In the final episode of 2021, Ian & Royce discuss the widened uncertainty related to new COVID variants. Royce discusses his view on the recent Canadian data, both GDP & jobs, while Ian opines on the potential for the Bank of Canada to deliver earlier-than-expected rate hikes. The two hosts go back-and-forth about the most optimal policy sequencing, specifically whether or not central bankers should shrink balance sheets before delivering rate hikes. The potential for yield-curve inversion is growing, and that may ultimately harm the recovery. Royce finishes the show by discussing how falling energy prices will matter going forward for U.S. inflation.
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Ian Pollick: Is the Bank of Canada going to hike rates in January?
Royce Mendes: Wasn't the beginning of this podcast about Knightian uncertainty and the difficulty of putting probabilities on things?
Ian Pollick: Yeah, but I'm going to ask you because you're a known Knight, sir.
Royce Mendes: Look, I think 70% is aggressive. I would be more around the 20 to 25%.
Ian Pollick: Hey, buddy, how's it going?
Royce Mendes: Good. How are you?
Ian Pollick: It's good. We haven't done one of these in a while. I missed you
Royce Mendes: A long time. It's been a long time, too long.
Ian Pollick: Will you make me a New Year's Eve resolution that we'll do more of these in 2022?
Royce Mendes: Let's talk. Let's talk.
Ian Pollick: Ok, so you know, let's start off talking.
Royce Mendes: There's only so much time I can spend with you, Ian.
Ian Pollick: This is true. But you know, speaking of time, I have a question for you. What is the Mendes routine for the holidays? Is there like a movie that you watch every year? What do you do?
Royce Mendes: Home Alone.
Ian Pollick: Is that your Christmas movie?
Royce Mendes: That is my Christmas movie. Number one Christmas movie. Home Alone. The original Home Alone, of course.
Ian Pollick: Ok, so not Home Alone 2 or 7? It's just the first one. Do you know that you can actually Airbnb that house out?
Royce Mendes: For one night.
Ian Pollick: And Buzz will serve you pizza.
Royce Mendes: No, that's not true.
Ian Pollick: No, it is true. It is true.
Royce Mendes: We should just get Buzz on the program. I feel like he'd do it. To serve us pizza while we're doing the podcast.
Ian Pollick: I like Scrooged personally. You know, I love me a good Bill Murray movie, but that's one of my favourite Christmas movies of all time.
Royce Mendes: What about Christmas Vacation? That's a good one.
Ian Pollick: It's OK. But listen, let's get right into this. You know, obviously, let's just take a step back and talk really over the past two weeks. We've gone through a lot of market highs, a lot of market lows. It kicked off with the news of the new variant. We've subsequently heard conflicting evidence on how bad or how good or how mild it is. But what I think it reminds the market is that there's this inherent non linearity in exiting the pandemic. So it's not clear to me that this won't happen again, but talk to me from a confidence perspective. And when I say confidence, I mean, your forecasting confidence. What is this doing to uncertainties? What's it doing to your medium term outlook?
Royce Mendes: It's what I would call Knightian uncertainty or what economists would call Knightian uncertainty. It's the type of uncertainty that you can't quantify. You can't easily put probabilities on the outcomes. It's very difficult to be forecasting in the current environment. And obviously, as we look ahead into 2022, the economy in Canada at least seems to be healing quite well. So the question is, how does the Bank of Canada respond to that this week? My guess is that they will kick the can down the road, say something like, you know, the economy has evolved largely in line with our expectations and then put an asterisk on the outlook, given what's happening with Omicron. Because, as you say, every day we get a different headline, every day the market is reacting to that headline about Omicron, but I still don't think we know enough. What do you think about the Bank of Canada this week, where the risks lie?
Ian Pollick: Well, before we get into Bank of Canada, let's just kind of bring everyone up to speed on what we've been looking at. And, you know, I want to get a sense of the parameters. So the first parameter was we were talking about Q3 GDP, not just us, but the street as a whole as being much weaker than the bank expected. You know, I think what we've learnt is that the bank's pretty good at forecasting very near term growth trends. So not only did GDP basically come in line with the bank was expecting, but we did get a pretty big revision once again to the level of GDP going back a couple of years.
Royce Mendes: Yeah, let me jump in here and just talk to everyone about how this all balances out. Because you're right. The Q3 growth rate for GDP was very close to the Bank of Canada's estimate, but then there were some downward revisions and actually a bunch of up and downward revisions going back quite far. When we look at how that all balances out, it actually means that GDP is still about almost one and a half percent below its pre-pandemic trend. So on that metric, I would say it was a little bit weaker actually than the Bank of Canada had penciled in to the October MPR. On the flip side of that, of course, is the labour market, which came out much better than I would have assumed that the Bank of Canada had penciled in to the October MPR.
