Ian and Royce discuss new information regarding the Bank of Canada’s toolbox. They analyze the most likely ways the central bank can adjust its policies in the event that upside or downside risks materialize in light of the latest commentary coming from officials. The hosts also look at ways monetary policymakers can alter the mix of stimulus as they inevitably bump up against the limits of bond buying even in base-case scenarios for 2021. Ian and Royce end the show by bidding farewell to 2020 in a unique way.
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Royce Mendes: The economy is operating with far less supply. We don't really want to encourage people to go out and start interacting again. So that could be another reason that other central banks are saying we want to get more clarity. We'll wait a little while until it's safe for people to go out. And then we'll really exactly what you said, turbocharge the economy.
Ian Pollick: Hi, everybody, and welcome to the final edition of Curve Your Enthusiasm for 2020, I'm Ian Pollick and I'm joined by my co-host as always Royce Mendes. Royce, this is our twenty seventh episode and it's been quite a year. I hope that we have enough content for this to be a super good episode. What do you think?
Royce Mendes: I definitely think we do.
Ian Pollick: And I think we do because, you know, I think the one thing that's been proven time and time again in 2020 is just when you think you're in for a lull, you got kind of a surprise. And obviously this week, the big surprise was what should have really been an inconsequential economic progress report the day after what seemed to be a pretty benign Bank of Canada meeting. And we got a lot of information. Why don't you just briefly talk about what we heard and let's get into it.
Royce Mendes: All right. So you're right, the Bank of Canada meeting was pretty benign. But what Beaudry said the following day was pretty interesting. He had a speech that went into detail clarifying any misconceptions about the Bank of Canada's quantitative easing programme. He said this is not printing money. We are not financing the government. That's interesting. But I think for markets, what was more consequential was when he went through the potential tools that they have at their disposal. He talked about adding more firepower to the quantitative easing programme. He clarified that in the question and answer period by saying he meant that they could add further duration. He spoke again about cutting the overnight rate to a number that would still be positive, but lower than the current effect of lower bound, which is twenty five basis points. That's something that Governor Macklem recently opened the door to in sort of, I would say maybe an off the cuff remark.
Ian Pollick: It was super off the cuff, right. Like we had picked up on it. But usually when you don't see it in the prepared text, you think, well, maybe it was a slip of the tongue or maybe it wasn't so important. He was just kind of, you know, saying what's on his mind. But the fact that it was brought up again to me, this now is the party line. Would you agree with that?
Royce Mendes: It was in a prepared speech. And I think, well, we should take from this is that the bank is looking very closely at whether or not it can do this. Why don't we talk about what the advantages are? But I want to go through maybe a little bit of a scenario analysis with you. Let's talk about what the bank's options are in terms of if the economy is sort of status quo with regards to the outlook, if there are downside risks that materialised and there are upside risks that materialised. So first, I'll throw to you, what do you think happens under status quo?
Ian Pollick: Listen, I think when I read the bank statement last Wednesday, to me, the only thing that really stood out was this subtle language change when they were talking about QE. And I forget what the actual wording was, but they basically said something like it could be calibrated in such a way to achieve a stable inflation target. And I read that as being very symmetric, i.e., you know, if it looks like the trajectory of the economy is harder than they expected, then they could reduce QE purchases, which is kind of our base case. It's your macro base case. It's my bond market based case in the status quo environment. I think it gets back to kind of those first principles where we were told that they would feel a little bit uncomfortable owning more than half of the bond market. You kind of get to that point by the end of next year, which tells me that, you know, the real option for them is to start slowing down a little bit.
Royce Mendes: Slowing down, but probably adding duration. Am I right about that in the status quo environment so that you don't change the overall mix of stimulus.
Ian Pollick: For sure. I mean, the Canadian taper is effectively the same as US Operation Twist almost. Right. And it's just because you can reduce your notional, but you buy a little bit further at the curve. Now, again, the US is very centred on the 30 or part of the curve, whereas Canada, it's really been five and 10. So it doesn't completely kill that steepening dynamic that we've been talking about. It just changes the composition where that comes from.
Royce Mendes: Ok, let me talk about another option for the status quo. It would be an outright taper with no lengthening in duration, but a cut to the overnight rate. And what this would do, it would bring down the short end of the curve, which actually could help weaken the currency. That might be something that they're interested in given where we're seeing the Canadian dollar trading. What do you think about that one?
