Royce and Ian are back together after a few weeks off to dissect all of the conflicting economic data releases in the US. Royce talks about how some of the growing pains south of the border might be a precursor to future developments in Canada. Ian gives a rundown of how investors are digesting all of this new information, and flags some potential catalysts for market volatility in the coming months. The episode closes with Royce discussing new research on the neutral rate in Canada, which suggests that the economy might need rates to eventually rise higher than the Bank of Canada thinks and at a faster pace than the market is now pricing in.
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Royce Mendes: We have this persistent tailwind from this stock of household savings, so the Bank of Canada is sort of assuming that it just stays in savings, which it could. But in and of itself, it would also then start to flow into assets like stocks and housing and may have some destabilising elements.
Ian Pollick: Well, it's a beautiful day outside in downtown Toronto, it's pretty sunny here, Royce. I've missed you, man. How you been?
Royce Mendes: Where have you been? People are asking about this podcast man.
Ian Pollick: I took a staycation buddy, I need some time to be home with the kids. And it was a good time.
Royce Mendes: One day I'm talking to you on Bloomburg. The next day you're just red dot. Red dot for a week. You got to tell me I was worried about you.
Ian Pollick: Next time I'll let you know where I go. Well, you should be because you know why? You know, staycation aren't exactly as adventurous as they could be relative to other things we could do. Pre pandemic. So you know what I did, I was a little nostalgic and I actually bought myself and my kids a Crocodile Mile. You remember those things? Like the slip and slide?
Royce Mendes: Oh, yeah, yeah, yeah.
Ian Pollick: Let me just say this over the age of thirty five when run and throw your body at the ground and slide down something, it really hurts. So I don't recommend it for everyone. But listen, it looks like I missed a lot when I was out. And I want to circle back with a few things. I want to start talking about the employment and the inflation data in the US. In particular, I want to pick your brain. Is this a precursor to what we can see in Canada? Because what we saw is a deceleration in the amount of jobs being produced in the US. Maybe that was a head fake. You know, we have seen job listings almost exactly matched the amount of jobs lost relative to pre pandemic. But then we looked at CPI, which is very strong. So for me, sitting on my Crocodile Mile when I was looking at the data, the things that stood out to me were you had a CPI report that more or less mirrored the hours worked and the wages in the employment report, everything looked extremely strong. The question is transitory, not transitory. So bring me back to what you think this means for Canada.
Royce Mendes: Well, I think it's a precursor, as you mentioned. So these are what I'd call growing pains from reopening an economy that was shut down due to a pandemic. The good news is from the Labour report in the US is that it didn't seem like job growth was slowing as a result of labour demand. Businesses still seem to want to hire. It was labour supply that was the issue. And we can point to all the reasons that labour supply is restrained. Number One, there are still covid cases in the US, so some people might be afraid to go out. Number two, there are child care duties. A lot of schools and daycares across the country remain closed. So people cannot just get up and take the first job that is offered to them. And number three, and this is important for Canada as well, the federal government is still providing some pretty generous fiscal support, and that may be disincentivising some people from taking jobs. But all three of those things are going to fade as we move towards the fall. And it'll be the same in Canada. It's just going to be a delayed start. We're stuck in the middle of a third wave here, but I think we'll see similar growing pains. The important thing is let's not get too worked up about the inflation numbers or the wage numbers. I think a lot of that could be transitory.
Ian Pollick: So let me ask you this on the transitory side, because one of the things that I was looking at in the US jobs report was there seemed to be a disproportionate amount of very high level job losses in certain sectors that I think could best be described as pro pandemic, i.e., couriers, messengers, alternative delivery. Are we going to go through a period where some of the labour market data, which by definition is a bit lagged, is just going to show the transformation away from containment, not containment? So we should get a little bit used to some of this noise.
Royce Mendes: Right. So your point is that it may not be a net increase every month because there are some jobs being shed as we rotate the economy back towards what it looked like, pre pandemic. I think that's fair to say. But again, you know, one report doesn't make a trend. So we want to see more data on all of these fronts. But I think some of these things, some of these quirks in the data, we're going to have to just look through and try to find what the underlying message is. And I think the underlying message is we can look past most of it, but there are more price pressures than we expected two weeks ago, maybe when you and I were last chatting. And we have to take that into account, right? Because inflation begets inflation. So a little bit more inflation this month, a little bit more maybe next month as well. Eventually it starts to creep into inflation expectations. And if you looked at the survey from the University of Michigan that's showing consumer inflation expectations at their highest since 2011. So,
Ian Pollick: Yep.
Royce Mendes: You know, again, I think the Fed has got their collective heads in the sand right now by sticking to their view that they're not going to hike rates until twenty twenty for the Bank of Canada's much closer to what I think will turn out to be reality and projecting that they're going to be on hold until at least twenty, twenty two.
