Ian & Royce begin the episode this week discussing the most recent Labour Force Survey. They conclude that while the economy has reached a milestone in recovering all of the jobs lost during the pandemic, that’s not a sign of “mission accomplished”. Ian then takes a deep breath and speaks about the recent move in Canadian short rates, and why the profile for the Bank of Canada has been so aggressively repriced in the past week. Royce agrees, and walks us through his view on the upcoming Bank of Canada announcement, while Ian throws in a surprise by noting that he doesn’t believe the Bank will enter the reinvestment phase this month. The duo finish off the episode by touching on inflation and what the positive terms-of-trade shock does and doesn’t mean for Canada.
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Ian Pollick: So I think that you're right, to a certain degree, the bank can has left itself somewhat victim to an interpretation of tapering means tightening. Okay, Royce, let's talk about the big news in the room, and that's obviously the fact that Canada has reached a milestone. We have recouped all the jobs lost during the pandemic. But I want to get a sense of whether or not you think this is mission accomplished. Just keeping in mind that the Bank of Canada had released that employment paper a couple of days before the employment report, really saying that, you know, you can't just look at the headline number, you have to look beneath the hood. So what are your thoughts?
Royce Mendes: You obviously read my research because you're quoting directly from me. I do recognise this as a notable milestone, but it is not mission accomplished. The level of jobs is still below the trend of where it would have been and during the pandemic. We need to recognise that the population has grown. Even if COVID 19 has restrained immigration, it didn't completely shut it down and we need to get more people back to work before we can say that the economy is completely fully healed. Now you know this that the Bank of Canada published a research paper not long before the employment report, suggesting that we shouldn't even be looking at just the headline number. We need to look beneath the hood at some of the broader measures of labour market underutilisation and things like long term unemployment in Canada are still a problem. And so while reaching the pre-pandemic level of employment is important, it's just one marker along the way to a more full recovery.
Ian Pollick: So let's go a little bit deeper about it because obviously there is some evidence that the election played a bit of a part in the numbers. It wasn't a huge number. It was about, you know, twenty thirty thousand. Whatever it is, we expected to see those numbers that automatically come off public employment in the next employment report.
Royce Mendes: So there's actually a few temporary factors that we need to take into account. When looking at this employment report, you identified one, which is the effect of the election. And yes, by the time of the October survey period, those jobs would have vanished. But we also need to recognise that the effect of fewer seasonal workers being hired earlier in the summer caused fewer seasonal workers to be let go or to leave their employment at the end of summer in September, which meant that the seasonal adjustment process actually was doing work that was not necessary in pushing up employment. So those are two factors that will largely reverse themselves in October. And so, you know, we could be looking at an October that is weak after a very strong September, obviously.
Ian Pollick: The other thing, too, that I noticed was that when I looked at the hours work number, hours worked were not terribly good. We're still, you know, a percentage point and a half below our pre-pandemic trend. Talk me through how the Bank of Canada needs to think about that.
Royce Mendes: Well, that's really important because it's not necessarily the number of jobs in the economy that drives things like production. It's the number of hours worked. Everyone could have a job, but if we're all only working one hour of a week, that's not really a lot of production. So with hours worked still, you know, materially below the pre-pandemic level, that's probably an even more important indicator of Slack and and one of the things that they need to take into account. So when we look at this holistically again, it's very nice to see that the that jobs have retained their pre-pandemic level, but there are still broader challenges for the labour market to overcome before we can say that the Bank of Canada is ready to really tighten policy, for sure.
Ian Pollick: And the last observation I would make two is one of the more obscure components of the labour market report that I've been following really for the past year was just the those people unemployed who characterise themselves as temporarily laid off. And we saw that skyrocket up to about 700000 at the peak of the pandemic. As of this last employment report, you are now below pre-pandemic levels. And you know, I wonder if some of the low hanging fruit from this cohort is now gone and incrementally, it just makes it harder to achieve the same momentum that we've seen in the labour market reports.
Royce Mendes: That's a really good point, but I have a question for you. This labour market report, as we pointed out, is is good, but it's it's not good enough to be the sole driver of what's going on in markets and the pricing for the Bank of Canada. Why don't you talk about what's happening and what you think is pushing so much hawkishness by investors?
