Ian & Royce are back in the studio this week, discussing their interpretation of the Throne Speech and what it means for macro and rates. Royce talks about the sustainability of fiscal support, while Ian ruminates on what needs to happen for issuance risks to increase going forward.
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Royce Mendes: Happy Friday, everyone, and welcome to another episode of Curb Your Enthusiasm. I'm your host, Royce Méndez, executive director and senior economist here at CIBC Capital Markets. I'm joined, as always by my co-host, Ian Pollack, head of Global Fixed Strategy. Ian, I need to congratulate you on being ranked number one strategist in Canada for the third consecutive year. Now, correct me if I'm wrong, you've only been doing this at CIBC for three years.
Ian Pollick: Yes, that's correct. And I would just like to thank everyone who voted for me. I'm very humbled by it. And more importantly, I'm just happy that all the research that we're providing you, whether it's from my group, whether it's from CIBC economics, whether it's from your distribution point of contact, that we're giving you what you need. It is very important to us. And again, I am humbled and I thank everyone. Royce, happy Friday.
Royce Mendes: Happy Friday, my friend.
Ian Pollick: It's been a relatively quiet week. And I think there's really only one thing that we need to talk about in terms of some of the developments that matter for the economy and for the Canadian fixed income market. And that's obviously the throne speech from yesterday. Going into the speech, there was a lot of hypersensitivity from the bond market. There had been some whispers that any new spending announcements could result in additional issuance, that obviously mattered for the shape of the yield curve, particularly when we overlay that onto the calibration discussion that came out of the Bank of Canada a couple of weeks ago. But it's not clear to me that we actually got all that much new information to sink their teeth into. So why don't we take a few minutes on the episode today and just talk about from your lens and from your perspective, did we hear anything meaningful? And maybe just give us a quick summary of what they did say?
Royce Mendes: Right. Let's start with reviewing what they did say. And it was that they will do whatever it takes to fight the virus. Of course we know. And which was recognized in the throne speech yesterday is that the path of the economy depends almost entirely on the path of the virus. So number one: keeping it contained. There is going to be more money spent on testing and health initiatives. Number two: containing the economic fallout from covid-19 and the associated public health restrictions. We're going to see as much spending as is needed to keep the economy as intact as possible, which will set up the economy for its best chance at regaining all of the ground we've lost and then eventually accelerating into growth. That being said, it is sort of ambiguous as to what the exact numbers are on some of these commitments. Of course, they will change and could change depending on the path the virus takes through the economy. If we see a very large second wave, you can expect a lot more spending. If we are able to contain the second wave relatively early. And Klank, the curve, then you can see spending sort of come in below some of the larger forecasts that we've seen released now at the time of the last fiscal snapshot, the infamous three hundred and forty three billion dollar projected deficit of this year. We need to take into account a few things. First of all, the growth projections in that document were actually worse than what the growth projections are now at the moment. So there should be an upgrade to the revenue side in terms of tax collection. In addition to that, there was a significant amount of money. Seventy two billion dollars allotted to the Canadian emergency wage subsidy that has not been spent in the fashion that the government had expected it to be. So that's going to shave off a lot from that deficit. Now, the Serb payments are running ahead of what the forecast was. There have been additional initiatives to expand EI and transition everyone to EI, which are going to cost more money. But again, it is ambiguous as to exactly what the deficit is going to be for the coming year, let alone future years. You know, there was commitments in there made to initiatives that are longer term in nature, non covid relief in nature. But there was also a commitment to fiscal prudence and sustainability. So there needs to be tradeoffs likely made and decisions made regarding spending initiatives and what maybe needs to be cut back. These are all things that will be left for a more comprehensive document, a budget update, which will come out later this fall and hopefully include enough years where we can get a sense of what that spending expected to look like. Now, I did notice, though, even with the government, I would say, over delivering on the spending, from what early indications were in the media, you didn't see a lot of market reaction yesterday. So I'll kick it back to you and you can talk a little bit about what the implications are for markets from the speech from the throne.
