Ian and Royce are back in the studio, talking about the potential merits of a Bank of Canada microcut. Ian discusses the interesting way in which yields have been rising, while Royce does a deep-dive on the forecasts we can expect to see coming out of the MPR next week.
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Royce Mendes: In this case, we can't outsource things like dining out, going to a bar, going to your local dentist or going to get a massage, things like that cannot be outsourced. In contrast, however, you can have an outsourcing of big manufacturing.
Ian Pollick: We are back in the studio for our first Curve Your Enthusiasm of 2021, we hope everyone had a wonderful holiday season. Royce, are you there?
Royce Mendes: I am.
Ian Pollick: Happy New Year, buddy.
Royce Mendes: Happy New Year. I miss you.
Ian Pollick: I miss you, too. Did you and your roommate have a good new year?
Royce Mendes: It was good. It was, of course, a very quiet New Year's, but not bad at all.
Ian Pollick: Do you have any resolutions this year?
Royce Mendes: I never make resolutions because I think if you're going to change something, do it right that day. Don't wait for New Year's. I have a very strong opinions on this.
Ian Pollick: I can tell you I've thought about this before. Listen, let's jump into it, because it's only the 12th, 13th day of the new year and there's been a whole lot of stuff happening. And I think an obvious starting point for the podcast today is just to talk about the narrative behind potential micro cuts from the Bank of Canada. As way of background, remember that this really started at the end of last year where we had Governor Macklem talking to parliament in an off the cuff remark when someone said, well, what tools do you have left if conditions get worse? One of the things he said was potentially the effect of lower bound has been narrowed. And that central bank speaker for maybe the overnight rate can stay above zero, but it can be below twenty five. You and I talked after the fact. We didn't really take too much out of it. But then after the December rate decision, Deputy Governor Paul Beaudry put it in his prepared remarks that they're evaluating whether the effect of lower bound is lower. And I think that's really where this narrative came from, why the bank could potentially cut. And they end of the day, you know, we're in a situation where policy needs to be at the EOB. And if they think the EOB is lower than, why wouldn't they be there? The question is, is whether or not that does anything to the currency. Does it do anything for the economy? Will the banking system be able to tolerate that level of overnight rate? What do you thinking for next week?
Royce Mendes: Well, first of all, we don't even know if it's feasible to lower the effect of lower bound just yet because it's going to depend on the research that's ongoing at the Bank of Canada. I was thinking, why don't we do this in a pro con sort of way? So why don’t we start off with the pros, it could weaken the currency and micro cut. It could offset a tightening in financial conditions. You know, bond yields have been rising, could do a little bit there, and it could add a bit more stimulus to the economy as it starts to enter, hopefully in the not too distant future, a real recovery where we don't look back from any other pros you'd add there.
Ian Pollick: I think that when you look at Canada, one of the interesting things about our market is that for a market with so much excess liquidity, you have a lot of dispersion in the very, very short end of the curve. And these are interest rates that ninety nine percent of the population would never look at. But for market participants, you know, you have Treasury bill yields that are five or six basis points. You have BAs trading at eighteen basis points. You have Corra trading at 20 basis points overnight at twenty five, Sidor at forty five. There's a lot of dispersion amongst those short interest rates. And, you know, to me, when I think about one of the pros, it's really this situation where you have a market that has so much excess liquidity but too much bifurcation amongst all the short rates. So I think it'd be a good way for the bank, which, you know, correct me if I'm wrong, but when I think about a central bank that is handcuffed, I wouldn't say the bank falls into that narrative, per say. But they are challenged to provide more accommodation should they feel the need to give in proximity to zero, given the fact that large scale asset purchases arguably aren't really doing all that much, particularly within the context of how the bank would calibrate it further. Because remember, their calibration, their tapering is really just we're going to buy less, but we're going to buy longer. So the net amount of interest rate risk we removed from the market is unchanged. But what we saw over the past week was that when US Treasuries sell off, Canada's moving one for one, particularly in the long end. So I think one of the pros is this could be an easier way to add accommodation.
