Ian and Royce discuss what calls they got right and what surprised them in this week’s Federal Budget and Bank of Canada announcement. They give their views on which central bank’s outlook is more likely to be realized between the Bank of Canada and the US Federal Reserve. Ian discusses how the expected supply in the Government of Canada bond market this year will interact with the central bank’s tapering plans. Royce talks about why market pricing for the terminal rate in Canada might not actually be that aggressive.
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Royce Mendes: I'm saying that, yes, one separate factor in this recovery is that domestic demand will be very strong. Another separate factor will be that exports will be strong overall because countries are rebounding.
Ian Pollick: So Royce, it has been a dream week to be a Canadian strategist, Canadian economist. We have a lot of stuff to talk about. But first off, how are you?
Royce Mendes: Good. Let's get right into it. I'm going to give credit where credit is due. And you got a big call, right this week, the Bank of Canada taper their quantitative easing purchases by one billion dollars. But I am keeping score and you did get some things wrong as well. So why don't we jump right into it and talk about the decision? What surprised you?
Ian Pollick: So aside from the statement itself, what surprised me where I got things wrong were twofold. Number one was I had thought that given some of the deterioration in economic activity because of the resurgence of viruses, that the taper would really be characterised as a technical adjustment. And that's absolutely not what happened. We can get into a bit more when you talk about the details of their forecast, but it was very much a monetary policy decision. And flowing from that was the second thing I got wrong, which is that I thought because it would be a technical adjustment and I didn't think that they would be able to close the output gap in twenty twenty two, that they could just get away by reducing front end sector purchases to accommodate the taper and rely on forward guidance to really cap the front end of the curve. In actuality, what happened was we got the billion dollar taper as expected. It was a much more hawkish overall communication about the trajectory of the recuperation phase. But also in the Q&A, Governor Macklem said when someone asked him what the distribution of taper purchases would look like, he said broadly consistent with what we're buying right now, which tells me that is it's a net reduction. It's not just coming from the front end.
Royce Mendes: So you're implicitly throwing some shade my way because I didn't get the call right on their forecast. Let's just lay it all out there. They are optimistic about the outlook. They moved their forecast up from four percent growth this year, all the way up to six and a half percent growth. That is moving from the low, low end of the consensus all the way up to the high end. We don't usually see swings like that in terms of how likely that is to play out. Look, I think we should be cautious. They are projecting that the third wave of the virus is roughly equal to what we saw during the second wave in terms of its economic impacts, which is not that much. However, I'm not so sure that's right for a few reasons. First of all, we have variants of the virus that are far more transmissible and infectious than during the second wave, which means that we've seen more shutdowns required and maybe for a longer length of time than what we saw during that second wave. There's also less cover being provided, likely coming from the housing market and the energy sector, which did a lot of work in covering for the services sectors that were really hard hit. There was a lot of growth that showed up in housing and energy. There's not that much growth left that we see happening.
Ian Pollick: Well, it's interesting because I think you take a step back and we'll get into some of the forecast details in a moment Royce, but I don't believe either central bank's forecast right now, whether it's the Fed or the bank, one being too optimistic, one being too pessimistic. And I think that has a material implication for asset prices in both countries for the shape of the respective yield curves. When you think about which central bank forecasts are more uncomfortable with, is it the Fed saying that, you know, we can maintain low administer rates for a very long period of time without generating sustained inflation? Or is that the Bank of Canada saying that we expect growth to be very strong despite some of the near-term challenges?
Royce Mendes: Well, I think you hit the nail on the head that we're talking about the difference in forecasts here instead of the difference in framework's right. Because the Bank of Canada showed us this week that they are indeed willing to allow inflation to overshoot. And that's exactly what they're trying to generate, which we've talked about. We think that they could be sort of pseudo average inflation targeters. In terms of which one I'm more uncomfortable with. I think it's the Fed outlook.
Ian Pollick: I would agree.