Ian Pollick: So I think this week is all a bit about the Canadian dollar. And the problem here is that, you know, the Canadian dollar in of itself is not signalling Canadian strength. It's more of a secular turn in the US dollar. And that's a very hard thing for a central bank to combat. Right. That is a relative marketplace. And the interesting thing, though, when we take a step back and say, well, why now? Why are they talking about this now? Is it because maybe they're concerned that the optimism related to the vaccine rollout could dissipate or there's going to be some hiccups or challenges? Because honestly, when I look at Dollar Cat, yeah, sure. Fine. We all know what it's been doing. It's been rally or the Canadian dollar's been appreciating. But when I look at Canada on the crosses, it's been weakening. When I look at Canada on a trade weighted basis, it's really done very little all year long. So I guess it comes back to the point that maybe they don't really care all that much about the Canadian dollar and how its trading versus its global peers, it's more versus our biggest trading partner. I just don't know how much of an efficacy this has and actually weakening the dollar, because the cautionary tale in all this, of course, is Australia. The RBA lowered rates by 10 basis points. The currency weakened for a second and then started to appreciate thereafter. And I think one of the reasons why the Australian dollar appreciated so much despite the cut and QE was they basically rolled out negative rates. And that's something that the Bank of Canada or they haven't said they've ruled it out. They reiterated last week in the Bodrey speech it's not practical for the Canadian financial system. In that type of environment, I still get very nervous that you could have a cut in the taper, produce some type of weakness immediately. But the persistence is very fleeting. What do you think about that?
Royce Mendes: Yeah, well, I'll actually add something to that in the current environment, it's actually not as important to have a competitive Canadian dollar simply because we know that the path of the economy over the next year is going to be heavily dependent on the vaccine rollout and what it does for domestic consumption. So I would argue that that was the reason that Bodrey was sort of evasive when he was asked about the Canadian dollar. He knows that these would typically be levels inconsistent with generating strong rebounds in exports or associated business investment. But at the current moment, maybe that's not really a worry. Let's move on to the downside risks and I'll throw a few options out at you and maybe I'll actually give my order of operations first and then maybe you can comment on it. So I would say the downside risks were to materialise. I would argue that maybe lowering the overnight rate might be one of their first options at the moment. Adding duration to bond purchases would probably be the next option. Increasing the strength of forward guidance would be up there. I mean, depending on what a near-term weakness did to the medium term outlook for the economy. And then finally, I'd throw out their yield curve control, which I would say in Canada may not be as effective, particularly in the parts of the curve that you might want to use it as it would be somewhere like Japan or the US. What do you think about that?
Ian Pollick: Here's what I worry about. I worry about when you get so close to the lower bound and we're already there. But when you get even incrementally closer and you recognise that, what are the biggest challenges for the banking system in any region that's close to lower bound is net interest margin compression. The question is how much of this rate cut would be passed on to households if it wasn't mandated to be so? So I worry that even though you do have a bit of spare room left, maybe this sounds like more of a job for fiscal policy, but for containing it to the bank and thinking about order of operations, I actually think what they try to do is the opposite. I think they would try and do something like yield curve control first. I think they would try and really start to hammer down that five year rate in Canada. And to be very clear, you know, you look at the net supply profile right now. We've talked about this before. They're effectively doing this yield curve control late already where they've taken all supply out of the five year sector and the wings are a little bit higher. So maybe they make that a bit more official and they mandate it. But I was a bit surprised that they're talking about the effect of lower bound, as if it is some type of theoretical construct like our star. I mean, why are they talking like that? Why aren't they just saying that we can review the policy rate and we think that money markets and the financial system can operate above zero. Why are they talking about it in the context of a "noun" almost.
Royce Mendes: My guess is that they didn't really do a lot of research in between the 2008-2009 financial crisis or even after that to investigate how low they could take rates. But now that they are at the effect of lower bound or what they're currently calling the effect of lower bound of twenty five basis points, they're realising that if they could squeeze a little bit more juice out of the overnight rate, they would like to. And they're probably conducting that research right now. And that's why I think they're sort of putting it out there. If I had to guess with Governor Macklem first alluding to it and now Bodrey mentioning lowering rates further in the official text of a speech, they're probably leaning towards it being a possibility that they can lower rates. That would be my guess. Let's switch gears to a little bit more of a bright scenario where the economy outperforms the best case scenario.
Ian Pollick: I'm actually going to pause for one second because I want to ask you a question and I don't know how comfortable you're going to feel answering this, but let me try and put it diplomatically. What we saw the last time that Governor Macklem was at the helm or number two at the Bank of Canada was during the financial crisis. One of the unintended consequences of the government cancels decisions at that time was to materially strengthen the Canadian dollar. At one point it is trading at par. Then it went through the US and we saw that that did have a pretty large secular impact on the manufacturing sector in Canada. Does the memory of that premature hiking rates matter right now, meaning that is there an overt sensitivity to Canadian dollar strength? Do you think he wants to rectify any maybe potential prior mistakes? Do you think that's why at one twenty seven dollars we're talking about cutting interest rates?