Ian Pollick: Well, it's a good question. And as I was saying earlier, heading into the actual speech itself, there was a lot of anticipation that all we needed to hear was the word spending, and that would create some weakness in the parts of the yield curve where the government has said they are extending the duration of their issuance into i.e. the 10 year plus sectors. The problem is, as you rightly say, Royce, it was sufficiently vague that we really didn't get a clear understanding because what the bond market wanted to hear was the pie that you have allocated to the Serb, the emergency wage benefit, the small business loan relief. Is that bucket now full or are you going to not even reach it? And it sounds from what you said earlier that we still don't really know. There may be some overspending from the Serb, there may be some underspending from the wage or the rent subsidy in particular. So we need to get a more thorough fiscal snapshot, which really doesn't come until November. And that really meant that the only asset that moved yesterday was the Canadian dollar. And it's not coincidental that on the day where the dollar was generally somewhat stronger than expected, just given you're going through a mini period of declining risk appetite, gold prices are selling off. If you actually look at the tic data. And from the start of the speech, which was around two forty five in the afternoon, the Canadian dollar did cheapen about almost a half a full big figure. So it leaves me a little bit curious why would the Canadian dollar care about the throne speech when their bond market didn't? I think it's one of those situations where the CAD is now starting to pay more attention to domestic factors. Our colleagues in FX strategy in particular, Bipan Rai and Sarah Ying, what they've been noticing recently is that the Canadian dollar has not been paying attention to domestic developments. That makes sense because we're seeing the same thing in New Zealand, the same things in Australia, where despite quantitative easing programs that are quite large and the balance sheet is growing, you're actually seeing very strong outperformance of those currencies versus a basket of other G10 crosses. And I think now we're starting to get a redirection away to this idea that perhaps you get more spending. Maybe that means that the spending is being redirected in parts of the economy that don't necessarily increase the likelihood of a faster macro revival. Because the interesting thing here is that if you listen to the speech and you believe what you just had Royce, that they are going to course correct during this recuperation phase, that is a clearly bond bear signal. It is a stronger Canadian dollar signal. So it's a bit of a misnomer because what it tells me is that cost assets are not speaking to one another right now. And I think you need to get, as you said earlier, more fulsome details coming from the fall Economic and fiscal update for you to see the response that the bond market in particular had expected. And I think we need to overlay this with the fact that the Canadian profile for liftoff is almost a full year ahead other central banks, remember, the Bank of Canada has the first rate hike priced in 2023. If you look at other parts of the world, the UK is in 2025. Europe there's no real telltale signs of a move back into positive territory while our neighbor to the south has interest rates priced to begin normalizing in twenty twenty four. So I ultimately think you need a bit more of details again to force a shake out of market pricing. But a question I have for you, Royce, is this one of the things that triggered something in my mind, as you said, they're going to do whatever it takes. It's the right thing to do. But if we're not talking about austerity, we're not talking about raising interest rates. But how much are we borrowing from future growth, future demand, given that we have such a high debt profile that's going to start sinking in in future years? Is this the right policy?
