Ian Pollick and Royce Mendes discuss the most recent Bank of Canada interest rate announcement, implications from the Monetary Policy Report (MPR) on the bond market, and delve into their view on the evolution of Canadian QE.
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Ian Pollick: Good morning and welcome to the 15th episode of Curve Your Enthusiasm. My name is Ian Pollick, Global Head, Fixed Income, Currency and Commodities Strategy, at CIBC Capital Markets. And I'm joined as always by my co-host, Royce Mendes, Executive Director and Senior Economist at CIBC Economics. Royce, how are you?
Royce Mendes: Doing well. Welcome back, Ian.
Ian Pollick: Thanks very much. Listen. It's a very important episode for us today.
Royce Mendes: It is?
Ian Pollick: It is. Did you know that, statistically speaking, if an episode or a television show or a podcast can make it past its 15th episode, then it at least lasts a minimum of two years?
Royce Mendes: Wow, so I guess we're together for the long haul.
Ian Pollick: Well, maybe I shouldn't always wish for certain things. Listen, it's been a very interesting week. And I think obviously we need to start with the Bank of Canada interest rate decision, policy statement and accompanying monetary policy report from yesterday. To me, the big things that stand out obviously were the introduction of forward guidance slash conditional commitment, as well as some of the central forecasts. So why don't we start off by getting your thoughts on what did you think of that central forecast? Aggressive? Conservative? What do you think?
Royce Mendes: The central scenario looks very reasonable to me. It's in line with our below consensus forecast for Canada in 2020. In fact, it has a slightly weaker outlook. The most important parts of the assumptions suggest that even by 2022, Canada's economy will still be undershooting its potential and inflation will still be below the Bank of Canada's target. It's pretty clear why then the Bank of Canada decided to issue that conditional commitment to keep the overnight rate at its effective lower bound until inflation sustainably reached target. Basically, the bank isn't touching the policy rate for the next two years, and the governor said as much in an interview with Amanda Lang on BNN. I guess the biggest question for me is if the bank doesn't see the economy fully healed in two years and inflation isn't at target at the end of the forecast horizon, then why didn't they add even more stimulus? Maybe the uncertainty of the whole forecast was an issue, but the governor noted that the central scenario was what drove the policy decision. Anyways, I think we look to October now for any major changes. They are doing some very important work on some of the long run assumptions and will likely be able to show with more conviction by that time that demand is certainly going to undershoot supply for the foreseeable future.
Ian Pollick: Royce, one of the defining things for me when I look at some of the recent anecdotal evidence of how the economy is progressing, whether it's the Business Outlook survey or whether it's the text of the Monetary Policy Report, is really this theme of supply coming back online at a much faster pace than demand. Therefore, potential output is also interrupted relative to its previous trend, relative to our own base case and the central scenario. How do you think demand can move forward with limited accommodation, given we're already at that effective lower bound?
Royce Mendes: Look, the central bank is somewhat constrained now that its policy rate is at the effective lower bound. But there are still tools that they can use to support demand. I think we'll look to October for an introduction of yield caps. We've talked about the reasons why it will be important for the bank to pivot towards such a strategy at some point, not only for the macro economic considerations and the benefits that you would get from something like that, but also the financial system and bond market considerations that we need to take into account. Maybe you can just jump in and give us some of those?