Royce Mendes: I don't know about the answer exactly. I would say, though, that we're a long way off from par. So you're right that this is sort of a different environment. But what we've realised since the financial crisis is that the Canadian dollar needs to be even weaker than one twenty seven to generate traction in non energy exports. And maybe I'll throw it back to you. Is that maybe the sense in markets, however, that the bank might prematurely change policy in a way that would strengthen the Canadian dollar and a markets just trying to get ahead of that because of the history here.
Ian Pollick: So one of the things that we talked about and, you know, some other members of the FIC strategy team we put out in the FX weekly last week, this article that talks about the size of the balance sheet when central banks are conducting quantitative easing and how that feeds into the currency. And what are the things that we found was that when you take a look at all of the QE programmes that were introduced in twenty twenty and you divide them up between the newcomers, which is the Bank of Canada, the Reserve Bank of Australia, the RBNZ, the Reserve Bank. And you look at the currency performance of that cohort versus kind of the old guards, which is the G4, i.e. the Fed, the Bank of England, Bank of Japan, the ECB. You've seen this broad based currency outperformance coming from these newcomers. And the question is, well, we know that these new QE programmes tend to have a very large impact or a larger impact on the bond market. Why aren't we seeing it in the currency market? And at the end of the day, when you look at total balance sheet expansion, you sum it up across all the central banks within the G10. You've added nearly nine trillion dollars of additional QE this year, but some 80 percent of that is still coming from the G4. So size does matter even though you have these new entrants coming into the market, which means that, you know, I wonder that even slightly reducing some of these QE programmes, does it actually matter for the currency? And I don't necessarily think it does. I don't think we're getting that normal response where you increase or decrease the balance sheet and you get an associated impact on the currency because everyone is doing it at the same time.
Royce Mendes: But what are you hearing about in terms of why markets are looking for the bank to reach a higher terminal rate or a higher rate earlier than the Fed?
Ian Pollick: Part of its structural, Right. I mean, we've talked about this before, but it's just one of the quirks of how the Canadian fixed income market works, where there tends to be these structurally high points on the yield curve. They tend to be in the very short data part that I've been calling it the macro mirage, because honestly, I speak to a lot of investors and there's very few that I actually hear that narrative from where they do think the banks are going to go first, go deeper and higher. And there's really no associated kind of narrative that the Canadian economy is doing really, really well. So I think part of it is structural. The other part, I think, is when you look at some of the restrictions that average inflation targeting puts on, for example, the Fed versus a central bank like the Bank of Canada, it is true that the Bank of Canada has more degrees of freedom to respond to policy adjustments, and the Fed does, given that now they're not just looking at inflation and growth and thinking when it gets to two percent, it's how far above two percent are for how long they have to be. I think that by itself is worth some forward movement from the bank. But is it worth nearly seventy five basis points of additional hikes over the next four years? I would say it's not.
Royce Mendes: Good point. Maybe the bank and maybe when we take a look at the order of operations, what they need to do, even if they don't change their mandate, is increase the guidance around what they're going to do. As the economy closes its output gap, slack is absorbed and inflation reaches sustainably two percent. Are they going to allow it to overshoot, to make up? And maybe they have some flexibility there? They haven't made a concrete promise to do so, but that could help. Maybe let's turn to the upside risks to the economy and I'll throw a few of the options out there. And you can tell me what.
Ian Pollick: But just before you do that, I think it's important that we kind of put this in context, because last week your group put out a pretty meaningful report talking about the upside risk to 2022 growth. Can you just briefly give us some numbers to work with before you introduce this upside base case?
Royce Mendes: Yeah, so we're looking for growth to accelerate as early as the second quarter as people start to get vaccinated, as the economy is able to reopen, really pick up speed around the middle of next year. But that growth really shows up in the annual rate of GDP in 2022. So we have an acceleration all the way to five point one percent in 2022. That's probably easily the highest amongst the consensus. The other key. However, is that we see less scarring from the pandemic than we believe others are forecasting, particularly the Bank of Canada, which lowered their potential growth outlook.
Ian Pollick: What do you mean by scarring? Do you talking about the permanent effects of a recession?
Royce Mendes: Yeah, that's exactly it. So the permanent effects on both the employment market and in terms of capital accumulation, essentially during the financial crisis, we saw factories closed, people shut them down and they were never turned back on. This time around, there are businesses that have closed, but essentially a lot of the capital is still there and it's just waiting for the demand to pick up again. As people start going to restaurants again, you're going to see a lot of increase in, I would say, supply of restaurant services. So, this time around, it's sort of the industry mix, which gives us a little bit more of an optimistic outlook for how the economy is able to bounce back in terms of its potential output or supply. So it's not that we have the bank actually needing to hike earlier, it's that we see both growth and potential output as being more robust in terms of the recovery than the Bank of Canada does.
Ian Pollick: Correct me if I'm wrong, but when I think about kind of the accounting identity of the output gap, when we have faster potential, doesn't that mean that we have a wider output gap of growth isn't exceeding that? So is this a function of, you know, we have a more productivity entering the economy potentials higher, labour income is higher? Is that kind of what you're getting at?