Ian Pollick: Absolutely. And I would say just for context. What we've seen really over the past five days has been just a tremendous amount of pressure going on in our money market futures complex. Our backs contracts have been under severe pressure almost every single day. And right now, for example, the time that we're doing our podcast taping, you have almost four full hikes price for twenty twenty two. You know, that is a very hawkish profile, particularly when you look at what the consensus forecast is. Which is, you know, I'd be hard pressed to find any bank on the street that's looking for two hikes next year. You know, we have our October twenty two forecast. And listen, I think that's probably correct. I don't think you can dismiss a potentially earlier hike in July, for example. But to say that we're going to begin hiking potentially as early as April and then going sequentially each quarter over the balance of the year is a bit inconsistent with everything that we know today. So the question is, how did we get here? I would say the initial catalyst was probably a whole bunch of relatively good data, but also the Bank of England. Remember that the Bank of England surprised markets by suggesting that they could hike rates as early as this year. The market had previously been shocked by the last Bank of England meeting.
Ian Pollick: February was priced and now we're talking about a potential move in December, and that move is predicated on this one idea that inflation is going to be more persistent than expected, given the similarities in the Bank of England's mandate. The Bank of Canada's mandate, namely that their inflation target was granted. The Bank of England does also have financial stability directly in their mandate. I think there's a lot of people in the global macro community that believe that the bank can turn even more hawkish at the October meeting. We have just released a paper, and what we found in the paper was we looked at the flows coming into the money market over the past month, and the question we asked ourselves was this if it was a lot of old longs exiting the market or was it new risk entering the market? There's a subtle distinction, but it matters for the persistence of the move. If it was old longs leaving the market, then this could go on for quite a long time and it starts to divorce itself from the fundamentals. If it was brand new risk coming into the market, then implicitly there's less permanency, particularly given how much is already priced for the terminal P&L in these potential trades and why I care about this, other than it being super interesting from a technical perspective, is that there is no social contract in Canada between boxes and the bond curve in many other markets.
Ian Pollick: What happens in the short end is policed in the bond curve. In Canada, we know and we've talked about it on this podcast a lot. There's often strange things that happened in our money market curve that, you know, we don't often think too much about, and we just chalk it up to being a small, inefficient market. But now, as you are bringing forward the timing of expected Bank of Canada hikes, the bond curve must react. And we've seen that in a repricing of two year yields, which are up twenty five basis points over the past two weeks. That is a gigantic number because it represents a 50 percent move from the starting point level of yields. So now you're left in a situation where you are almost fully priced to have one hike delivered each quarter in twenty twenty two. And the conclusion of our paper also was that when you look going forward, because we think this is a bit looser type of flows entering the market, that now is a very good time to start thinking about fading recent pricing. Because the next thing I want to talk to you about is the upcoming Bank Canada meeting.
Royce Mendes: Hold on a second. So this is really being a pain trade, right? Expecting that some of this hawkishness would would wear off. I've got two other theories of of why investors might be more likely to want to price in more hikes rather than fewer. Let me know what you think of them. Sure. The first one.
Ian Pollick: Wrong. Im just kidding. Go.
Royce Mendes: Is that the market was let down the last time that there was a conditional commitment in Canada. So following the 2008 2009 financial crisis, the Bank of Canada came out with a novel conditional commitment. And I think it's sort of surprised the market subsequently by saying that the conditions had been met earlier than thought and rates were lifted. The second point is that this time around, tapering was done much earlier than in some other jurisdictions. And oftentimes whether we would agree with this or not, tapering is tied to the timing of rate hikes. So what do you think about both those points, and I'll give you your time to answer.
Ian Pollick: Thank you very much. I would say that what I was going to try and add to your first point, which you're absolutely correct, is that TIFF Macklem was also the senior deputy governor at the time. That conditional commitment was made. So I think there is some impression in the market that there could be an abandonment of the conditionality laid out in the forward guidance today, which I think makes a lot of sense. You know that that is a risk. I think it's been a risk for a while. But remember that the Bank of Canada has been telling the market that it expects the output gap to close in the second half of twenty twenty two. Yet we have been priced for a July hike for a very long time, so I would argue that I agree with you that there is a risk there, but it's already been priced to a certain degree. The fact that we're pulling it so much forward and adding so much speaks to something else. And the tapering earlier than most other central banks globally. That's a really important point. And what surprised me at the time, and you and I talked about this when they tapered in the April meeting, we had been calling for that taper for a very long. Time and that taper, we argued, was based on technical considerations, but the Bank of Canada purposely told us that was not the case, that it was a policy move. So I think that you're right to a certain degree, the Bank Canada has left itself somewhat victim to an interpretation of tapering means tightening.
Royce Mendes: Right? I mean, these are muddled communications. Remember when the asset purchases were first unveiled, they were said that they were being done for
Ian Pollick: Market stability reasons.
Royce Mendes: Yeah. Market stability reasons. And then all of a sudden one day the governor called it QE and it had morphed into quantitative easing.
Ian Pollick: Yeah. When they told us that it wasn't QE before.
