaging of these very large top end fiscal policies, then it makes conditions even worse. And I think that gets us back to, well, how do we segregate the impact of rates from QE winding down versus issuances rising? And the two together obviously have a very meaningful impact. And I think that is a good foray into the currency market.
Royce Mendes: Yes. So let's talk about the currency a little bit. So obviously, in the current context, the US dollar is selling off on good news, whether it be with regards to the economy or just fiscal stimulus alone. That's because we're seeing a risk on trade, which is pushing currencies like the Canadian dollar, the Aussie dollar or other currencies higher.
Ian Pollick: That's also a commodity story. It's not just a risk, it's a commodity, too.
Royce Mendes: Ok, fair enough. But the question I have for you is, you know, when I think about the medium term and I think about fundamentals, I think that more fiscal stimulus in the US is a substitute for leaving rates on hold at the zero lower bound for longer. So the more fiscal stimulus you get or the more government spending you get, the faster we can see QE wind down, the faster we could see rates being hiked. And that's sort of in line with our view that the Fed doesn't need to leave rates on hold till 2024 to achieve both of its mandates, inflation and maximum employment. What do you think about when the market might seem to move away from the risk on risk off trade to a more fundamental view of fiscal stimulus economics at rates?
Ian Pollick: So I think what you said is correct. It's a bit dogmatic, I think, when you think about the dollar weakness story, because I think right now, you know, it's a very simple narrative. It's one where you have a Federal Reserve that is promoting inflation running higher than they have traditionally allowed it to be and letting it run longer than they've traditionally tolerated. And when you take a step back and say, well, traditionally when you have higher inflation, you have reduced purchasing power, there's really two ways to accommodate investors or to compensate them. One is you hike interest rates so you can keep cash and try and earn that relative differential. Number two is you have to have a cheaper currency. Right now the story is the Fed is committing themselves to not raising rates for a very long time. Therefore, the idea that you could get inflation and this is not really the reflationary, this is just basic facts for inflation, expectations of when the Fed's going to step in and promote a cheaper currency. So I don't know if fiscal policy by itself is something that gets the market thinking, hey, things are looking good, rates are rising, rate differentials are starting to matter again. Therefore, the dollar should be a bit stronger. I actually tend to think of it more along the lines of until the Fed is going to market their expectations, exactly what we've been talking about for the past 15 minutes, you're going to end up in a situation where good news equates to a weaker US dollar.
Royce Mendes: Right. But it's until that happens. So I'm asking you the question, when do you think that's going to happen?
Ian Pollick: I don't know. I mean, let's think back to our forecast, right? So what do we have on average H1 growth versus H2 growth this year? Is it meaningfully different?
Royce Mendes: H2 growth is completely different, but the Fed is forward looking. They're going to be able to recognize that. And I think what's really going to change the outlook and this is, I can take this back to the Bank of Canada, which you saw in the latest NPR, was the rollout of vaccines allows forecasters whether they be private sector or public sector, to have more certainty that good news is on the horizon. And maybe the base case for the FOMC members was that eventually the economy was going to have put the pandemic in the rear-view mirror. But to have more certainty about that gives you more optimism and allows you to maybe pull forward those rate hikes, which you really put out very far into the future previously.
Ian Pollick: So, listen, I think I'm a bit more pessimistic than you are. I think that's just the nature of me being a bond guy. You know, I get worried crossing the street that something might happen to me or turning the corner. I feel like there's a lot of stock being put into this idea that we need to get through this production hub for vaccines, we've got to get the rollout happening. And all of a sudden, you know, all this lag consumption is going to come back online. I don't know if that's necessarily true. And I think it's a lot to hang basically every forecast that I've seen, including our own on. So, you know, I'm not so sure that you're going to get that light bulb moment from the Fed like, aha, yes. Now, let's talk about not keeping rates low for years. I don't think that's a 2021 story, dude. Where I get a bit concerned too, is just this idea that what if savings don't actually turn into consumption? What if they stay permanently high?
Royce Mendes: That's a good question. And let me explain this a little bit to you. So we have a stock of savings versus a savings rate. So the stock of savings is what's in people's bank accounts. The savings rate is every two weeks when you get your paycheque, how much do you save out of that? That's the savings rate. What we expect to happen in our forecast, which you're right, is optimistic, is that we don't need to see the stock of savings actually being drawn down to spend with. Just the normalization of the economy requires, all it requires is that people stop saving as much from each paycheque and start to spend more. And I'd add another thing in here. A lot of people think about this pent up demand as being going out for dinner seven nights a week or going on three or four vacations a year. That's not what this hinges on solely. There could be part of that. But there's also going to be a lot of people going for surgeries, medical procedures, dentists.