Ian Pollick: One of the things that we've learned in Canada over the past 10 days has really been that you have this explosion of issuance, but at the same time, you have a very big offsetting acquisition coming from the Bank of Canada. And when you look at the debt management strategy that was released on July 8th, what it showed was this huge increase in bonds being issued across the entire yield curve. And what we did is we took a look at what the Bank of Canada was buying to try and understand what that net supply would look like. In aggregate, it looks like the Canadian bond market is moving from a small net negative supply environment in fiscal Q1 to a very positive supply environment over the balance of the fiscal year, which is roughly around 30 billion in each quarter. Now, that's not all uniformly distributed across the yield curve. For example, in the five year sector and in the 30 year sector, there's basically no net supply. It's about plus one billion just given the size of quantitative easing operations direct and those maturities. And where you have your real problem points is in the two year sector, your three year sector, as well as your ten year sector. I think the conditional commitment slash forward guidance that was provided yesterday or two days ago is very important because it effectively acts as its own yield cap in the two year sector. The problem is, though, is that when you draw out the acquisition of these securities by their maturity point and you say to yourself, by the end of the current fiscal year, what proportion of these maturities is the Bank of Canada going to own? All of a sudden, you see that the two year sector is north of 75%. The bank will own more than 85% of the five year sector, 65% of the 10 year sector and 50% of the 30 year sector. These are levels that are inconsistent with a market that is fully functioning, that can provide price discovery, can provide signals. And I think the bank recognized that. And in a report, we argued very vehemently that the only way around this was the Bank of Canada will need to start including benchmark bonds in their purchases. Indeed, over the past couple of days, we've learned that two year benchmark has been included, the five year benchmark has been included, and we're waiting with bated breath to see what happens with both the ten year and the third year. Now that by itself adds about one hundred billion to the pool of bonds that they can buy. The problem is, though, if you believe that this quantitative easing program is going to last or be as permanent until the economic recovery is well underway, then you end up still in a situation where you bought too many bonds. So that's why I think yield curve control is such an elegant policy tool because it obviates the need to distort the market by buying too many bonds. You signal that you have infinite demand to own a sector. And it's now not just a function of keeping yields a certain level, it's more of a function of preventing yields from rising, but also reducing the potential negative impacts to owning too much of the bond market. One of the things I wanted to actually ask you, Royce, because I still can't wrap my head around this. I find that the fact that they've told us that, you know, quantitative easing will continue until the economic recovery is well underway. But then they also said that for policy rates, you know, until the economy is at full capacity and inflation's at target or sustainably achieved, then we'll start hiking interest rates. That, to me, feels like you have different guidance for both quantitative easing and for the overnight rate. That doesn't seem like a consistent kind of messaging. What do you think about that?
Royce Mendes: I actually disagree with that. I think it is consistent with the order of operations that they want to communicate. What it means to me is that you're going to see QE phased out earlier than you see the policy rate being increased. And that's, you know, of course, what happened in the US. You saw QE wound down and then you started to see the policy rate being nudged higher. I think it is wholly consistent with what they want to communicate now. Whether or not that was done in a way that was clear for everyone to see, maybe not, but I think it makes sense to me, what I believe they're trying to tell us is that well into the recovery means that we may not be at full employment and inflation may not be at target when they start to wind down the QE program. But certainly when you start to see that policy rate move higher, we're going to be at sustainably at 2% inflation and we will be at an unemployment rate that looks something like full employment.
Ian Pollick: See, I disagree with your disagreements. Because if you think about that messaging for various parts of the market, you clearly saw the Canadian dollar rallied a full cent yesterday, the bond market rallied as well. That is not a normal type of coordination of prices because one market heard something, the other market heard something else. So I don't understand why the Bank of Canada would want to be pinpoint precise, to say that we think that the output gap is going to close in year X. Therefore, by the time that year X comes along, we will absolutely have to start winding down QE. I think that given that it's an open end QE program, you have tremendous amount of degrees of freedom or optionality to really tailor it the way you want to. And you can talk about the size as much as you want, but to prematurely signal that QE will end before policy rates rise, I think is a very dangerous message and I think could have very negative complications going forward. I don't think we're going to agree on this one.
Royce Mendes: Actually, I think what you said is fair. If me or a small group of people are the only people who understand what that messaging was exactly meant to say, then the Bank of Canada failed in its communications. Additionally, I would agree it's dangerous to guide the market so far ahead into what the order of operations will be, because who knows what the situation and the environment is going to look like a few years from now. So actually, on those points, I would agree with you.
Ian Pollick: Hold on. Hold on. My heart just stopped. Are we agreeing on something right now?