Royce Mendes: I think the Bank of Canada is roughly mid twenty twenty two that the output gap closes. Yeah, that could be true. Again, I think there are overly optimistic even for the end of this year, Q3 and Q4. I'm not sure that we get to the levels of activity that they're expecting. And I'm not sure that given what we know about the variance and the efficacy rates of the vaccine, whether we'll be able to increase our mobility and interaction as much as what's baked into the NPR forecast. But overall, I think we're seeing the Bank of Canada's forecast closer to what's likely to happen instead of the Fed forecast, which suggests that they're not going to hike rates until twenty twenty four.
Ian Pollick: So let's just talk for a second about the Bank of Canada's forecast. And I want to get back to a point that you just talked about, which was it's evident that we all know that the Bank of Canada has a flexible inflation mandate around a two percent midpoint. By the end of the forecast horizon in the latest monetary policy report, which was twenty twenty three, had your inflation at two three, which is almost four tenths higher than the year before. So talk to me about the kind of path that they have laid out for inflation because it goes to point one percent in twenty twenty one one point nine percent to twenty two, two point three percent of twenty twenty three. Why is it look so weird?
Royce Mendes: So you're seeing a lot of the base effects and the twenty twenty one forecast. Right. So you're getting an overshoot of inflation and you're seeing also what's happening with energy prices, which have been very strong lately. So it's pushed up gasoline prices. And what they do by convention is just take the current oil price and project that into the future. So you actually see some of that inflation coming off because it's a flat projection for something like gas prices. But then into twenty, twenty three, what you see is that the underlying inflationary pressures start to build up and lead to above target inflation. And that's really something I don't think I've seen before in a monetary policy report where the end point for inflation is above target.
Ian Pollick: The other thing I want to ask you about to raise what we're just digging in the details here. There's a lot of people asking the question, why was the Bank Canada so hawkish? Was part of it reflecting the fact that they want to remind people that the housing market isn't going to go up forever, that if you take on leverage today, you have to be careful about what it means for the future. So part of it I sympathise with that. There is a signalling mechanism here at work. And indeed, when I look at the composition of GDP growth, one of the things that stuck out to me was that you have a very, very large contribution coming from housing in twenty twenty one, nearly two percent, but then basically nothing and small negative for the next two years. Am I right thinking that this was just a reminder that interest rates will not be at the lower bound forever and they're trying to get that message across. Or is it too simplistic?
Royce Mendes: Yeah, that's something that likely came into their minds when they were thinking about the messaging, that they're no longer in a position to say that rates are going to be on hold for a very long time. Governor Macklem made that statement during the worst of the pandemic when public officials in general needed to do everything they can in terms of policy actions and communications to avoid panic. We're in a different stage and we're fortunate to be where we are now. We've avoided the worst case scenarios and they can walk that back and they probably need to walk that back, given what we're seeing in the housing market. But I don't think that they can go much further. Their hands are sort of tied, right? They obviously have very blunt instruments and they're not going to try to cool the housing market, which is one sector of the economy, and risk cooling everything else as well. So what I think they're hoping for is that some of their friends in the government and in the regulatory agencies take some more steps as well. And I think maybe more importantly, what they're hoping for, which sort of it lines up with this optimistic forecast that they're laying out in the MPR is that covid will be behind us. So all of the perverse impacts on the housing market from covid in so far as people looking for larger houses, for work, for recreation, for schooling, people not being as tied to urban centres, people having more cash on hand because they're not spending as much on services which they would typically consume. All of those perverse impact will be in the rear-view mirror later on this year or into twenty, twenty two. So this is just a temporary sort of situation. Whether that plays out or not remains to be seen.
Ian Pollick: So it's interesting, right? Because obviously we had another huge event this week in Canada. It was the federal budget, the first one in two years, and there was a lot of expectations going into the budget. We'd get some macro prudential measures which coincide with what OSF did a couple of weeks ago, which was to raise the qualifying rate and there be 20 guidelines. At the end of the day, it seemed like a very token type of gesture where there's a small tax on foreign owners of domestic homes that are not used, hard to enforce, hard to find, can't be generating a huge amount of money for the government. Are you surprised that we didn't get more heavy handed macro prudential introduced?