Royce Mendes: Right, exactly. So, of course, over the next couple of years, actual GDP growth is easily going to outpace whatever potential is. But we have potential a little bit higher. So there's a little bit more room for the economy to run before reaching its potential where it would start to generate above two percent inflation. So we're more optimistic on the GDP front. We are more optimistic on the potential GDP front. It adds up to us still believing that the Bank of Canada hikes rates in 2023.
Ian Pollick: And when do we have the output gap closing?
Royce Mendes: So we have it closing around the turn of the end of 2022 early 2023.
Ian Pollick: Ok, so in that view of the upside case.
Royce Mendes: I would argue that that's not the upside case. That is sort of the base case. Yeah, that's the best case because think about it this way. If the bank comes around and sees the world through our eyes, they'll see that both GDP and potential are higher. No need to change the timing of their commitment to keep rates low. The upside scenario is that growth turns out to be better in the next couple of quarters and they need to do something about that because now you're building up more momentum even ahead of when you get the really big bumps in GDP from mass vaccination. And that's what I would call the upside scenario.
Ian Pollick: Ok, so what I think about that upside scenario, it's interesting that you mention that because there is a recent RBA speech and I know you keep mentioning Australia, but there are a lot of parallels. And, you know, the recent RBA speech, they basically said, listen, we would be willing to cut interest rates again once we know the economic recovery is well underway and you kind of take a step back and say, "well, what did you just say?" And it's really just a sentence for them saying we're going to really turbocharge this economy. We're moving you from a V6 to a V12 and we're going to make sure this gets done. But that could also be a function of just trying to support inflation, which in Canada, you know, you tell me this all the time, the easiest thing to forecast is CPI. We already have inflation in Canada. Core is already relatively sticky. So when I think about that kind of size of the world, of that scenario, the world, the first thing I think about is bond yields. Right, I'm a bond guy. So obviously, I think about yields rising and we know there are some parts of the yield curve. They just do not want to have yields rise unchecked. And that's when I think when you listen to what Beaudry said last week, he did mention something along these lines that they could reduce the amount of stimulus in the system if there is an upside scenario. So I almost think that they would move straight to a taper and then the yield curve control at the same time and that upward scenario.
Royce Mendes: Ok, and one other thing I'll add on about central banks in the current environment, they may not want to add a lot of stimulus right now because the economy is operating with far less supply. We don't really want to encourage people to go out and start interacting again. So that could be another reasons that other central banks are saying we want to get more clarity. We'll wait a little while until it's safe for people to go out. And then we'll really exactly what you said, turbocharged the economy. I think in the upside risk, you maybe taper out, right. You could also potentially change the forward guidance. Right. Like that is a conditional commitment. There are conditions. If those conditions change, you change that guidance. So I would keep an eye out for that in terms of thinking about upside risks. Any disagreement there?
Ian Pollick: No, I think you're right. And listen, I think that we should kind of think about winding this down. It's the last podcast of 2020. Can you briefly just talk to us about over the next couple of weeks? This week we have CPI, we had retail sales. Anything that you're looking for that is not status quo.
Royce Mendes: Look, these things are kind of lagged and what we really want to know at this point is how bad December is going to be. And you sort of have to use those high frequency numbers, which are somewhat unreliable. So I would argue that the data is going to be very secondary. But I'll flip it back over to you. Anything in markets we should be watching during this period, during the holiday period?
Ian Pollick: Obviously, I think the big news this week is going to be the FOMC meeting. There is a lot of central bank meetings this week, but in particular, we're looking out for the Fed because obviously the big narrative is, do they or don't they? Are we going to get wam extension in their purchases or are we not? Our base case continues to be we think that you ultimately do, but it's unlikely that it happens this week.
Royce Mendes: All right. Virtual Hi5. Good job this year.
Ian Pollick: Wait, wait, wait. I wrote you a poem.
Royce Mendes: Really?
Ian Pollick: I did. It's it's our final episode. And I wrote you a poem. Would you like to hear it?
Royce Mendes: Seriously, this is this is actually a surprise, OK?
Ian Pollick: Yeah, no, you do. I'm going to start.
Royce Mendes: Go ahead.
Ian Pollick: There are cruise ships and Viking ships and sail ships, but the best ships are friendships. Royce, thank you for being such a great co-host this year.
Royce Mendes: Thank you. Very original. Thanks.
Ian Pollick: Thanks. Listen to all our viewers and all our listeners. Thank you very much for joining us. It's been an amazing experience this year getting all the feedback. We really look forward to being back in 2021 someday Royce and I will actually be together in the studio. Until that time, We hope you have a very healthy, safe and joyous holiday season. And remember there are no bonds harmed in the making of this podcast.
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