Royce Mendes: It's very small. [laughs]
Ian Pollick: [laughs] Well, listen, I think one of the things that we need to start thinking about, and I know that it may be a little bit out of the box, but it is a very real possibility that progress on generating a vaccine, we're seeing a second wave or even potentially a third wave, means that the limited amount of room that the government has or the Bank of Canada has left to provide, given the commitment that we are already at that effective lower bound. What is the reaction function like in a situation where demand is getting worse, it is not coming back online, supply gets curtailed? God forbid we have another lockdown. What tools available do they have to provide real stimulus? Are we talking about, hypothetically, a non-standardized rate cut?
Royce Mendes: First of all, I think you would see the bank obviously refocus its efforts on financial stability, particularly if it were a more global second wave, which I would say at this point can't be ruled out for the Fall. On monetary policy, you could see the bank choose to lower the overnight rate a bit more, maybe down to 0.1%. But they've said that it sort of gums up the system to have rates anywhere below 0.25%. So I think the threshold for such a move is pretty high. I think you can basically throw out negative rates at this point. They are not going to use them if things get bad again and this financial system needs support. There's evidence in other parts of the world that they can do more harm than healing and can lead to less lending, not more. But other than yield curve control, which is, of course, in our base case forecast, they could do things like funding for lending, which has worked quite nicely in other countries. But maybe you can talk about how the bank could make QE actually more impactful if the scenario worsens?
Ian Pollick: I think you said exactly what I was thinking. You really have this very big binding constraint in Canada, because when you scale the size of Canadian QE for the size of our market, it is absolutely enormous. And the problem will always be that you are continuing to run up to these constraints is that you just don't have that many bonds unless you open it up to the building benchmark securities, you start buying all the benchmarks themselves. Then you get into this gray zone, is are you monetizing the debt directly. And I think politically, that may be a bit challenging, but in that type of scenario, I think obviously you'd have to do what has to get done and that is absolutely what needs to get done. Again, yield curve control is so important because it's limitless. There's no finite amount that you need to purchase because you can signal this infinite demand. So, Royce, one of the questions I had for you today, I was looking at the retail sales report in the US. Obviously, the numbers came in a little bit better than expected. Maybe that's going to signal something for our own retail sales data next week, maybe not. But one of the things that's obviously important in gaining more narrative in the US is that the US is about two weeks away from losing some of its fiscal relief benefits, like the $600 that certain households are getting. And that really brings an echo to the lapse of the CERB, which I think takes place in August or September. Obviously, we can expect to see some consumption patterns decline once those fiscal relief programs start to expire. Where do you think we're going to see it in the data first?
Royce Mendes: Well, let's hope that unemployment insurance benefit in the US doesn't expire, because I think it's pretty important to supporting demand and particularly supporting demand for households that need it the most. Now, in Canada, the situation is a little bit different. The federal government doesn't just want to end the CERB program. It wants to phase it out and actually transition a lot of people off of CERB and potentially onto the wage program. Now, how are they going to do that? They haven't outlined the details yet, but they have extended the wage program and they have added extra money in the fiscal snapshot to the wage program. My guess is that they use sort of a sliding scale. One of the reasons we've heard from businesses that the wage subsidy hasn't been used as much as maybe the government anticipated was that you had to show that revenues were down pretty significantly. And if you called back your workers, you had to pretty much expect that your revenues were going to be down for a few months into the future, because if they weren't, you'd all of a sudden lose the weight to 75% wage subsidy. But you would have those workers back in your place of employment and you would be paying them, you would be on the hook for paying them. Essentially, that meant that companies had to have some foresight in a time when I think nobody has a lot of certainty about what's ahead. So what I would expect is maybe the government does something like that, you know, if your revenues are down 30%, you get the full wage subsidy. If they're down 20%, maybe you get 50% of the wages covered. If your revenues are down 10%, maybe you only get 25%. That would give the program a little bit more flexibility. Now, I've heard other suggestions for this. I've heard maybe just simply lowering the threshold. Maybe you could do it in an industry specific way. So say for airlines, the revenue threshold is a decline of 30%. For restaurants, it's decline of 20%. I would argue that that could be seen as picking winners and losers, so could be politically difficult. But you can see how the government needs to adjust the program to get more take-up. So hopefully what it means is that when the CERB ends and, you know, I think most forecasters would see that as being pretty much in the base case that there is take-up on this wage subsidy and there is still fiscal support being provided to the economy.