Ian Pollick: Yeah. So one of the things that we've done is when the Bank of Canada released its paper on labour market uncertainty back in October, they basically tried to say, listen, we can't just look at the headline measure. We need to look at a whole bunch of other measures, seeing how far they are free post-pandemic peaks, and they really split it up into three broad measures. One was just inclusivity. One was this overall conditions and one was just labour market conditions relative to the pre-COVID baseline. And we tried to recreate that chart. And it's that circle chart that has a bunch of the little lines and if you exceed the circumference, then you're above your pre-pandemic trend. And it looks like for the most part, this very much looks like a labour market that's at full employment. I know that in Canada, we don't really have official estimates, but can you just walk us through what you're thinking of in terms of proximity to full employment and what that means for wages?
Royce Mendes: First of all, kudos to your you and your team for putting this together. I think it's an extremely useful indicator, which we can see a bunch of different labour market measures all at one time and how they're comparing to pre-pandemic trends, so if you're not on Ian's distribution list, I think this is definitely a reason to get on to see this thing. I would argue, though a little bit, this is not a major argument, that we're not yet at what I would call full employment. We're still seeing issues with long term unemployment. There are still pockets of weakness. Largely, I would say, though, putting aside Omicron for a moment, this is looking like an economy and in particular a labour market that does not need zero interest rates for much longer. I think we can both agree on that. Am I? Am I right?
Ian Pollick: Yeah, you're right. You're right. We can agree. We're agreeing.
Royce Mendes: So, you know, you look ahead to the upcoming Bank of Canada meetings. I'm not going to put a prediction on how Omicron plays out over the next six weeks or so between now and the January Bank of Canada meeting. But at this point, we have to assume that I think it's live. Now, can you remind everyone of what the market has priced in for that January meeting?
Ian Pollick: Yeah. So it all depends what you assume repo or core is going to be. But right now, if we kind of pin it at 15 basis points, the market's got about thirty five basis points for the meeting gap. So you have basically about, you know, a little over 70% probability of a hike in January. And you know, one of the things that I want to tie this back into with is, you know, this week feels very, very too soon in a sense to hike rates. I don't think it's going to happen this week,
Royce Mendes: Especially with this massive cloud of uncertainty hanging over the meeting with regards to Omicron.
Ian Pollick: I agree. But let me ask you this in general, if you're the Bank of Canada and I want you to walk us through a stylized response where if you're already dealing with the situation where you have elevated inflation and you believe that the labour market hypothetically is at full employment, how long after do wage gains typically start to accelerate to the point where is the bank worried that you get this wage acceleration that is coming at the same time that you get this supply side deceleration of inflation so that you keep at very high levels?
Royce Mendes: So here's the thing. We only know when we're at something like full employment or we've reached the potential of the economy after the fact, when we start to see wages increase or we start to see inflation start to accelerate, you know, underlying inflationary trends, not this, this stuff that we've seen over the past year. But what I would say, something interesting that I picked out of the last labour force survey, is that we're seeing businesses in addition to the non-monetary benefits that they're offering, you know, more flexible working arrangements, you know, other benefits. They're also hiring or relaxing the educational requirements for job postings. So typically, if you needed, let's say, a university degree, businesses are willing to accept a college diploma. Typically, if you needed a college diploma, now some businesses are actually hiring people with the high school diploma. This is what I would see as a precursor to wage gains and suggestive of something that is very close to full employment. So you ask about the inflationary environment in 2022, and I think you're absolutely right. That sort of wage push inflation is going to start to pick up, but we're seeing disinflationary trends from the energy market. Hopefully, we see some easing of supply chain issues. We did see in the latest US trade data that the auto industry, the North American auto industry at least is seeing more trade across borders, which is hopefully suggestive of some easing supply chain issues. So there will be a hand-off from supply chain driven inflation and goods inflation to more service inflation. And that's the type of inflation that the Bank of Canada wants to head off, right? Now the question is whether to head off that inflation, the Bank of Canada needs to hike as many times as the market has priced in. I mean, what is it five hikes now that are priced in?
Ian Pollick: It's about five and a half hikes, almost six hikes end of 2023, five hikes in 2022. So you have this very imbalanced kind of profile where the market's really pricing in a very, very accelerated pace next year and then a very slow pace afterwards. And then, you know, what's interesting is that in this cycle, it seems to be a very truncated cycle where you have most of your hikes delivered in 2022, an implicit pause over most of 2023. And then you have rate cuts effectively priced for 2024 and 2025. You know, it's funny because, you know, as an institution, as you know, we officially have a forecast of two rate hikes. It's very likely, and tell me if I'm wrong that we'll probably be changing that closer to three hikes in 2022. That's not all that far away from five. And, you know, given the normal degrees of over optimism, five versus three, it could be one of those weird situations where the market may have been right for most of the time in pricing what it was, now Ultimately, I don't think you'll get five hikes next year, but it's not as wrong as it looked a month or two months ago.