Royce Mendes: And I actually think that's a good way to transition into the cons. One of the cons, I would argue, is that you're using some of the remaining ammunition when at the moment it seems like brighter days are ahead. What we're seeing right now, the economy is under immense pressure in many parts of Canada, but it seems like market participants, businesses and households, as their responses were captured in the recent Bank of Canada surveys, suggest that there is clearly a bright light at the end of the tunnel. So if you used it now, what happens if down the road we are in a position where these current vaccines don't work against some mutation of the virus? At the moment, it seems to be working against the mutations that have occurred, but may not be true. So it takes a few months then to redesign the vaccines. In that situation, you might want to add stimulus, not necessarily because the economic impact would be different between doing it this month or down the road. But because I would argue the financial market impact would be different because you have something to unveil to markets to say, look, we're trying to calm things down again, the path for the economy this year really depends on infection rates, not interest rates.
Ian Pollick: How long were you saving that one up for?
Royce Mendes: You know what? I've used that in written text before. A change in the interest rate of 10 basis point is not going to do a whole lot. Moreover, I think if you use that ammunition, you might not be able to hold it out as a threat to over markets. So if you use it and the currency doesn't react at all, well, then now you can have some market participants making one way bets from that point on. Any thoughts on that? Because I've sort of framed it in something that's really your expertise. Is the market reaction to some of the announcement effects?
Ian Pollick: Well, I think you're right. When I think about some of the cons, obviously, I think about the Reserve Bank of Australia. And what we saw there was you did have this cut delivery towards the end of 2020. But really the currency listened for a very short period of time. And then it got away from them. And now they're in that situation where you really are very, very close to that lower bound. And the credibility of lowering rates further to weaken the currency just really isn't all that valid. So I wonder that is one twenty six, one twenty five, even one twenty four dollar Canada, really a level where we need to start spending on that additional room. And I don't think it is. You know, one of the things that we are seeing is the micro cut really isn't all that priced for the January meeting. Maybe there's 15 percent, 20 percent, depending if you think it's 10 or 15 basis points. And at the end of the day, I think when you look at very short term interest rates in Canada, one of the things that's keeping rates so big is just a function of supply. You don't really have a lot of supply of physical BAs coming into the marketplace. You don't really have too much of a supply of commercial paper. And so that's really meant that the Treasury bill market's been soaking up a lot of that excess demand at a time where there's really not a lot of supply. Want to think about a bit further? I think there's some bigger questions we have to ask ourselves. Like, if the effect of lower bound is lower, then I would think that our star would have to be lower as well. And therefore, if you're starting from a lower starting point, then maybe the impact that we should be expecting to see markets is a bit further up that curve. Like maybe that 2 year point that 3 year point, which arguably still looks very, very high in Canada. I mean, would you agree with that?
Royce Mendes: No.
Ian Pollick: No. Why not? Let's get the ivory tower hats on.
Royce Mendes: No, absolutely not. I completely disagree with that. If you think about it, the effect of lower bound is a technical point on a continuum of interest rates. So in theory, interest rates can be infinitely positive or infinitely negative. But this is technically a constraint on the movement of monetary policy. Our star, in contrast, is the level of interest rates. No matter what the starting point is, the level of interest rates that the economy can sustain when it's at full employment to keep everything sort of moving along nicely and keep inflation at Target. So, no.
Ian Pollick: Wait I'm going to interrupt you because I think I understand where we can reconcile each other. And that's one of my actual resolutions this year is to be nicer to you. And I think in the spirit of reconciliation, could we say that if they do think that it'll be as lower, but that doesn't have an impact on our star, as you eloquently told the all, maybe that just means that we're unlikely to reach that level because we're starting from a much lower point.
Royce Mendes: That's possible. But remember, they already lowered our star during this crisis. So our star has come down. It's sort of a separate measurement and it's a completely different process. I would argue that the current discussion about the effect of lower bound is really in the hands of the financial sector experts at the Bank of Canada, not the monetary policy wonks who would be studying our star. These are two different research agendas that are being undertaken. I do agree that if you're starting from a lower point, if you're trying to be patient and you're trying not to over tighten policy, maybe you don't get to our star before the next shock happens. That would be by definition, I'd agree with that.
Ian Pollick: Ok, so it's just something a little bit earlier that I just want to go back to. And we were talking about our pros and cons. And it sounds like our problems, just to be clear, is a bit longer than our con list. Is there any other cons before I go on that you want to talk about?
Royce Mendes: No
Ian Pollick: You have to wait them to right?. You may have five pros, and three cons.