Ian Pollick: For sure. It's interesting and it's a good way to think about it. And I think as we move forward to a lot of the expirations of these programs, we have to be very cognizant of what a pivot may look like from policymakers. Yesterday was pretty interesting because in the NPR itself, we were shown that the COVID weighted basket was a little bit less negative in terms of the disinflation that we're seeing in the very big headline index. But in his Q&A yesterday, Governor Macklem said that the frequency of reweighting the CPI basket is going to become a bit more frequent. And that's a very good thing, I think, in the very near term, but do you think that that has limitations or potential repercussions if you start to reweight the basket too often?
Royce Mendes: No, I think it's probably appropriate to start reweighting that basket a little bit more often. I don't think there's any issues with that. I will say I actually found the research that Statistics Canada and the Bank of Canada did on this basket update or COVID basket for consumption. Less interesting than I thought it might be because the measure wasn't that much different than actual CPI inflation. So if we had seen it a full percentage point stronger or something, we could've asked ourselves, what are the implications for policy, what are the implications for households? And then what are the implications for RBs? But given that they were so close together and, you know, moving forward, I think arguably, if you look at some of the high frequency data on consumption and credit card data or debit card data, you can see that consumption is moving towards a more, quote unquote, normal track. You know, I think some of those issues will be even less important in the future. So I wouldn't take a lot out of that research that the bank and Statistics Canada did. I mean, that's one of the disappointing parts of doing research, is that sometimes you do all the work. You have an interesting hypothesis. It turns out the result isn't all that interesting.
Ian Pollick: Yeah. But you know what? At least we know what that number looks like now. And it's not a big question looming over the market. So what do we think for CPI next week? Are we still going to be in this disinflationary year over year type of environment?
Royce Mendes: No, I actually think we see a bounce back. You know, the numbers haven't been finalized when they'll come out a little bit later today in the week ahead publication. But I think we see a bounce back. There's another strong month for gasoline prices, I think, in terms of ex food and energy, you know, the economy will continue to reopen. I think some of those steep price discounts that you saw might have dissipated and actually some retailers might have started increasing prices a little bit, and I think that will show up in ex food and energy. And then you have the food category, which last month looked particularly weak when I compared it to the US numbers, so maybe a little bit of strength there. So, you know, I think there should be broadly signs of inflation showing up again. And we can sort of eliminate some of the worries. There weren't a lot of worries, but some of the worries that we were headed for more persistent deflation.
Ian Pollick: Nice. So, listen, I think that when we take everything that we've talked about today, I just want to talk about some of our favourite trades over the coming week. Obviously, with CPI coming out, with inflation looking to run a little bit hot, we generally like being long ten year break evens in Canada. They've lagged recently versus TIPS, so it's a trade that we always liked and we want to go in and out of the trade. I think it makes a lot of sense over the coming week. Given that the Bank of Canada has begun to include benchmarks into its QE purchases, the cheapest bonds in the curve are all the benchmarks. So we really like owning the benchmark rolls. In particular, I think the forty-eights fifty-ones roll looks very, very attractive here. 10 year rolls are going to trade somewhat directionally with the market, but I think over the long term, still a very good trade. We're getting a lot of questions on what this all means for swap spreads now that you're including the benchmarks into the QE eligible baskets. Same story, we still think the five year sector outperforms. We still think there's mortgage flows that need to come and pick the market up. We're seeing a lot of cross market issuances coming back into Canada. That's really what's been happening to the 10 year sector this week. So we like resetting these fives-tens spread as spread flatteners at current levels. And in terms of tens-thirties, you know, it's a very, very hard curve to trade right now. I think I'd feel more comfortable calling it once I see some more supply domestically in the long end. For now, I would stick with fives-tens steepening trades. Royce, is there anything else that you want to talk about before we kick it off for the weekend?
Royce Mendes: No, I think that was a great episode.
Ian Pollick: Listen, have a great weekend. Thanks very much for joining. And to all our listeners, we hope you have a great weekend. We'll speak to you next week and remember, no bonds were harmed in the making of this podcast.
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