Royce Mendes: So we've talked about why maybe, you know, hiking five times without giving the economy time to digest those rate hikes is sort of dangerous with such a highly levered economy, you don't really exactly know where neutral is always and you want to hike, let the economy respond and then maybe hike some more. But I want to ask you a question. Let's say market is right for both Canada and the US. So five hikes in Canada. What is it? Two hikes in the US?
Ian Pollick: Three hikes.
Royce Mendes: Three hikes in the US. And that probably comes in what the second half of 2022? So it means tapering takes the majority of the first half of 2022. What does that do to the curve? What seems like, that's a flattening curve in Canada, at least because the Fed is still buying bonds into 2022 and taking term Premia off out of the long end?
Ian Pollick: Well, I mean, I don't know, I don't know if I agree with that. You know, I think the Fed is really coalescing around this accelerated timeline, and let's assume that March is not when they finish tapering. Let's assume that it's consistent with our forecast that's in June.
Royce Mendes: It's a long time to be buying bonds, right when the when the Bank of Canada is hiking short rates?
Ian Pollick: It is a long time. But I would say that, just as we rely on the signaling impact of QE to make the market rally, I think it's a very similar thing that you're signaling the end of QE that you can get this rebuild of term Premia before the actual cessation of QE itself.
Royce Mendes: Let me ask another question. How important is it that the Fed signals not only that they're winding down the program, but that very soon they will start to wind down the balance sheet, not just taper asset purchases to zero, but actually have the balance sheet starting to shrink and more bonds being released back into the market. How important is that to get the curve steeper and how important is that to policymakers to do things like that to get a steeper curve?
Ian Pollick: Well, I guess, you know, let's ask ourselves, well, why do we want a steeper curve? And I think in general, the financial system wants a steeper curve. There's been a lot of literature suggesting that, you know, the sequencing of events in the post-financial crisis world is actually wrong, that they should have actually shrunk the balance sheet prior to hiking rates because remember, we were inverted by, you know, late 2018 or early 2019. That was the policy error pricing. You know, it's not clear to me, given all the discussions we've heard from the Fed that, you know, active balance sheet reduction as part of their sequencing, at least initially. I think it's the third step. I think it's, you know, you get your taper to a size where you're at zero active purchases, you start to normalize rates and then eventually you start to wind down the balance sheet actively. And even the most hawkish regional Fed presidents have kind of coalesced around that as well, so I wouldn't expect it for 2022.
Royce Mendes: There's one regional Fed president, actually, St. Louis President Bullard, who mentioned, and I don't think anyone really took notice of this. He mentioned a few weeks ago, maybe a month or so ago, that you could have a situation that before raising interest rates, you actually start to wind down the balance sheet. Now I think that's interesting. I actually don't have a problem with that because, you know, you've seen so much bond buying, probably excessive bond buying. Why not release some of that back and tighten that way rather than raising short rates?
Ian Pollick: I tend to agree with you from the perspective of a market participant because there's nothing more than I want to see is that, you know, I very much believe that we are entering this hiking cycle at very, very prematurely flat levels. And I do think we're going to be relatively inverted by the time we're midway through the cycle. But from the everyday Canadian, the everyday American, I don't think they care about balance sheet expansion. They need to feel it in their financial obligations and their debt servicing, right? And that's not going to do all that much. So I think if I'm a policymaker, I would rather raise rates because it's much more socialized than what it means to actively shrink the balance sheet for financial conditions. Do you know what I mean?
Royce Mendes: Yeah, I'm not as clear cut as you are. I think raising rates and winding down the balance sheet need to be done almost in concert. I don't think you should raise rates, the short rates too much and then have an extremely flat curve because I don't think that's particularly beneficial and it's just not a great mix of policy.
Ian Pollick: It's not, you're right. And if something bad happens and you're in a situation where you still have a very elevated balance sheet than what we've shown, and I think, you know, this isn't a heroic kind of observation, but there's diminishing returns to scale of QE. So if you start QE up again, for whatever reason, when you have a very elevated balance sheet, it just doesn't do as much to the term premia, it doesn't do as much-
Royce Mendes: The counterargument to that is that you could cut the short rates that you raised more.
Ian Pollick: Yeah, exactly. So I think it's all about trying to figure out what their balance of risks are two years out.
Royce Mendes: But I would like to hear more of this discussion from central bankers.
Ian Pollick: Yeah, and they're not talking about it.