Royce Mendes: Even now, when we're talking about winding down asset purchases and we're getting to one billion per week, it's all of a sudden going from quantitative easing to reinvestment. Whereas other central banks would separate those two things. They would taper all the way down to zero and they would have a reinvestment programme in the background.
Ian Pollick: Let's just back up a little bit because this is what I was hoping we would talk about on our podcast today because I truly believe in my heart of hearts that this is the most misunderstood Bank of Canada meeting coming up that we've seen in all of twenty twenty one. And the reason for that is, you know, our official house call is that we do believe the Bank of Canada reduces its GBP purchases to one billion per week. However, unless we hear the words we are now in reinvestment, we do not believe that this meeting will signify the start of reinvestment, and I don't think that's broadly understood by the market.
Royce Mendes: But what's the difference? Can you explain to me the difference?
Ian Pollick: Absolutely. So the main difference is and this is a bit of a muddle communication because, you know, if you read what macklem speech was, it sounded like once they reach a billion dollars and that effectively there will be reinvestment. But if you read it a bit more carefully and you look at some of the underlying data, here's what now I believe when the Bank of Canada goes into reinvestment, they will be purchasing in total a billion to one point two billion per week, so four to five billion per month. That number is almost exactly what keeps the balance sheet stable. If you look at the balance sheet over, let's say, a 18 month, 20 month period of time. However, don't forget, the Bank of Canada doesn't just buy bonds in the secondary market, they take down 13 percent of every auction in the primary market. If I were to add up those two types of purchases, the bank right now is purchasing two point eight billion dollars per week. If the bank were to enter reinvestment in two weeks time, the amount of maturities that we see in the very near term would lead them to actually be buying much more than that one to one point two billion per week. And that is why there is a degree of dovishness that is inherent in this meeting from the pure misunderstanding of what reinvestment actually is.
Royce Mendes: That's interesting.
Ian Pollick: So let me ask you this because I want to talk more about this theme of this being a very important meeting other than the taper being announced and the potential for the market to be let down on reinvestment. Talk to me about what you think about forward guidance, because what we know is that if you look back at prior Bank of Canada communications, they very rarely acutely pin down a quarter to which they think the output gap will close. They tend to give you a range of period of time. Do you think number one, that we'll see a departure and they will say, Hey, guess what? We now see the output gap closing in Q four twenty twenty two. Or do you think we have to impute it from the actual forecast themselves?
Royce Mendes: So the answer to number one is probably not. I don't think that they're going to focus on one specific quarter for the timing of the output gap. The reason is is that focussing on half a year gives them a little bit more flexibility. Look, we know that they have to downgrade their GDP forecasts because of the Q2 miss and the Q3 tracking estimates, which are well below the, I think, seven point something percent forecast that they had in their last MPR. But we've also seen, as we talked about earlier in the podcast, that employment, at least at the headline level, has been stronger, I think, than they would have expected. And inflation itself has been stronger than than they would have expected it in the last MPR. So to balance those two things, look, we think these the inflation pressures are transitory. We think that the that there's still a while to go before we can call the labour market fully healed. But we don't know these things, particularly in the midst of a of a global pandemic. So why not give yourself a little bit more flexibility and still say, the second half of twenty twenty one? But in the forecast themselves, what we might be able to do is pin down which quarter given the GDP profile and the outlook for potential output growth, which quarter that they see the output gap closing. And we still think that that will be the fourth quarter. So there might be a little bit of an Easter egg in there and it'll be a dovish.
Ian Pollick: okay, So I think it's fair to say that when you kind of listen to what I was suggesting about the QE. Dynamics of the meeting, as well as what the forecast would implicitly say, that you think that this is not necessarily the hawkish turn that, you know, if you listen to our front end, what it's telegraphing, would you agree with that?
Royce Mendes: I absolutely agree with that.
Ian Pollick: Ok, so here's another thing I want to talk about, and this is a much more general conversation, Royce. It's this idea of how do central bankers are? How should central bankers react to transitory, non transitory, really supply side shocks that lead to inflation? Why is monetary policy seen today as being the right tool to fix this?
