Ian & Royce discuss the implication of recent vaccine developments on the bond market and what it means for our macro forecast. As well, Royce discusses what the appointment of Yellen to Treasury Secretary means for the FOMC. Ian speaks about the reflation theme and what the bond market expects from the upcoming Budget update on November 30th
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Ian Pollick: Hi, everybody, and welcome to another edition of Curve Your Enthusiasm. My name's Ian Pollick, global head of fixed income, currency and commodities strategy here at RBC Capital Markets.
Ian Pollick: At the end of the day, you can't facilitate QE directly without the help of the private sector. The private sector is showing up at these auctions. The private sector is taking down these bonds and the private sector is the one that's selling it back to the Bank of Canada.
Ian Pollick: Hi, everybody, and welcome to the twenty fifth episode of Curve Your Enthusiasm. My name's Ian Pollock and I'm joined today by my co-host, Ross Mendez. Royce. How's it going?
Royce Mendes: It's good. It sounds like you've moved out of the cave.
Ian Pollick: I have moved out of the cave. I'm in a very quiet room on the trading floor. And it's a good thing it's quiet because, listen, we do have a lot of stuff to talk about today. And the thing that I want to kick off is that for the past really three Mondays in a row, we've come into the office or come down into our offices at our homes, and we've seen very positive vaccine news. I have a pretty good view and what I think it means for the bond market before we get there, I just want to pick your brain. When you see this vaccine news, which we knew was always going to come at some point in time, how is that helping you think about your macro forecasts, if at all?
Royce Mendes: Well, it's definitely good news because it seems like the efficacy rates are higher than what people had guessed it would have been. So there's certainly light at the end of the tunnel. Now, in the near term, though, the coronavirus cases are rising in both the US and Canada. And it seems like the winter might be as challenging as maybe some of the more pessimistic forecasts would have taken into account. When we sort of add it all up for what it means to GDP, they sort of offset each other. Actually, we've been getting some better than expected news in Canada on the data front. So that's September, October is now rolling in. But then when we start to get to things month like November and December, we're guessing that we'll start to see some of this darker outlook start to show up. So when we look at, for example, the fourth quarter, I know some people are having to downgrade their forecast. But, you know, our forecast of GDP growth, around two percent, seems pretty reasonable still at this point. What I am saying at this point is actually what the implications are for Q1. There's sort of two different paths that we can take from here. One is that the lockdown's across Canada work very well, and by the end of December, we're able to reverse them. And we see a big pickup in GDP in January. And then, you know, there's no need to alter our forecast very much. The second path is that the lockdown's are working more slowly than we had expected and they need to be in place for longer than anticipated. That obviously would require some sort of a rethink for our early quarter GDP forecast for next year.
Ian Pollick: So let me just stop you there so we can get some context for our listeners. Remember that the Bank of Canada, for the Canadian economy, for Q4, they had a one percent annualized rate. We're at two percent. We've gotten some reasonably good flash estimates from Statistics Canada over the past 48 hours, 72 hours. And when we look at the implied handoff that we think we have with seven tenths monthly GDP for September, that gives a pretty good handoff from Q3 to Q4. That's worth nearly three percent by itself. So are you suggesting that November, December monthly GDP is going to be negative and reduce any of the good that we see in October potentially?
Royce Mendes: Yeah, that's what I'm saying. November, I'm not certain, is going to be negative. It could be very close to flat. But December is looking more and more likely, even though we haven't even begun the month, that it's going to be a negative print from there on. And as you rightly point out, the MPR was produced in October. It was before we knew what September looked like. The data is obviously lagged in this country. And before we start to see what some of the flash estimates for October, which again, have been better than most forecasters had anticipated. So that's where you get that that little bit of an offset. Even though the future is a little looking a little bit more dreary, the past looks a little bit brighter and it adds up to a Q4 that looks very much like it did, you know, a few months ago when we were producing forecasts.