Royce Mendes: I mean, maybe at this point all of the agencies are sort of hoping the same thing, that after the pandemic is behind us, that some of these weird impacts from covid-19 fade. You did ask a question which I didn't answer on the huge contribution we see from housing in the twenty twenty one GDP forecast in the MPR. And I would say some people might call that concerning because we have so much of the economy being tied up in housing. But I'd say that's on net. Probably good news because a lot of it is just residential construction. So adding supply of whether it's high rise condos or low rise building in suburbs, it's good news. What the Canadian housing market overall needs is more supply. So I think you see that big contribution this year. Hopefully a lot of that supply comes online and is available for use in the near future. But then in the future years, you don't see as much of it because it's already operating at a very high level.
Ian Pollick: So what you're saying is that contributes. Just home appreciation price, it is investment, it is the tertiary investment associated with building, which is a good thing, and that's just not sustainable over the next couple of years.
Royce Mendes: It's not sustainable at probably those extremely high levels. But you don't see it completely reversing, right? You only see it coming off a little bit.
Ian Pollick: Ok, so let's move on a little bit here, because I want to talk about the budget a little bit because there's some pretty important implications for the bond market. And you started this week thinking that maybe you have two either complementary or opposing forces, depending on what the government's financial requirements were or how they were going to distribute that supply. What ended up happening at the end of the day was we thought that bond issuance would fall. I think we had two hundred and sixty billion in our estimate. It was around there's a 290 billion and that's almost a hundred billion dollars lower from the prior year. But what was really interesting is that when you look at where this debt is coming from, you saw huge reductions in the level of issuance in two years, in three years and five years. You actually saw, despite the decline in gross issuance, you saw an increase in the level of 10 year supply. 30 year supply was unchanged, but still relatively high. And I took a step back and say, what does that mean going into the taper? Well, I had thought that the taper would be coming from the very front end, which meant that it almost had no impact because the amount of supply falling was larger than the potential taper. It even seems right now that when you look at the supply reductions in the very front end of the yield curve, they actually are still larger than what the Bank of Canada is likely to do with their tapering. Except from the very back end of the curve, you have 10 years supply that's growing primary level, but also the bank Canada is going to be scaling back in that part of the curve. Same thing with 30 years. And one of the things we need to think about is forget about the notional amount. Think about the interest rate risk associated with it and the rule of thumb. The longer the maturity is, the more rate risk being removed or being injected into the market. So to me, the big question is that in Canada, the ecosystem is very, very balanced for years between the sovereign and the sub sovereign issuance. And you now have a situation where you could really get some crowding out. You have a lot of pressure coming into the long end of the yield curve. And I think that the big theme going forward is that you have this very big unwind of some structural richness in the back into the curve, which leads me to believe that, you know, I question how long this new targeting of the back end can persist, i.e., is this an indefinite move where every single year they're going to have the same amount of long bonds, same out of 10 years because almost 50 percent of all issuance now is 10 years plus. So I'd be curious to hear what you're saying, because within the context of the appropriate fiscal anchor to use, which is really debt servicing, if we are talking about much higher levels of interest rates going forward because it's supply induced, do you think that we could get a temporary reprieve in some of this composition and more thoroughly? Talk to me about the fiscal anchors that were or were not present in the budget.
Royce Mendes: Ok, so what do you mean by a big increase in interest rates? Because everything is relative here.
Ian Pollick: So let's talk about some scenarios. Yeah, 50 basis points higher, 100 basis points higher in 10 year bonds or 30 year bonds. And the reason I'm asking you this is because you and I have talked before where maybe the traditional fiscal anchors that we look at, which is debt to GDP, aren't necessarily appropriate. Maybe we should be looking at debt servicing costs.