Ian Pollick: Yeah, I agree. And you know, one of the things that Governor Macklem said last week was a little bit in line with that. He did say that he is questioning the efficacy of QE just given the inequality in the economy. But he also talked about allowing the economy to unfold in a very. Away, which almost by definition means more pressure being baked into the cake, even if they do start raising rates. It just means that at whatever level they ultimately end up, it's going to be a bit lower, at least at the start, than where they would want to be. And I think that's reflected in the CPI path and the Monetary Policy Report.
Royce Mendes: Right. So what they'll do is they'll wait a little bit longer before hiking rates. If you think of a typical hiking cycle or recovery from a recession, the Bank of Canada or the Fed will start hiking rates before the economy has reached full employment. But this time they want to wait till the economy is fully healed and they're seeing the whites of inflation's eyes. So by definition, they're putting themselves behind the curve a little bit, but they're not too worried about that. But, you know, this is in line with our overall thesis that the neutral rate might be a little bit higher than what the Bank of Canada's median estimate is. And eventually, actually, once they start hiking and they see that the economy is still performing well, and there is this tailwind from this stock of household savings being at least used a little bit for spending, that there's a little bit of a tailwind that allows them to hike rates faster than the market is now pricing in. The market, at least for Canada, isn't showing the policy rate reaching two percent till twenty twenty six. I think barring any unforeseen downside shocks, I think we'll be at two percent well ahead of that time. But with all of this data coming out, it's not exactly clean reading. It's difficult to dissect. There's still debates going on about what was happening in that non-farm payrolls report. Retail sales was weak. There was a revision to the prior month, but there wasn't a lot of momentum in April in the US. What are markets making of this data that is pretty messy on the surface?
Ian Pollick: Well, I think you hit the nail on the head there, buddy, because this is a highly contradictory data profile. Some weak, some not weak, some lags, some not lags. And I think for the most part, I think the best word to describe it is purgatory. You you look at the shape of the yield curve, whether we're talking five thirties, 10s thirties, fives- tens, and whether we're talking about Canada the US, really on a constant maturity basis, these curves aren't very much different than when they were in March. And the story that we've been talking about for a long time is that the bond market has gone through three distinct phases over the past year and a half. And the first phase was last year, where we just reprice inflation expectations. The second phase was real yields started to lead the sell off and that increased the relationship between moves in the back into the curve and market pricing for lift off and then in the March Fed meeting where they kind of pushed everything off and said, actually you know what, don't worry, we're still a bit dovish here. It kind of put the market back into the reflationary camp and break even for the most part, been leading the way here. But, you know, you go back to the CPI report last week and US break evens are lower relative to the Wednesday high. Same thing in Canada to a certain degree, although we trade at a pretty big discount and the curves are flatter in the US relative to Canada. So to me, I think the market's happy with its assessment of where inflation is going to come from. But where it's getting a bit concerned is on the timing of Lift-Off. You know, you still have a profile, as you rightly said, that has the bank going in September '22 has the Fed in December Twenty twenty two, not much has changed from terminal pricing, which I use five or five year OAS in Canada. You're almost unchanged. In the US you're a bit lower. So I think markets are a bit waiting for a catalyst until we get a clean break in either direction.
Royce Mendes: So the million dollar question is, what is that catalyst? When are we going to see the Fed mark to market their expectations or when are we going to see the market just move without the Fed changing their tone but pull forward expectations?
Ian Pollick: To me, I think it's going to be a function of the inflation data. I think that the job stat is nice to have. And I think if you see that inflation is not transitory, that's one scenario that I think leads to a very large selloff in the steeper curve. The other scenario is one where we do get some confirmation that the employment report last month, particularly in the US, was an aberration, that labour demand remains strong and really supply is the issue, then that's a situation I think, that can re-tether long rates and short rates. And I think that's a situation where you start to get a flatter curve and that's a situation we start to pull the timing of the Fed forward a little bit.
Royce Mendes: Yeah, I sort of buy that. But I guess from my perspective, I think we can still see the economic stars lining up that the US economy is ready for rate hikes and the Canadian economy is ready for rate hikes in the second half of next year. But, you know, how disruptive is it going to be for the Fed to have to do a 180 and now tell the market that it's twenty twenty two instead of twenty twenty four? Is that going to cause a lot of volatility?