Ian Pollick: So when I think about that to me, no offence, when I hear what you just said and I think about bond market pricing as an example, there's not a lot of new information there. So while we may be thinking about this in a quarter over quarter term, it is very evident to me that the bond market is looking a bit further than this. It's looking a bit ahead. And really over the past few days, we've gotten some very mutually reinforcing data or soundbytes. One is that the Biden transition is now fully happening. The second is that we are now seeing that Janet Yellen is likely to take post at the Treasury. And that's really important because to many that does suggest that you do get this fiscal stimulus package that is a bit larger, that is more permanent, that's directed to the Fed. And I think that obviates some of the bad news that we heard where the Treasury was trying to take some cash back from the Federal Reserve. So when I look at the Bah market response to some of this vaccine data is very clear to me that the bond markets are treating this as fiscal stimulus without actual bond issuance. And that's really important because it starts to have implications for some of the really well known themes out there, which is a steeper yield curve in twenty, twenty one, so if I'm taking this back and I'm going to ask you a question, when you think about Yellen at the Treasury and you think about the potential impact to central bank independence, did you learn anything? Are you thinking about this or do we not really care?
Royce Mendes: Yellen understands the Fed better than anybody. Yellen understands the White House better than most. She's been posted there. She has had jobs across the spectrum in economics. So I don't think there's anything that should be too surprising in what the market is perceiving Yellen to be doing when she takes her office. What I will say on independence is that my point here is that I don't think it matters who would have taken the post, whoever it is, if they were a credible pick, who cared about the economy at large more than politics and other things, there is going to be cooperation between the Treasury and the Fed, and that's what should be happening. And it is going to have to mean sacrificing some perceptions of independence. What am I mean by that? Well, if you think about after the financial crisis, originally there was a stimulus bill. It was large and everyone was on board. The Fed was conducting large scale asset purchases or quantitative easing. Thereafter, though, the government was not able to produce more stimulus. In actual fact, it turned from stimulus into a drag because of the fiscal cliff in the US. So now you had essentially the Treasury rolling in one direction and the Fed rowing in the other direction. And you had a very slow recovery. The hope, I think, here is that there will be that cooperation. You will continue to see articles in The Wall Street Journal about the Fed's independence. But I would argue at this point, that's the sacrifice we have to make to get a robust recovery. One point I do want to make, though, on Yellen, you mentioned more permanent stimulus. I'm not so sure she's such an advocate of permanent stimulus. She is part of a think tank, you know, that is concerned about budget deficits in the near term. Look, she's going to be on board with every other credible economist out there. That stimulus to fight the pandemic and to promote a strong and robust recovery is important. And that's what I'm talking about when I say the Treasury and the Fed will be rowing the same way. But I do think that down the road she will be in the camp that will try to set the stage for sustainable fiscal finances at the federal level.
Ian Pollick: When I say permanent, I mean more permanent than a one shot dose in the arm, no pun intended.
Royce Mendes: So more like Canada.
Ian Pollick: Yeah, exactly. And I think this is more of this ongoing steady drip. It may not be here for years, but it's going to be there for enough time that it can be somewhat self-fulfilling to whatever progress you're making on the virus over progress scientists are making on the virus.
Royce Mendes: So you have more what you're saying is in Canada, we have more foresight. We know that these programs will last up until next summer.
Ian Pollick: Well, there's expiration dates and there's a worry that these things are going to expire prematurely or cash is going to be withdrawn. And it's not a certainty that I think the bond market needs for a lot of these calls to come to fruition. The other thing, too, is I remember several years ago on the speaking circuit, Yellen, I was at an event and someone asked her, what was your biggest regret from your time at the Fed? And she said that I did not raise rates fast enough in twenty sixteen. I waited too long between the first and the second hikes at the start a normalization. That idea of regret is resonating with me because that really reinforces this idea that when if she does get this job and she takes this job, that once she's in there, given her experience, given her maturity, there's not going to be any time for regrets. We may actually get a very, very fast rollout of stimulus. Some of it could be more out of the box. And the market is thinking and that really, to me reinforces this idea that, you know, you have to be very careful on the level of interest rates here. And that's a good Segway for what I want to talk to you about, which is because when we think about the main event in December, obviously the Federal Reserve and there's a growing chorus of economists, strategists, investors, all arguing that the Fed should unequivocally not only expand QE, but expand the duration of QE purchases. Again, that's one of those things where that can really start to impair or arrest that prevailing narrative, which is the curve has to steepen. That could be a near-term shock. It could be something that's more persistent. Now, from my perspective, when I look at the level of rates and I look at the level of real interest rates in particular, it doesn't seem to me to be any reason for the Fed needing to step in and arrest any gain that we're seeing in yields. So, I think if you think about some of the constraints of average inflation targeting, we know that it's going to take the Fed longer to get to a point where they feel comfortable to lift off. Ok, fine, that should be reflected in later dated inflation markets, which to a certain extent it is, and it's absolutely priced into the very short end of the curve where markets are expecting the Fed to begin raising rates. The question I have for you is that absent a sustainable structural break, higher in yields, which could be forthcoming if we do get a faster vaccine rollout, a nearly more permanent stimulus program on the back of Yellen at the Treasury, do you think the Fed actually has to step in here or can they save their bullets? And it gets back to this idea that you have your tool kit, its defined tool kit. When do you choose to use it, knowing that you don't have that many tools left? My answer is that they do not do it. That's our view. What do you think about that?
