Ian and Royce discuss the recent bond market selloff from their own perspectives, and conclude that a ‘high pressure’ economic outcome isn’t the driving force. Royce surprises us with his love of farms, while Ian talks about his expectations for the BoC meeting next week and when we can expect a taper.
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Royce Mendes: And the Canadian dollar is not that much stronger than it was a few months ago.
Ian Pollick: Honestly, I've known you for a really long time and sometimes you surprise me with how smart you are.
Royce Mendes: All right, Royce. We're back in the studio, but we're not really in the studio. And remember, last time we were on the episode, we talked about FaceTime-ing one another. So you game?
Royce Mendes: Let's do it.
Ian Pollick: OK, let's do it right now. Hold on. There you are, buddy.
Royce Mendes: Hey, there's your pretty face.
Ian Pollick: You look terribly good looking. It's nice to see you. Listen, there's a lot going on since our last discussion. What are you thinking about right now, man?
Royce Mendes: Look, I wanted to ask you what you're thinking about. What's going on in the barn market, what's going on with this selloff? Tell our listeners.
Ian Pollick: Sorry, I don't mean to do this every episode, but you just said the barn market. You did, you did. OK, just saying. OK listen, I think that the velocity of the repricing that we've seen in the bond market over the past two weeks has been nothing short of extraordinary. And I think you take a step back and I think there's kind of three angles we can think about when we're discussing it. The first one is how are central bankers playing into this? And correct me if you feel differently, but I think not acknowledging the degree of improvement the economy has made relative to expectations at the end of last year are almost underwriting the move meant higher yields. The other factor, too, is clearly there's a technical aspect here. Obviously, when you have so much momentum in the bond market, that momentum feeds on itself. And we've put out a couple of pieces talking about the memory embedded in, for example, 10 year yields. And, you know, that basically says a 10 year yield today is going to remember almost 100% of what it remembered yesterday. Therefore, the movement the next day is going to be sequentially higher. And then finally, you have the decomposition of how yields are changing. And this is perhaps the most interesting. If we really believed that this was an overheating economic scenario where the bond market was pricing in a high pressure outcome, I think we would have expected to have seen a larger move in breakevens or market based inflation compensation. What we've actually seen is the opposite. We've seen real interest rates rise, term premia increase and real term premia in particular increase. To me, that is just a reflection of the improvement in the near term economic trajectory, which I think when you put those three forces together are creating a very vicious circle. So you've blown through all these really important technical levels, you have a situation now where you're now above or very close to being above your pre pandemic levels. And I think that in of itself is the story. I think we were just normalizing to where we were pre pandemic paying tribute to this growth profile. What are you thinking about? Because you and I think about the bond market a very different way, and that's a good thing because we can complement one another. But what are you thinking about?
Royce Mendes: Well, I'm obviously thinking about the barn market.
Ian Pollick: (laughs) Moo!
Royce Mendes: Look, I'll take the other side of this in terms of I'll take the side of the central banker. What do you want a central banker to do? I mean, Powell explicitly said this is not calendar based guidance. This is guidance that is based on reaching certain thresholds for the economy so everyone can make what they like of the data that's been rolling out. And obviously, when they come out with a new summary of economic projections, that dot plot is going to look different. So, I mean, I don't really understand point one that you made, but the other two points, I'm with you.
Ian Pollick: Let's get back to that, right? So the point that I'm trying to make and what I said earlier was that this lower for longer debate is reinforcing the disorderly moving yields, because by suggesting that keeping rates low will lead to a very good outcome in the future, the path to that good economic outcome is a high pressure scenario. So that high pressure scenario is being underwritten by central bankers today and by not acknowledging some of the improvement in growth, we're saying well we're really going to overheat. That's what I mean by that. So I think this lower for longer is reinforcing lower bond prices.
Royce Mendes: But didn't you just say that this is not a sign of an overheating economy because we're not seeing breakeven inflation rates rise?
Ian Pollick: It's not. I think it's just getting back to the level that we were at pre pandemic, and that is a level of economic activity and a level of yields that, you know, relative to three weeks ago was very, very far away.
Royce Mendes: Look, I'm with you on that. I just don't see how what central bankers are saying or are not saying or what you would have liked them to say plays into that.
Ian Pollick: So let me ask you this. Did you listen to the Powell interview yesterday?