Royce Mendes: Exactly. Exactly. And that's sort of what I was going to get at, is that when I look at the big picture here, I would think that maybe the best option at the moment is that if they can announce that the effect of lower bound is lower, maybe don't actually move on that at the moment, but say they are ready to because maybe that starts to price in some cuts in the future if the economy is sluggish to recover. But you don't actually move it at the moment. What do you think about that?
Ian Pollick: I think it makes sense, right? I mean, it's just a question of what are they trying to target? If they're trying to target the currency, then jawboning it a narrative around potentially being able to use rates further, that something is going to overhang on the markets. Every time you get an appreciation of the currency, you know, you're going to get some type of pushback in the back of your mind that, wait a second, maybe they could lower the base rate, but if they're trying to target that dispersion in very short term interest. It's which arguably would be stimulative, like you, 10 basis points in a very short term interest rate may do a bit more than the currency being a cent cheaper.
Royce Mendes: Sure. It's like it's like squeezing a little bit more out of a lemon. It's not going to get a lot, but it's going to do a little.
Ian Pollick: Exactly. And I think if you're trying to target the currency, it's one thing to keep that narrative alive. And if you're trying to target the actual level of interest rates, then you probably have to do something else. And I had a crazy idea. And I don't know what you think about this, but what if you don't need a micro cut? What if the channel that they're trying to target is the very short term interest rates like Repo or Kaura? What if they stop paying interest on reserves and they allow a lot of the cash that's sitting at the bank balance sheet to re-enter the market? Suppress short term money market rates, that would have the same effect as a cut, but it wouldn't have, let's say, the potential burdensome consequence of penalising the banking system, i.e. prime doesn't fall. It could help to offset some of the potential unintended consequences of the balance sheet maturing, for example, the term repos that are coming due in April. Do you think that's viable? Is it too micro for the bank to consider?
Royce Mendes: I think the communication of that type of strategy would be so difficult that it would almost remove it from consideration. Remember that the Bank of Canada, yes, they use financial market participants and strategists and economists like us to convey to the general public sort of the stance of monetary policy. But they also want to be as clear cut as they can themselves. So they if they're easing policy, the main tool for easing policy is lowering the policy rate. If it can be lowered or conducting quantitative easing. What you're talking about is sort of a shadow easing in monetary policy. And I'd sort of argue it could garner a lot more questions and a lot more problems for the Bank of Canada at a time when the bank is...
Ian Pollick: They're under the microscope.
Royce Mendes: Yeah, and I would argue that they want to avoid that. So I think it's an interesting idea you put out there. I just don't think it's feasible in terms of the communication and the way they would conduct policy. They're pretty conservative in the way they operate. And I don't think the strategy you outline is really the simplest way to deliver the same amount of monetary stimulus as you could in other ways.
Ian Pollick: Yeah, I think it's an elegant solution. But you're right. I don't know how you explain that to my parents, for example.
Royce Mendes: Well, I mean, actually, to be honest with you, I don't know how you would explain it to some economists. Right.
Ian Pollick: Well, that's because you guys live in an ivory tower. I just want to go back to something I was saying earlier because you said something where you can do nothing and you looked at the Business Outlook survey and you looked at the consumer expectations survey. It was pretty good, or at least much better than I would have thought given the survey window, which only captured a bit of the lockdown's. But one of the things that you rightly flagged that I want to talk about is the inflation expectations component, not output prices, not input prices, but the general level of forward looking inflation expectations. It didn't move enough for me to say, oh, my God, everything's being unanchored, but it did move slightly lower. Is that cover enough for the bank to be concerned and to act, or is that just something to be mindful of?
Royce Mendes: It could be. I mean, it's it was longer term inflation expectations that were sagging even further as the as seemingly the economic outlook was brightening. It's sort of inconsistent. Right. And also, you know, I've heard so many times people talking about these supply chain disruptions and a little bit of inflation showing up this year later in the year because we've had some capacity destruction. So you have demand surging at the time. That capacity is not back to full tilt. You might get a little bit of pockets of inflation. So it was really interesting to me to see inflation expectations five years out sagging at the moment. So I would argue that in reading through the text, which as you've pointed out a number of times, the Bank of Canada, the leadership, prepare and review that text and they can word it in any way they want to word it. They flagged it, but it wasn't an outright concern. But I don't know what you make of it at a time when financial markets are actually pricing in higher inflation compensation over the next few years.