Ian Pollick: I think it will. And I think it's across the entire investable universe. Right. Because if you take that scenario to its logical conclusion. If the Fed has to do a very fast 180. Well you're going to get a repricing in rates, okay, and that repricing is going to come through higher real interest rates, the higher real interest rates does two things. Number one is, is it strengthens the dollar. The second thing it does is it hurt commodity prices. So you almost have this the market that will trade almost a disinflationary impulse because you have a stronger dollar, potentially weaker commodity prices at the same time that the yield curve is flattening. So I think that the cross S perspective is that it could potentially lead to a bit of a risk off. And I think the bigger adjustment for rates investors is the shape of the curve will almost fully move into a flattening mode. You know, the question is, how much further do you have to pull it up? If you're priced for December Twenty twenty two, You know, I don't think that if the market were to price the Fed six months earlier, say in June, that we would necessarily get that scenario in an orderly way. I think you get signs of it. But to be clear, I don't think this is an economic environment that's conducive to pricing the Fed for the first half of twenty twenty two. And I think you would agree with that.
Royce Mendes: No, that's right. But I think when, because it's because of their objectives. Right. We're taking into account that their objectives have changed both north and south of the border. The objective now is to hit full employment. And this full employment that they're trying to hit is a fuller employment than it was before because they wanted to be very inclusive. They're going to pay attention to some of the minority groups, be it racialized Canadians, women, youth. They're going to pay attention to how those recoveries are going. And it probably means that they're going to push the labour market a little bit further than they would have otherwise. And you're right, I don't think that can happen in the first half of twenty twenty two. But by the second half, it could happen. And once they start raising rates and maybe this is where some of the big disruptions happen, is I think that they've got to move faster then, certainly faster than they did in the last cycle, which they were very cautious about pausing and watching how the economy responds.
Ian Pollick: Well, dude they hope once a year Twenty fifteen - twenty sixteen. I would hope that they move a bit faster than that.
Royce Mendes: But that's what the market is sort of telling us right now, is that it's seeing a hiking cycle a lot like the one after the financial crisis. I don't think this is going to be anything like that for a few reasons. One is the economic scarring is not like it was post financial crisis. Number two, we have this persistent tailwind from this stock of household savings. So the Bank of Canada is sort of assuming that it just stays in savings, which it could. But in and of itself, it would also then start to flow into assets like stocks and housing and may have some destabilising elements. But I don't think that's the right path. I think people over time will just spend a little bit more of their income and save a little bit less and work it down that way. But that is a fundamentally different assumption than what goes into the neutral rate assumption that they published. The neutral rate assumption that the Bank of Canada publishes explicitly assumes that all tailwinds and headwinds have faded. But in this case, there is a persistent tailwind. So I think they're going to see that persistent tailwind and have to keep hiking and they're going to be more confident in hiking. And what do you think of that? Is that where more disruption happens or is it you don't seem to think or are not too worried that pulling forward the Fed six months causes a lot of disruption?
Ian Pollick: Well, that's not true. I think that in isolation, if you pull lift off forward, does it really do much? No, but the question you didn't ask is, what if by putting forward we're also repricing the pace or the path that is arguably much more disruptive because in the scenario that you paint, it's one where the economic scarring isn't as deep. Therefore, you can tighten policy a bit faster without it propagating to disruptly the economy, particularly if you have a high level of savings to begin with, which is offsetting the government's deficit. The question, though, is when you look at a market like Canada, you know, Canada has a relatively fast pace, but also a relatively high terminal. And I know that you do look at the whereas one month OS trading in twenty twenty six and yes, you are not above two percent. But when you look at something a bit longer, like five year, five year OAS, you're about 240 and that's kind of approaching the higher end of the banks neutral estimate. I think if you were to have a much faster pace, we're talking three hikes per year, then yeah, I think that's going to play out the scenario that I originally talked about, where there is a cross market hit, there is a gigantic move in the curve. But what I want to talk about is, I get the sense that you want to talk about the neutral rate. I know you just dropped a paper this morning. You know, I've read it. It's excellent. Let's talk a little bit about it, because one of the things that is restricting us from really thinking that the five year point in the Canadian curve is to egregiously mispriced, is this idea that terminal is a beacon. It is where you ultimately end up. But you may never actually get there. If you in an environment where you actually may get there. Or if you could perhaps exceed what the current estimates are, then that's a totally different story for valuation discussion. So the first question I have for, Royce, is why today? Do we have any idea that the terminal rate being discussed is actually inappropriate, i.e. too low?