Royce Mendes: So the way to explain it is at the moment the private sector has pulled back, or in this case, the parts of the private sector have been pushed back as a result of restrictions to fill that gap in in household incomes and business incomes. In some cases, the government has had to step in. If the government had not stepped in or stepped in, maybe to a lesser degree. The worry is, is that the economy would come out of the pandemic less intact than it is. One of the reasons that after any recession, you see the unemployment rate spike, but it takes a very long time to come down. Why is that? Well, it's because a recession causes businesses to shut their doors and it takes a very long time for new businesses to pop up and fill their places. In this case, the longer this shutdown goes on or parts of the economy are shutdown, the longer the virus is with us, the more businesses that won't be able to survive. And this moves away from simply flicking a switch off and flicking it back on, as we saw in the early part of the recovery. And it becomes more like. A typical recession, and that means that businesses, even after the virus is no longer with us businesses will have failed if there was not support either through household supports or stimulus or business support or stimulus, more of those businesses will have gone under. And as a result, it would take us even longer to get back to full employment and longer that, you know, people would be on unemployment, people would not be at work, people would be losing skills. The other point to make about, of course, this sort of worry about intergenerational transfers, I hear that a lot is that we're borrowing now today to support the economy, but we're leaving the debt load for our kids. The one thing that I would point out, aside from the fact that this is a very different environment that we're living in today because interest rates are very low at the moment and expect it to be very low for quite some time, is that a long period of unemployment for a child's parents is potentially a worse outcome than a debt load, which will have been a one time level shift increase in the debt load, not some sort of structural deficit which can be worked down by increasing GDP. You know, it's often times like if you take a look at a country like the US, people worry about increasing the debt to pay for infrastructure, but infrastructure tends to compound at a much faster rate than financial debt. The 10 year government bond yield in the U.S. is compounding at, well, less than one percent at the moment per year. Infrastructure debt in terms of if you don't fix a road or a bridge in the first year compound much, much faster than that. And also as the side benefit of Americans not having to drive over an unsafe road or bridge. So, again, we need to think of these things in terms of different types of debt that we leave to future generations, whether it be an infrastructure debt, whether it be a debt in terms of long periods of unemployment for parents of children, which makes, of course, the children's lives more difficult. These are all the things that we need to take into account when we talk about this increase in the debt. And as I said, most importantly, interest rates are very low, expected to be very low for a long time. And secondly, these are pandemic related expenses at the moment. So, you know, after we exit the pandemic, we would hope that this doesn't turn into structural spending. That is the key thing I'm watching on, not what is spent directly to combat the economic effects of the virus.
Ian Pollick: I'm going to stop you there. And I think that, you know, on the one hand, it's a bit ivory tower. I think that we can't ignore the fact that you have politics that have to come into the mix here. And at some point, unfortunately, we're going to get some austerity forced down the pipeline. And I can't help but think that perhaps a situation where we are borrowing demand or we are borrowing potential spending for future generations doing it today. And I think it's absolutely the right thing to do. I just get concerned about on a go forward basis, how do we prevent this type or this level of fiscal stimulus being a permanent fixture of the response, because what ultimately could lead to is debt deflation over time if that debt falls under its own weight. I think it's a really important thing to think about and we're not going to solve it on this call.
Royce Mendes: Let me make just a few more points here. One is that you're absolutely right. We don't want to see this turn into structural deficits. We want these to be stabilizers for the economy. And once the economy is back healthy, these increased level of shortfalls shouldn't be seen. Secondly, however, if we embark on tightening too early, I think we encounter risks on both sides of this. So one is the risk, of course, that we are increasing debt. We have to pay more for our debt. There is the so-called wrath of markets or the bond vigilantes coming to teach the borrowers, the federal government borrowers in Canada a lesson. The other risk is, though, we don't spend enough something that we saw in some countries after the financial crisis and it's left more to monetary policy to do the heavy lifting. That would mean a longer period of low rates to get the economy back to a point where we are seeing sustainable two percent inflation, which the Bank of Canada has committed to seeing before raising interest rates. That long period of low interest rates has inherent risks. Of course, it means that the private sector will probably be more likely to borrow. It means that provinces could also build up more debt loads. It means that we could see asset price bubbles. Of course, anyone living in Toronto and/or Vancouver knows all about that in the real estate market. These are things that we need to take into account. There are risks. On both side and I want it presented as a more balanced view than I think we've been discussing lately.
Ian Pollick: Ok, that's a fair point. And again, for the sake of time, I want to move a bit forward here. We have had very little data this week. There's really not been much to chew on. We did get our flash estimate for factory orders today for the month of August. It didn't look particularly good. So as we head into GDP next week, the industry level GDP report on the 30th. So that's next Wednesday. We are going to get a flat estimate again for August can you just remind everyone on the phone a couple of things. Number one is, what are we currently tracking for Q3 growth? Did you happen to look at those factory orders, numbers that were released? And do you think that we're at risk at all from having to lower our current tracking?