Royce Mendes: Yeah, the Fed doesn't need to do anything at this point. Lowering longer term interest rates isn't going to spur the economy back to life. It's not going to get a vaccine injected in people's arms faster than would otherwise be the case. That's the most important thing that matters for the economy at this point. I'm surprised, though, your comment about Yellen's biggest regret. I would argue her biggest regret should be that she raised rates too early and could have pushed the unemployment rate lower. Look, one of the reasons she's being appointed is because she is supposedly the pick that will satisfy both the progressive side and the more conservative side of the Democrats. And how would you do that? Well, the best way to do that would be running a high powered economy. As she's put it in the past. She worried that inflation was going to break out. It didn't break out. So I would argue again, her biggest regret should be that she raised rates too early.
Ian Pollick: Well, I would suggest you don't put words in people's mouth, because that's exactly what she said. And I think it was in the context of she probably wanted to get rates higher at a faster pace when the world was synchronised because remember, 2016, you had synchronised growth literally everywhere. So there was maybe an ability to sneak in a couple more rate hikes without having that convexity that you saw in 2018. But what are the things that we learnt in the past 48 hours is that Canada is going to get a budget update. And I'm switching gears here a bit because there's a parallel. Canada's going to get a budget update. We know that there's been very little information coming from the media. We haven't heard a lot about some of the innovative programs that the government is thinking about. But we have heard more tax from the opposition, to the incumbent administration about the independence of the Bank of Canada. I don't think that the bank of Canada has done absolutely anything wrong. I think other actions are completely justified. Do you see this newfound kind of opposition against the bank as a warranted or is it more political? And B, what do you expect from the budget update on November 30th.
Royce Mendes: From a purely economic standpoint or financial market standpoint? There's nothing the bank has done wrong.
Ian Pollick: I agree.
Royce Mendes: It's conducting QE a decade after most other countries, our economies entered into QE for the first time.
Ian Pollick: So you think it's political? OK, I agree with you.
Royce Mendes: I thought we're not putting words in people's mouths here.
Ian Pollick: Oh, there it is. You were listening. Okay. Please do continue.
Royce Mendes: I will say, though, on the upcoming budget, I'm not sure what the takeaway from the market will be from this, because I don't think they're going to provide much of a medium term outlook. So if they tell us, look, the budget deficit this year is going to be three hundred and fifty billion or four hundred billion dollars, and the next year it's going to be seventy five, one hundred billion dollars, does it really matter? These are one time budget deficits. And what we know is that these one time budget deficits don't really require any sort of change on the revenue front because they're going to be grown away. So a point that we should take from this is that maybe taxes will go up, maybe taxes will not go up, but they do not have to go up as a result of the pandemic. The reason that we would start to be concerned in the economics community is if there is a transition to more structural deficit. And I'm not so sure that we are going to know any more of that on December 1st than we do today. Maybe we will. Maybe we won't. But that's to be determined,
Ian Pollick: Okay. I say that the bond market in Canada largely agrees with you as well, because really what we're looking for from a rate perspective is how much are you going to spend next year? Do you provide any semblance of an anchor, which I don't think that they will. That's just consistent with recent communications. And if we do get on with spending is over and above what is really being floated around as a seventy five to one hundred billion dollar deficit, than is this idea that, yes, you're going to have some more bond issuance that's going to matter at the margin and it's going to exacerbate potentially any broader theme that you're seeing in the G four rates markets.
Royce Mendes: Maybe I will maybe I will pick up on one thing and take the bait that you left for me and say that the criticism that the Bank of Canada is financing the government, I think is off-base.