Royce Mendes: I did.
Ian Pollick: Did you think it was a good idea or bad idea? Because, I only ask that because it was seen largely when it was scheduled late last week as a way for Chair Powell to kind of calm the bond market, reduce the velocity. And in fact, there were some whispers that perhaps he would introduce some type of Operation Twist today. I never really bought that. You know, that's one of those sensationalist ideas that, yeah, it's really cute in theory. It makes a lot of logical sense. Unlikely to be the platform. Did you think that his interview did more harm than good or did you learn anything?
Royce Mendes: Look, in retrospect, it was a bad idea, but hindsight is 20/20. We can obviously see that he didn't get the reaction he wanted out of the bond market. But it's not his job to underwrite certain parts of the market's expectations heading into a speech like that. As you said, some people might have been overly optimistic that he was going to say something extremely dovish, but I think if you and I were sitting here prior to his speech and we were having this discussion, we would have had been expecting him to say largely what he said, which was not anything really different than what's been communicated.
Ian Pollick: There's no new information. I think we're aligned here, dude, because I didn't learn anything from his discussion. If anything, it was just a more clear messaging of what he said before. And I think he actually did a good job in what he was trying to explain. But relative to the expectations put on that speech, it failed. It didn't do all that much. And in fact, you know, you saw yields skyrocket after the fact, equities started to decline. And that's kind of interesting, right? Because, you know, you can argue with me all you want about semantics, because I know you love doing that, whether or not this was a bond market selloff based on a high pressure outcome or just a normal trajectory to a speedier recovery. If that's the case, why aren't stocks liking this? Have they moved to higher previously and now they're just losing a little bit of traction? Because there's a disconnect here, because at the end of the day, bond yields are higher because they're signaling a fundamental improvement in the outlook. Why aren't stocks reacting?
Royce Mendes: Look, stocks are reacting the way they should be when bond yields rise. I think this is probably just the normal digestion of a recovery. I don't think there's anything, I mean, correct me if I'm wrong, anything disorderly happening in markets? I don't think financial conditions have tightened too much to be consistent with a strong recovery.
Ian Pollick: The velocity has been disorderly, right? That is not normal. Last week was demented. You know, it's very rare that you see a five year yield double in ten trading sessions. It was actually less than that.
Royce Mendes: I mean, OK, OK, we don't usually talk in yields doubling. What's the basis point move? Is that unprecedented? Just the basis point move.
Ian Pollick: It's not unprecedented. I think it's unprecedented given that there is a fundamental catalyst triggering it or a central bank speech that made that momentum so apparent. It innocuously came out of nowhere, but in retrospect, again, to your point, hindsight is 20/20. A lot of these vulnerabilities have been bubbling beneath the surface for the past kind of six weeks or so. Nonetheless, I think it was amplified by maybe positioning, by technical considerations that we don't need to get into on this conversation. But I want to shift gears a little bit here, because let's say you're sitting in Ottawa right now. You're the Bank of Canada. You've had a doubling of five year yields. You realize that other economies like Australia, where the RBA has failed to defend its yield curve control target for a few sessions now, the bond market is not listening to them. What are you thinking about?
Royce Mendes: I think you want to cause as little damage or disruption as possible. So when the Bank of Canada comes out with its statement next week, they're going to be doing a high wire act. They have to acknowledge that the data has been rolling in better than expected. You know, the fourth quarter GDP number was roughly double what the Bank of Canada had in the January MPR, the January flash GDP estimate from Statistics Canada indicates that the first quarter is sort of tracking a growth rate above 3%. The Bank of Canada, of course, had in the January MPR a contraction of about 2.5%. So things are far better than the bank had estimated. Now there are still challenges on the horizon. First and foremost, there's the potential for a third wave here of the virus in Canada. We can't discount that. So the bank cannot come across too hawkish in endorsing some of these optimistic views about what is coming down the road for the economy. I think, as Powell said yesterday, we have to actually see the improvement in the economy before we see central bankers really make a change. We're sitting here in Toronto in lockdown on March 5th. That is not exactly an economic situation that is really optimistic or positive. So I would say I wouldn't expect any huge waves of changes in the statement. Now, an interesting question I'm struggling with is whether they drop the reference to 2023 being when the output gap closes, that could be one small difference. Another difference could be whether they signal something about asset purchases.