Ian Pollick: I knew you were going to say that. I knew you were going to say.
Royce Mendes: Well, it's in my research. So I hope you knew I was going to say that. It doesn't require this huge change in animal spirit. It's just a normalization. And because you're starting from such a low base on GDP, that normalization adds up to a lot of growth. And that's why I think you can see forecasters optimistic. Chair Powell said this. I'm just not sure. And I think they see the route for the economy very similar as we do. I just don't think that that has been incorporated in their forecast with the degree of certainty that it could be later this year if vaccine rollouts go according to plan, if immunization happens according to plan.
Ian Pollick: That was a very long if statement. And thank you for econosplaining what a savings rate was to me.
Royce Mendes: What is econosplaining?
Ian Pollick: Econosplaining. It's when an economist explains when they think you don't understand.
Royce Mendes: Oh, econosplaining. Isn't that the whole job? And what would I call you?
Ian Pollick: Strategizeplaining? You know, I think the task that you're talking about, i.e. sounding more certain, bringing forward rate hikes, it's not a terribly hard job given where the market is. Like, you know, I just checked before we started recording today, the Bank of Canada's priced to go between, call it February and March 2023, there's no February meeting ever. So call it Q1 23. And that's really been flirting with Q4 22 Q1 23, plus or minus 10 basis points in ten years. In the US, at one point in last August, we were priced for 2025 liftoff. Now we're priced for Q3 23. When US ten year yields were one eleven one twelve we were priced for the summer of 23. That doesn't sound crazy to me. So I don't think you necessarily have to pull market expectations that far forward. I think the market is going to stay somewhat more hawkish in line with what we've been talking about on this episode.
Royce Mendes: Good point. That's a good point. And maybe the way we need to frame this discussion is not so much about the market's timing of the Fed, but maybe the market's timing of the Bank of Canada, which I think you would agree with me, seems a little bit early.
Ian Pollick: Listen, I think I am very happy to coalesce around a central view, as we always do together. I think this one I'm a little bit more uncomfortable with the idea that the bank has to go after the Fed. What changes my mind, and where I get fully in your narrative, is if the bank does adopt average inflation targeting at the end of the year. Because right now, fundamentally, you say, well, you have one central bank that needs to see more inflation rather than less and one that needs to see inflation getting to the point where it needs to be with a closed output gap.
Royce Mendes: But we've discussed that they could employ something even that is pseudo inflation targeting. And you actually recognized on the last episode that the neutral rate in Canada is not the same as the neutral rate in the US. It needs to take into account the currency.
Ian Pollick: Because you need an FX.
Royce Mendes: Right. And if you have the Bank of Canada hiking ahead of the Fed and the currency moves stronger or remains strong, then I don't think that's consistent with having inflation sustainably at 2% and all of those things that the Bank of Canada wants to assume.
Ian Pollick: But I think we're getting cute. I think we're getting cute because what if we have the bank price from March and the Fed price for November? You telling me that six month gap is going to make the currency that much stronger? I don't think it would.
Royce Mendes: No, I'd leave that to you. But that's not the way the market is priced at the moment.
Ian Pollick: All right, listen, dude. You and I tend to disagree on a lot of things. But, you know, one of the things that we're going to leave this episode agreeing on is that the Fed does matter for Canada. And one of those important regime shifts is occurring right now where for the past really six months or so, a lot of the developments in the Canadian bond market have been Canadian focused, even though we have a huge amount of spill-over from abroad, QE adjustment, QE trajectories, the shape of the curve, etc.. You know, that's really been a function of just domestic investors realigning themselves to a new supply environment, a new QE environment. But now as we go ahead. The ball is back into the Fed's court, so that degree of losing somewhat of our autonomy in terms of our market being able to move by itself is only going to get more important as we go forward. There was a lot of really good points that you raised today, even though I don't necessarily agree with all of them. But is there anything you want to tell our listeners?
Royce Mendes: I think you're absolutely right. Like, let's not sleep on the Fed just because we're here in Canada. Everyone always talks about the special relationship between Canada and the US. You know, there is this special relationship between Canadian markets and the Federal Reserve.
Ian Pollick: Absolutely. So, listen, it's our 30th episode. I think it was a damn good one, Royce. A damn good one. I hope everyone has a wonderful weekend. Thank you for tuning in. And remember, there were no bonds harmed in the making of this podcast.
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