Ian Pollick: Well, it's interesting because I think that's the other thing we need to talk about is, you know, you think about the bank of Canada, small, open economy, small central bank, very large QE programme. And as we said earlier, these purchases, which are still relatively large, really aren't doing a whole lot to stem the sell off that's being left out of the United States. And it kicked off last week when you had the Georgia election runoff and you get this blue wave narrative that is a reflationary impulse. And then you had a relatively weak headline on non farms, but you had this very big average hourly earnings number. And, you know, we've gotten used to these big wage prints because we know that job losses are coming from the lower sector, lower paying sectors of the economy. So it always strikes me as a surprise that the market takes such a hawkish signal.
Royce Mendes: One other thing I'd add on the inflation compensation in the market is that it has a really high correlation with oil prices for whatever reason, and maybe commodity prices more generally. And and that might be one reason that there is this inconsistency where financial market participants are looking at these measures, whereas households are actually generally just looking at the overall economic environment, one area that I would argue that households might have better foresight in this case.
Ian Pollick: You know, I think we need to talk about it, because when you're talking about financial conditions, obviously in the past week alone, we've seen 10 year yields rise. Twenty, twenty five basis points. But there's something very interesting about this selloff that we haven't really seen over the course of the pandemic. And really, it's been led by a rise in real interest rates or said differently, it's real term premia that's rising. If you go back to, say, June, when we had the really first big sell off following the march, kind of cut to zero, everything's been led by a widening of breakevens. You've actually seen a decline in breakevens over the past week. You've seen real interest rates rise. And that's created a very weird situation, because when you think about other asset classes, what they care about, well, equity markets should love larger inflation compensation because it means revenue growth. But when you think about higher real interest rates, particularly for the tech industry, which is very capital intensive, these are higher costs that have to come in. This is the discount factor. That's why rates as a bedrock helps to reprice everything. But we haven't really seen it yet. And it's having this daisy chain impact where you still have from oil prices, real interest rates are rising. That's why the US dollar has gotten somewhat of a bid. And that's why the Canadian dollar has been under a little bit of pressure recently. But there's now a growth element to the bond selloff that I think is somewhat unsustainable. Just given everything we're talking about with near-term growth dynamics, particularly in Canada, with two of the largest provinces now in Fresh Lockdown's versus this light at the end of the tunnel. So it's a bit interesting to me that financial markets are not really putting too much belief on the near-term decline in potential growth outlook relative to where we get to the other side of the tunnel.
Royce Mendes: Can I just ask you to clarify something? You mentioned that tech giants have high capital expenditures, but I think it's the exact opposite. It maybe it's a definitional difference, but tech giants tend to have very low capital expenditures. If you think about the largest five companies on stock market indexes today, there there are a lot of tech companies. And if you think about the largest five companies on the stock market, maybe 30 years ago, there were a lot of factories and manufacturing companies. They produce real things. They had really high capital expenditures. I would argue the complete opposite almost as that the current tech giants have very low capital expenditures. But maybe I'm just I have a different definition.
Ian Pollick: Maybe you're just a different kind of cat. No, no, you're right. And what I actually meant by that and thank you for clarifying me is more that when you look at how most of the tech companies fund themselves through revolving lines of credit, it is through the debt markets. It's not necessarily the outlays are so big, but they are more capital intensive in their borrowing requirements. So that's why you tend to see when you have rising interest rates, tech tends to lag.
Royce Mendes: Interest. Broadly speaking, we're obviously in a very tough spot. But I would argue the data from last year provided a bit of good news. And I'm talking about what we saw in the aftermath of the first wave. We saw the economy snap back quite quickly. You saw jobs start to rebound much earlier than we had anticipated and in much larger scope. And you actually saw businesses start to open or reopen their doors after temporarily closing at a very fast pace. And you know which industries we actually saw the quickest rebound.
Ian Pollick: Economists?
Royce Mendes: Not economists, actually, is the ones that were hardest hit. So restaurants, bars, things like that. You could see businesses actually reopen at a very fast pace. And I want to make this distinction between this recession, which I think is different for a number of reasons, and the 2008-2009 recession this time. Why is capacity coming back so quickly? Why where jobs rebounding so quickly? Well, in this case, we can't outsource things like dining out, going to a bar, going to your local dentist or going to get a massage. Things like that cannot be outsourced. In contrast, however, you can have an outsourcing of big manufacturing. And that's exactly what happened when the lights were shut off in factories after 2008-2009. And that's why I think this time is different. As soon as the demand starts to come back, we'll start to see supply come back online. Entrepreneurs will be enticed back into the market. This is not discounting the pain of entrepreneurs and people who work at those companies during these waves of covid. It's saying that I think the resiliency of the overall economy is more this time around and the ability to bounce back is stronger this time around than it was in 2008-2009.