Royce Mendes: Unless that this is, you know, something we've figured out clearly that this is the way to do it. I think we have to have academics, market practitioners and central bankers talking to each other and figuring out what the best way to get out of this is because we're doing this at a time that, look, I mean, we're still in a pandemic and we're talking about exiting extraordinary policies. And yes, the economy is in the right place. But who's to say that another one of these major risk events doesn't show up three months from now? And we have to go back to easing, so we want to be prepared for all these outcomes, right?
Ian Pollick: I don't know about easing, but I think it goes back to your point is, is this an economy that needs zero rates and it's probably not, and it goes back to our earlier point, you know, your confidence spans are so much wider and it's a known unknown, but I don't think you can have policy for the counterfactual for what the trend is right now.
Royce Mendes: Ok, but also, how do you want to tighten, right?
Ian Pollick: That's the better question. How do you want to tighten?
Royce Mendes: Yeah. Putting more term premia back in, you know, that tightens the housing market, certainly 30 year mortgages in the US and, you know, even in Canada, getting the five to 10 year part of Government of Canada yield curve up is going to help tighten financial conditions for the housing market, right? And maybe that's maybe the right place. Maybe it's the wrong place, but I'd like to hear the discussion.
Ian Pollick: Let me ask you this in terms of just balancing out the week. You know, obviously we have a lot going on in Canada, but we have a very big CPI report in the US on Friday. Markets looking for an acceleration in the annual pace to almost 7%. You know, we've seen the move in energy prices. What are energy prices do to this risk, to the risk of a very large print? Like, is this being accurately factored into the forecasting?
Royce Mendes: This is November, right? So I think this is the right call. Just under 7%, I think I think the consensus and we're at 6.7%, highest in almost four decades, but I think you hit on the exact right point. Energy prices have fallen and that's going to make accelerating inflation very difficult. That doesn't mean that we're going to see a deceleration very quickly. I think that's still for the rest of this year, you're going to see very high inflation prints in Canada and the US and even early into next year, you're going to see them still very elevated. But I think once you get to March, April, May of next year, the comps for inflation become difficult and I think you start to see disinflation. And you know, it's still elevated compared to 2% targets, but it's disinflation. Here's the question for you. We're going to see 6.7% inflation this week. Let's say we're right on that forecast, but the 10 year yield is what one and a half percent? Is that the market's confidence that this is transitory?
Ian Pollick: You know, I don't think it's that clear cut. I think it's a few things, right. I think partly it's a function of, you know, equities for really the first time all year are showing real signs of weakness. And that weakness is manifesting itself in the profit taking and just recycling cash somewhere else in the universe. And that happens to be the bond market. There hasn't been a huge amount of supply in the market as well. I think people are trying to get a little bit duration just in case, you know, there's usually a past few years, there's always been an accident in December and early January that's been risk off. So I kind of understand it. But if you do go through the situation where we do see reliability in the vaccines to this new variant and you do get kind of an on point message at the Fed meeting that they are going to accelerate the taper. And I think duration is very dangerous right now, and I'd rather be short than I would be long over the balance of the year. You know, I want to ask you a question. So, you know, we talked about it, kind of went back and forth, but give me a probability in your mind, is the Bank Canada going to hike rates in January?
Royce Mendes: Wasn't the beginning of this podcast about Knightian uncertainty and the difficulty of putting probabilities on things?
Ian Pollick: Yeah, but I'm going to ask you because you're a known Knight, sir.
Royce Mendes: Look, I think 70% is aggressive. I would be more around the 20 to 25%.
Ian Pollick: Ok. So you have a very low probability because I think every meeting should be 20, 25% in this environment. And walk us through one thing, because one of the things I often talk to clients about is the probability of a 50 basis point hike. I usually dismiss it, saying, well, I don't think they're that far behind the curve, but you know what's an economist's take on this? You know, the question is, would the Bank of Canada at lift off hike 50 basis points?
Royce Mendes: So this is all about communications. This is less about, you know, monetary policy. Technically, if you want to shock a model 50 basis points because you think that's the right amount, then you should shock the model 50 basis points. But this is all about communication, and the Bank of Canada doesn't want to lose credibility on either side. And hiking rates far more than the market expects is not helpful. Waiting another six weeks and getting the other twenty five basis points in there makes sense. Monetary policy works with long lags. The difference between six weeks between one meeting and the next is not enough to actually justify the surprise. But you know, if you're a technocrat and you don't care about, you know, the communications aspect of it, then you could do 50 basis points. I don't think it's likely.
Ian Pollick: OK. That was a very nice way to say it. So listen, I think we've talked about a lot of stuff. This is our final episode for 2021. It's been a hell of a year, Royce. And listen, I hope you have a wonderful holiday season. To all of our listeners, we hope you stay healthy, we hope you have a wonderful holiday season and we'll speak to you in 22. And remember, there are no bonds harmed in the making of this podcast.
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