Royce Mendes: Well, it's the wrong tool to fix a supply problem, but it is still not the correct policy to tighten monetary conditions, and you and I were meeting with clients. I guess it was last week and this question came up, and I gave the example of what should the central bank do if there was an earthquake that destroyed most of the power supply in a city or province? What would happen in that scenario is, you know, things like food prices would rise because, you know, freezers weren't working. Gas prices would rise. Other other forms of energy prices would rise. What should the central bank do? Should the central bank immediately tighten policy to contain that inflation because it could very well contain some inflation? But by doing so, how would that work? So they increase interest rates? And what would that do that would cause an economic contraction? People would lose jobs? Is that the right way to deal with catastrophic event? No, it's not. And, you know, in this case, it's very similar. We have supply constraints, whether they are shipping containers or semiconductor chips that are restraining the supply in the economy or whether they are forced shutdowns or capacity limits that are restraining the supply in the economy. Should we push down demand by forcing more people onto unemployment, I would argue that that is not the right policy. The right policy is the one that the Bank of Canada is following, and the Fed is following right now is to, first of all, identify that these are transitory, which we believe they are as well. And then to wait them out. The longer you wait them out, though, the risk is that they infect inflation expectations or that wages start to go up because there is some sort of dislocation in the labour market so far in Canada, neither of those things are happening.
Ian Pollick: But there is a potential for them to happen. So I do understand why there is a lingering concern. Look, I want to move on because there's one thing that I've been receiving a lot of questions on. Some very astute clients are noticing the fact that when you look at Canada's terms of trade, just given the move in energy prices, broader export prices, we are now at the highest level in our terms of trade index that we've been in for 20 years now. Typically, that would be associated with a strong Canadian dollar with rising national income and therefore be significant to suggest that, you know, the economy is working the way it should. It's moving along in a very orderly way. Is there a different interpretation today, given some of the dynamics we've talked about on this call that we should be thinking about the terms of trade improvement differently?
Royce Mendes: Yes, because the rise in commodity prices is not flowing through to the economy in the same way it typically would think about back in twenty fourteen fifteen when oil prices fell. What happened? So first of all, obviously corporate.
Ian Pollick: Capex declined.
Royce Mendes: Well, let's go through all of the things that happened. Capex decline. That's one thing that happened. Corporate profits fell, government revenues fell. The Bank of Canada cut interest rates because employment was falling as well. And of course, the Canadian dollar depreciated this time around is, as you point out, this has been an absolutely huge terms of trade shock, the largest probably since the commodity price supercycle. And we haven't seen that to the same degree in the opposite way. Well, why is that? We've seen corporate profits rise. We're probably going to see government revenues helped by this. Inflation is higher as a result, because people, you know, not only do we produce energy or commodities in this country, we consume them as well. But we haven't seen capex rising. We haven't seen a significant increase in employment and we probably won't see the Bank of Canada turn hawkish on this news. The reason is is that there's now a wedge in between the pricing for commodities and the expected capex or production new production that will be added. This is a different world we live in. We live in a world of..
Ian Pollick: Well, we are in the middle of the energy transition as well, right?
Royce Mendes: So I think, yeah, yeah. So so we're adding things like carbon taxes. We live in an ESG world. So, you know, we're actually trying to reorient the economy. So we're not seeing and you know, I would say that a lot of producers are sceptical and view some of these price increases are Temporary and, you know, whenever OPEC decides to open the floodgates, the prices could fall back down. So we're not seeing the capex and we're not seeing the hiring and that's what really drove the economic growth in in previous cycles. And so in that case, yes, corporate profits are up. Yes, government revenues are going to look a bit better, but this is not materially changing the trajectory for the economy at large and so shouldn't affect much. The Bank of Canada's view on the Canadian economy.
Ian Pollick: But I do think, though, that and I agree with all those things and, you know, elegantly said, as always. But I think one of the by-products that we could see is just a strengthening Canadian dollar. Would you agree with that?
Royce Mendes: Well, we have seen that so far, but we haven't seen it. I would say to the same extent we have for sure in in prior periods and. And let me just make make another point. You know, we have also seen a wedge in between oil prices and gasoline prices, right? So oil prices are high, no doubt, but gasoline prices in this country are at record highs. And so the inflation impact on Canada is also more acute. So it's working in both ways. We're not getting the same positive economic benefits from higher commodity prices, but we're getting some more powerful negative economic consequences from higher commodity prices. So it works both ways. And that's why I don't think, you know, if you told me, you know, oil prices would be this high, I would have said that the Canadian dollar would be stronger than this. And there has been a little bit of a disconnect, which is actually quite a tight relationship. And I'm working on the paper. You'll see a chart in this paper between the Canadian dollar and the terms of trade, but it's sort of loosened this year for these reasons. And you know, there's no reason to believe in the future that that will get materially tighter between those two things. These are secular changes in the economy that we're seeing happen and changing the response of commodity producers and changing the price of it, of commodities in Canada to consumers.
Ian Pollick: Ok, I agree. And with that, I'm going to say, let's cut it here. We've had a good episode. We'll be back to discuss the Bank Canada after their meeting. So sit tight and remember there are no bonds harmed in the making of this podcast.
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