Royce Mendes: So in terms of what we're looking for, for July, we're looking at something very consistent with what the original GDP industry flash estimate was from Statistics Canada, which was roughly a three percent increase. And this comes on the back, of course, a healthy six and a half percent increase in June. There are parts of the economy that continue to move ahead in July. But one interesting point I want to make is keep an eye on the education component of GDP, which we saw yesterday in the SEF Data seasonally adjusted. It'll show a big increase in July, but that's only because the shortfall in July on a not seasonally adjusted basis from what it usually is, isn't that far. It's kind of eating away at some of the increase we might see in future periods in terms of what we're tracking for the next few months for GDP. I would say for August you could pencil in roughly one percent increase, and I think we're still very comfortable with that and then see something even less than that in September that still gets you to a very, very strong Q3, seasonally adjusted annual rate growth forecast of more than 45 percent. But keep in mind that that is largely because of the strong handoff from Q2. I think what we're clearly seeing and what we've been telling clients and what we've been talking about on this podcast is that we have exited that initial sharp rebound phase of the recovery. And we are in this more prolonged recuperation phase, which may be winding. We're starting to see evidence that we are indeed in the midst of a second wave of the virus. And the risk is certainly that more of the economy needs to be shut down relative to what could be reopened in the months ahead. And I think, again, that puts some downside risk on our forecast. At the moment, we don't have any outright backsliding in our forecast. So no negative GDP prints, no negative employment prints. But from where I sit today, that is far from a certainty.
Ian Pollick: I'm hearing you correctly. Our current quarterly tracking is roughly consistent with where it was prior to some of these flash estimates. And just I think we're entering this new situation where markets have to start to understand this is that when you first went through the crisis, we knew that the data that was coming towards us was not going to be very good and we start to receive it. And then we went through that period that provided us a baseline to measure future activity indicators from now. The problem is that because we are firmly in a second wave, at least in Canada, potentially, that we could be moving back into that situation where we know the forward looking data may not be very good. So the usefulness of the macro data broadly to the market may be quite limited, and that opens up some more transitory risks like the election, like some month end or quarter end allocation trades. Would you broadly agree with that, that the quality of the information we are going to get from the incoming macro data over the next three to six months may not be that high.
Royce Mendes: Can you reiterate what you mean by quality of the data?
Ian Pollick: So think about it like this. In March, we knew that the data we were going to get in April or May because of the backward looking nature and the time lag of the data, we knew that it wasn't going to be very good. But we also knew that once we got that April/May period, that the data we were going to get in August and September was going to be quite strong. If we believe right now that we're going back into potentially a contractionary environment, then are we learning all that much from the trajectory of the data in terms of what it means for the future output gap, or are we going back into that cycle where it's going to get bad, than it's going to get good again? And then we really haven't seen an organic enough of a runway to tell us how the economy is really doing?
Royce Mendes: Right. So the official data. I agree with you. I think we'll need to revert back and use the playbook that we used a little bit from March, April, May, June. Is some of this more high frequency unconventional data to track the economy and the trajectory of the economy simply because, as you say, the August data might not be telling us that much about what's going to happen on October, because really what is happening in October is dictated by whether or not. We are in some sort of a shutdown, again, related to the virus. This is going to be a period where we have to be aware of a whole host of information, not just what Statistics Canada is producing.
Ian Pollick: All right, listen, I think this was this is a great discussion, as always, is how is the new house, by the way?
Royce Mendes: It's a wonderful you have to come over and sit social distance in the backyard soon before it gets too cold.
Ian Pollick: I would very much like to do that and I'd very much like to see your roommate. On another note, I just want to wish everyone a very good weekend ahead. I hope everyone stays safe and healthy. I remember there were no bonds harmed in the making of this podcast.
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