Ian Pollick: It is off-base. Here's why I think it's off base. At the end of the day, you can't facilitate QE directly without the help of the private sector. The private sector is showing up at these auctions, the private sector is taking down these bonds and the private sector is the one that's selling it back to the Bank of Canada. So I largely reject this monetary financing, but that's just my two cents.
Royce Mendes: No, and I think I think you and I would agree that if we were in an environment absent QE, how much higher would rates be? Would they be 100 basis points higher.
Ian Pollick: Maybe 10 to 15 basis points?
Royce Mendes: Exactly. And that's the point right there. That's the point which is largely missed. And I think that's that's the place I think we need to talk about more. And certainly the Bank of Canada needs to talk about more that tell us how much QE is doing, because absent that, it looks like the bank is buying a ton of balance. The banks balance sheet has grown faster than any other developed market central bank. It does look like this should be a big deal. Why aren't financial market participants caring about it? Why aren't economists caring about it? There's not some big conspiracy here. It's because, basically we've done back of the envelope calculations at our desk or in our heads to tell us basically that it's not actually changing the level of yield that much. So by definition, that it's not financing the government. It's actually, in my opinion, not doing that much for markets or the economy at this point.
Ian Pollick: I would agree. I think it's doing more damage than it is good in terms of its current structure, which is, you know, what are the reasons why in our year ahead outlook that was released a couple of days ago? One of the things that we're very cognizant of is that, listen, I think some of the old problems created by quantitative easing in Canada, they're going to get better and the new ones are only going to get worse. This is going to be an iterative process until you get marginally closer to an exit strategy being communicated one day.
Royce Mendes: One question before we wrap, up one question for you. Maybe. What do you think would be achieved if the Bank of Canada switched to three billion dollars per week instead of four billion dollars per week? Could it achieves broadly the similar, the same result in longer term bond yields?
Ian Pollick: I think so. I mean, listen, the problem here is that, you know, we're being very realistic and honest. There is more supply than there likely is demand at the margin. You know, Canada went from a market that was chronically undersupplied to one that's for the near term is going to be quite oversupplied.
Royce Mendes: Yea, and the desire to save has skyrocketed as well, as we published a piece on cash last week.
Ian Pollick: You have excess cash sitting in the system. That cash, you know, absent productive enhancing investment, just sits there. That's what funds the banking system, leaving deposits at the Bank of Canada, which facilitates them doing QE. I mean, that's really how QE works in Canada. And I think that if they were to have a further tapering, its going to be required because in all likelihood the numbers that were kicking around for the deficit are going to mean that once again, the bank faces the issue of a program that's too large relative to the new stock bonds coming into the market. And I think what we've seen recently is that the bank has started to include benchmark securities, building benchmark securities, and that means that they can actually take the same interest rate risk out of the market while reducing the purchases. Because what I haven't really heard a lot of communication on is the efficacy of what the bank just did. Not only have they reduced purchases by a billion dollars per week, they're actually taking more interest rate risk out of the market. It's exactly what they said they were going to do. So it leads me to believe that there's no reason not to assume the same thing cannot happen with a further reduction, because at the end of the day, you know that two year sector purchases, which are still a billion and a half dollars a week, if forward guidance is credible and if the bank communicates effectively, you do not need to buy those bonds.
Royce Mendes: What they really should have done is end the bond purchase program, the one that was done for market functioning reasons, and start a QE program that would have distinguished the two. But they sort of just morphed that first program into the second program, which I think created unnecessary messiness around the programs.
Ian Pollick: I would disagree. I think it was a pretty seamless transition, to be honest with you. I think where there was some scope maybe in future iterations where we may unfortunately have to revisit the lower bound again and get more QE, is that the communication around what the intentions are could be a bit tricky.
Royce Mendes: Yea, I mean, Polus was saying it was designed for market functioning and then all of a sudden Governor Maclum took over. And you're calling it a quantitative easing program. I mean, for those of us who pay very close attention to those words, they mean two very different things. And the head of the central bank all of a sudden just changed the distinction. Look, we've got to wrap up, though.
Ian Pollick: Is that because you're wrong and you just want to get off the column?
Royce Mendes: *Laugh* No, no, no.
Ian Pollick: Just kidding. Listen, thank you very much to all of our listeners. We hope that everyone is doing well. Please stay safe. Please stay healthy. And remember, no bonds were harmed in the making of this podcast.
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