Ian Pollick: So let's take those in order. And, you know, one of the things I wanted to ask you is obviously, like you said, Q4 is better, Q1 flash was better. The implied handoff puts us into pretty positive territory. And we know a lot of the containment measures in some of the most locked down provinces eased up in February, more so in March. What is your output gap profile today relative to where it was, call it, two months ago?
Royce Mendes: So I think we could see the output gap closing towards the end of 2022 now, and that's a few months earlier than it would have been prior to the latest batch of data, I will also mention there were some revisions in that data which helped that Q4 growth rate, which is something we simply-
Ian Pollick: You can't forecast it.
Royce Mendes: Yeah, it's on unforecastable, but both economies, I think, are looking to close the output gap a little bit earlier than we had previously anticipated. I think we could see the US close its output gap towards the end of this year. I know that was something, though Powell was very hesitant to confirm. He sort of said that it's very unlikely to reach maximum employment this year. But I think it's something that at least has to be a consideration at this point. So, yeah, we're certainly looking at a better outlook than we were a month ago.
Ian Pollick: So let me ask you this, because, you know, you're the economist, so I'm just the strategist. And, you know, that means I'm your roadie. You're the rock star here, buddy. So I have kind of a back of the envelope way that I look at the output gap. And correct me if I'm wrong, you know, I kind of get a Q2 closure. Is it because I'm not accounting for an improvement in potentially. Is that why you're delayed a little bit relative to me? Do you have a better increase in potential as you have better growth?
Royce Mendes: That's the way to think about it. Is GDP in and of itself, some of it is going to building more potential in the economy. So if you have a better growth profile, it's likely that you should add a little bit extra to potential. So I think that's probably where you're back of the envelope calculation is different than our estimates.
Ian Pollick: Don't tell me how to do my job. No, I'm just kidding. So let's get back to the second thing, right? You know, one of the things that I keep getting asked by clients is whether or not the Bank of Canada is going to signal a taper. And my message has been they actually signaled to us in January that they were ready to taper when they have more confidence in the recovery. And I can't, I'm going to paraphrase here, but the statement in January basically said, as the Government of Canada gains confidence in the recovery, yada, yada, the pace of net purchases of Government of Canada securities will be adjusted as needed. And I think a lot of people don't understand what that net purchases sentence means. The more that I think about it, the more I realize all they're saying is that whatever bonds they buy need to exceed the quantity of bonds maturing. And that's really important because we know, based on what you just said, that their base case is now somewhat obviated, that it's much better than expected, which leads us to believe that the net pace of purchases has to exceed what's falling out. We're in a period of time over the next six weeks, and it started yesterday, actually, where you have this huge, truncated maturity profile of term repos. So you have kind of one hundred and forty billion or so maturing over the next six weeks. The Bank of Canada of meeting in April is at the end of the month. If you pin the Bank of Canada meeting at the end of the month until the end of the year, you have about 90 billion of securities maturing on the bank's balance sheet. That equates to roughly two billion per week. So I think what the bank is saying is that over time, as we gain more confidence in this recovery, the breakeven minimum rate of purchases that we are going to be happy with until we are well through the recuperation phase is two billion per week. So I think that you can get to that three billion level relatively quickly. I think it will be announced in April. I get a bit nervous about announcing it in March because you don't really have the platform to discuss it, unless you think that the speech on the economic progress that usually comes the day after is sufficient. What do you think?
Royce Mendes: No, I agree with you. I don't think that's sufficient. It comes too much later than the statement does and the statement is so short, it can't really go into any detail about asset purchase. So I'd agree with you. I just thought it was worth flagging, at least as a risk, because I'm sure they are already thinking about it and discussing it. And probably if they had an MPR that was coming out alongside the March statement, they could have made an announcement about what's likely to come a month or so down the road in terms of asset purchases. But I'd agree with you, it was just a risk I wanted to flag.
Ian Pollick: So let me ask you this, because you're pretty familiar with how the Bank of Canada operates, in a prior life, you used to work there. Right now, when you're in a meeting prior to a Monetary Policy Report, how much weight does the Governing Council have in terms of discussions with the staff about their projections? Or is this more of a vacuum governing council meeting? They kind of give an update on what they think is happening and these bigger discussions kind of take place over the next six weeks. How does it work?