Royce Mendes: So the bank does great work on the neutral rate, but as I said, it's a long term neutral rate after all, headwinds and tailwinds have faded. It's not a great guide to what's going to happen in the next cycle. Look, in the next cycle, if the Canadian dollar is at par with the US dollar, that means the neutral rate to keep the economy in equilibrium is going to be a lot lower because you're getting a huge drag already from the Canadian dollar. But if you think about this coming cycle, what is the one factor that is going to be overarching and not even just in Canada, in the US, in many developed countries, it's going to be this huge stock of household savings. And whether or not it gets used, I think the most reasonable assumption is that at least a little bit of it gets used over the next decade. And that puts a little bit of a tailwind in. And that means that you can't use the neutral rate estimates from central banks so religiously as point markers of where we're going in the next cycle, you have to be a little bit more dynamic. And and the research we put out today does that. It tries to build up a neutral rate using some of these dynamic factors. And it comes actually to the conclusion that the market is probably right in pricing a terminal rate, as you mentioned, a little bit above the median estimate of the Bank of Canada's long term neutral rate. I think Cain said it best in the long run, we're all dead, like we need to focus on what's going to happen in the upcoming cycle. And that's the way I think we're going to extract the most useful information out of the data. If we see spending, as I mentioned, a little bit more persistent at every level of interest than central bankers are going to know that that neutral rate is higher because of this factor. And one thing I want to clarify, you touched on the effects of government debt. And I know some people have commented that we've seen debt balloon during the pandemic. The important thing is, is this is government debt. On the government side, they've told us that they're not going to run surpluses to pay back that debt. And the neutral rate relies on the flow of savings and spending or investment. So if they're not going to run surpluses, then there has to be something else to offset the extra spending coming from all of that savings. And we think it has to be from monetary policy.
Ian Pollick: Or you just can't really dark. Sunny outside, you know, I think you open up your blinds a bit. I want to finish the episode with talking about one really important thing, the clear elephant in the room, which is the strength of the Canadian dollar. I put it a piece, right before I went on vacation, with Sarah talking about some of the non macro drivers of the Canadian dollar. And a lot of it has to do with the fact that we're seeing a very big transformational change in supply in Canada, as well as the fact that with all this excess savings, just the flow of cash moving through the basis market isn't as strong as it used to be. So, you know, there's more offshore issuance, for example, which means that you have more demand for Canadian dollars. There is less demand for foreign equities. We saw that recently, the international securities transactions data. How much does the Bank of Canada recognise that, Commodity prices aside, if you have some structural change in the way that the synthetic affects markets trade, which to a degree has an impact on the spot valuation, are they cognisant of that? Do they care that this is a type one versus type two type of move?
Royce Mendes: I think we got the answer last week in Governor Macklem's press conference. He said that you can't separate the two. He's saying that this is driven by commodity prices and for now he's OK with it because it's pushing up incomes in this country. Right.
Ian Pollick: So it's a positive terms of trading.
Royce Mendes: Exactly. So you can't separate and say commodity strength aside. I mean, look, I don't think it's all commodity strength. I think he's over attributing the strength.
Ian Pollick: He's oversimplifying.
Royce Mendes: He's oversimplifying the question because there's a lot of other things going on. Canadians are stuck within the borders of Canada. They're not travelling abroad. Usually we run a big travel services deficit. That means Canadian dollars are being sent out of the country. And that's putting pressure on the Canadian dollar. There's just a bunch of things going on. Some of the factors you mentioned that are not tied to commodity prices. But if that's the Bank of Canada's view and that's the one that they're going to stick with, then I think we could be here with this stronger dollar for a little while longer. But some of the fundamental factors are going to fade. Eventually, we're going to be allowed to travel. Borders are going to reopen commodity prices as supply comes back online, Globally, some of these commodity prices might come down and...
Ian Pollick: And in relative pricing for the bank and the Fed at some point normalises too.
Royce Mendes: Well, there you go. Exactly. Yeah, that's that's the big one. Right. Eventually, we expect that the market pricing for the Fed is going to be pulled forward. So for all those reasons, we don't think this is a permanent structural change in the level of the currency because we still believe that the currency has to be about 10 cents weaker than it is today to keep non commodity exports and associated business investment competitive in this country, in a globalised world.
Ian Pollick: okay so right before we break, I just want to ask you a quick question. We have CPI, obviously, a very important data point this week just given everything we were talking about off the top of your head, what are we calling for at CIBC?
Royce Mendes: All right. Always dangerous to forecast something the day before the data come out, especially when there was a huge surprise in the US. But here goes. Zero point two percent month over month, not seasonally adjusted for the headline CPI index, that takes the year over year level above the Bank of Canada's one to three percent target range. Takes it up to about three point one percent. And we actually expect that the core common component indicator rises to about one point seven percent.
Ian Pollick: Ok, so I'm going to take that over on the monthly. And here's the deal. If I'm right, you come to my house, you put on a waterproof mask, we'll go on a Crocodile Mile, right? Agreed.
Royce Mendes: When it is within the rules, then that's the deal. But.
Ian Pollick: Well you tell me!
Royce Mendes: What if I win?
Ian Pollick: I'll come and sit on one of your Moscow Chairs. How about that?
Royce Mendes: I don't think that's a fair trade. But you know what? Sure, I'll do it.
Ian Pollick: Ok, good. Listen, we want to wish everyone a great day ahead. We hope you and your families are well. And remember, there are no bonds harmed in the making of this podcast.
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