Ian Pollick: Is that just a long winded way of saying that you think there's a scarring after this recession than we saw in the financial crisis?
Royce Mendes: Yeah, that's right. There will likely be less scarring this time around. In addition to the points I made, you will also see businesses come back. It means that similar jobs come back so people don't have to go through big retraining programmes or anything like that to get their next job. They will probably be able to find it in a similar industry as they were working in before.
Ian Pollick: So I want to try and get back to the thing I tried to get back to before I tried to get back to it, that you sucked me away from it three times now and. What I wanted to ask you was you made the point very early on in the podcast that you're entering a very tough time right now where you have new lockdown's you likely have contraction and growth in December and January. But arguably, given the data that we've seen, the high frequency data is putting us in a bit stronger of a starting level, i.e. Q4 is not that one percent that the bank had forecasted. We are, what, closer to four percent? Five percent?
Royce Mendes: Yeah, that's right.
Ian Pollick: So even with these fresh rounds of lockdown and kind of economic challenges, does that change your opinion of one to A) we kind of reach that pre pandemic level in GDP again? And does it do anything for your output gap forecast?
Royce Mendes: A little bit on the plus side, a little bit on the negative side. You have a better Q force. You're heading into this slowdown in better shape. But I think the contraction in the first quarter of this year will be more severe than we had previously expected. So I'm not expecting anything very different than our last set of forecasts where you sort of reach the pre pandemic level of GDP around the end of this year and you get close to closing the output gap around the turn of 2022, maybe early, 2023. And that gets inflation close or actually to the two percent target and the bank sees it as sustainably and maybe we can lift off in 2023. I don't think any of the recent data really change that narrative.
Ian Pollick: Ok, so listen, we're about twenty five minutes into the podcast and I want to wrap it up a little bit and I think we would be doing a disservice to our listeners if we didn't talk about the Bank of Canada next week very quickly. And I think it seems like our base case right now is that we're going to go with the party line here at CNBC that we're not expecting a micro cut from the bank next week can never say never, but unlikely to happen. We could hear some language around the effective lower bounds narrowing in the press conference. I would think that in general terms, given the way the market has been selling off, which has been led by real yields, to me, there's a growth element there that makes me like the market. We generally like being in flatterers right now. I think the steepening can start to dissipate a little bit in the very near term. But talk to me very quickly about the forecasts. What can we expect from the bank next week.
Royce Mendes: So they might upgrade just a tick the twenty twenty estimate of GDP? And, you know, I would argue that 2021, they're in the right ballpark, about four percent growth or maybe a little bit more than that. But where I think that they're going to maybe have to reassess their expectations is for 2021 because they have a very modest growth rate. I would argue that, as I said, I think the capacity can be rebuilt a bit faster so we can actually have growth a little bit faster in 2022. That doesn't mean that you close the output gap any faster because remember, growth, actual growth and potential growth maybe are rising at the same rate, but it's a change in the level of GDP at the end of that period. I think that with regards to the micro cut debate, I'd agree with you. I don't think that would be our base case expectation at this point. I know things are bad, but the central bank can't fix these problems that we're facing at the moment. However, I will say you said maybe they had mentioned something about the ELB in the press conference. I would say that if they are lowering the ELB, it could actually show up in the statement itself. I'm not sure a lot of things are up in the air because we really have no idea if the research is going to find that it's even feasible to lower the effective lower bound. So I would say a lot of uncertainty going into this January meeting are great.
Ian Pollick: Alright Great. Thank you, as always.
Royce Mendes: Thank you.
Ian Pollick: Listen, it's good that we are starting up this podcast again in 2021. Man, I really look forward to the day we're both in the studio together, but I don't know when that's going to be. So until then, I hope you and your roommate have a wonderful week ahead. And to our listeners, we hope you have a wonderful week ahead. And we'll see you next week for post-mortem after the Bank Canada. And remember, as always, there are no bonds harmed in the making of this podcast.
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