Royce Mendes: So it's certainly not a vacuum. There is an ongoing dialogue between governing council and the staff. However, prior to an MPR, what happens is, is that there's a very formal forecasting process and there are meetings that the staff attend and present those views in a very formal way. However, in these sorts of situations, in non-MPR meetings, that doesn't really happen in that sort of detail. They're not running a whole new projection for these meetings. So that's why they tend to be light on the details of what the recent data mean for their forecast. That's why I don't think they're going to update the language surrounding what they expect for growth or inflation in the years to come or even the language about when the output gap closes. The most aggressive change I could see happening is just dropping the reference to the output gap closing in 2023 if they think it's going to close a little bit earlier than that. But again, that also presents some issues because then people could think, well we really have no idea they could pull it-
Ian Pollick: Forward or backwards.
Royce Mendes: Yeah, well, probably pulling it too far forward and then that creates a whole other host of issues. So maybe this is not an ideal situation, but maybe you don't mark to market all of the language or the specific numbers until April. But that creates as well some issues, I mean, that we've been talking about for some time where any forecasts made in December or January are completely stale already.
Ian Pollick: Ok, so speaking of mark-to-market, let's think about the Bank of Canada when it was under the stewardship of Mark Carney, one of the things that the Carney kind of administration, which Tiff was part of used to talk about quite a bit, was a type one type two response to the currency. Obviously, one of the things that we haven't talked about, Royce, is the recent move in oil prices. And when you think about that type one, type two response, when it relates to the currency, you know, I don't think we've landed on where our new forecasts are for oil prices over the balance of the year. But they're going to be higher than where they were, depending on how persistent this decision to not increase output is. How should we be thinking about that or how is the bank thinking about that? Because before it was a situation where the Canadian dollar was strengthening because the US dollar was weaker. But now you have consistently less weak US dollar not necessarily breaking out of its recent momentum, but you now have stronger oil prices that are adding a bit of a different narrative. So how should we be thinking about that?
Royce Mendes: Well, you know, in terms of just the isolated impact of higher oil prices, that's a positive terms of trade shock. So, you know, sending more barrels of oil down to the US, which we are doing in 2021 versus what we were doing in 2022, in terms of volume, just because the US is demanding more is helpful. But also the higher prices, of course mean that businesses in Canada are receiving higher incomes. So that's a positive. And if the Canadian dollar were to appreciate solely based on that, there wouldn't be a problem. Now where the problem starts to come in is if the Canadian dollar is strengthening, just simply because we have a strong risk on sentiment coming next week, let's say in an example and for no other reason, the Canadian dollar is strengthening just because the US dollar is selling off during those risk on periods. That's more of an issue. However, this recovery is going to be different than a typical recovery, right? We already know what the driver of the recovery is going to be. It's not going to be a balanced recovery. It's going to be a huge contribution from household spending more normally on services. So we don't need to take into account as much what the Canadian dollar is doing to exports or associated business investment. However, down the road, that's going to need to be more of a consideration. But at least for now, we can look past some of the strength in the Canadian dollar. So I'd be surprised if they made any reference to the strengthening in the Canadian dollar because they haven't really said much about it up till now. And the Canadian dollar is not that much stronger than it was a few months ago.
Ian Pollick: Honestly, I've known you for a really long time and sometimes you surprise me with how smart you are. And that was a really lucid explanation of why this recovery's a bit less tilted to the requirement for a cheap Canadian dollar, because it's going to be largely domestically led. That was a very solid point, Royce. Hats off to you, sir.
Royce Mendes: Thanks. But let's get back to talking about something important. Let's talk about that barn market. No, because seriously, I've been thinking about it during the podcast. You know, Canadian housing markets are on fire going crazy. I'm thinking, look, we go in together and buy a farm up in northern Ontario and build that barn.
Ian Pollick: And we talk about the barn market while we're building our barn.
Royce Mendes: I mean, the barn markets seems like the place to be right now. Every other asset class is selling off.
Ian Pollick: This is true. But let me ask you one last question. Do you know how to cook?
Royce Mendes: Not really. Not very well.
Ian Pollick: So we have to find Uber Eats somewhere because I don't know how to cook either. Listen, I think this was a great episode. We hope everyone has a wonderful weekend and we hope you and your families are safe. And remember, there were no bonds harmed in the making of this podcast.
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