Royce Mendes: Ok, so a few things on this. You're right. I mean, our argument has been that the debt to GDP ratios do not represent a good fiscal anchor because they're not really stable reflections of fiscal sustainability through time. Look, if interest rates are high and they're above the rate of nominal GDP growth that you expect, well, then a certain debt to GDP level is going to be far less sustainable than if interest rates are low and below the nominal rate of GDP growth. In this case, we would argue that the debt servicing costs, which is the cost that the governments actually have to pay. Right. Like that's what they have to pay. They don't really have to ever pay back debt. We've seen in Canada since Confederation, there have been very few times where the federal government has run surpluses and actually pay down debt. And you can go even further back. If you look in the history of a country like the U.K., governments just roll over debt at the sovereign level in particular. So the debt servicing cost is what matters. And if you look at debt servicing costs, they're obviously historically low and people will say, well, that's because interest rates are so low. Yes, that's true. But if we shocked some of this and we chalked it up to, let's say, four percent on the 10 year and let's say that happened over a five year period, you know, debt service costs would still be within the levels that we would say are sustainable, let's say now instead, interest rates rose to four percent tomorrow. That is, again, roughly double the Bank of Canada's neutral rate estimate. So it would be very high in the current context of the economy. Again, there is some breathing room there. There would need to be an adjustment, but there is some breathing room overall. What happened during covid? In terms of that one time or maybe two year string of very large deficits should be thought of more like World War One, the Great Depression or World War Two, insofar as they were very large deficit, but they are short lived. After covid-19 is behind us, a lot of the extra spending and the revenue shortfalls fade. The deficit shrinks back to one to two percent of GDP. That's fine. And debt servicing costs are very low. So there's no need to make a big fiscal adjustment here and raise taxes. Look, you talked a little bit about the issuance profile and what that means and the taper. Why don't you be a little bit more specific about what it means for your outlook for the curve?
Ian Pollick: One of the things that we were thinking about was, we wrote about it earlier in a piece called "RIP Steven, we hardly knew you. It was basically saying, listen, if you look at where a lot of these longer dated yields are in the forward curve, they're all coalescing around, over and above what we consider to be a neutral rate in Canada, which I think the Bank Canada this week estimated to be 275 at the top level. So when you think about how curves typically respond coming out of an easing cycle, they reach their peak steepness about 12 months after the fact after the last cut. We're well past that right now and we believe that the curve is heading flatter. You have to look at every input in isolation then will marry them together. So the budget and the issuance profile is unequivocally a step here. Just given that you have a very large amount of supply growing in the long into the curve, then you have to look at it within the context of the taper. Now, the taper in of itself, if it's broadly distributed in such a way that mimics the current composition of purchases, then that too actually is also a steepner. But when I think about some of the governing forces that will restrict a steeper curve in Canada, to me it's that you are getting to a very lofty level and what the market's expectation is for where the Bank of Canada overnight rate will eventually end up. So what I mean by that is when you look at the Bank Canada meeting this week, part of their inputs into their base case are that you have a nominal neutral rate. I believe the range is seventy five to 275. Right now. We're pricing in at the limit an overnight rate of 240 and have a couple of issues with that. My first issue with it is that you have to go back really to the mid 1990s to find any hiking cycle that had a higher overnight rate than the one before it. Number two is that when you think about what's wrong or what's restricting in Canada is that you have this terminal level that seems to be relatively high compared to prior cycles, 75 basis points above where we ended up in twenty eighteen. But also you have a pace, i.e. when does lift-offs start and when do you have subsequent hikes. That's getting close to its limitations too. So I think about the repricing that has to happen in Canada. It's almost like there needs to be a reallocation of the pace of hikes, which to me puts a lot of upward pressure on the two year sector, the three year sector notwithstanding, that supply is falling in that area. I think that the hawkish message coming from the bank supports a flatter curve in twos fives, twos tens, a steeper curve in fives 20s and 10 30s. Now, what I'm interested to hear your thoughts about are because I can see you rolling your eyes right now is what I'm talking about, the terminal rate. Do you believe that we have to see an overnight rate reach a level that is lower than the cycle before, which in this case is one seventy five?
Royce Mendes: Look, I think that's generally a good rule of thumb, but in this case, I think it's misleading because we're not starting this recovery in the same way we've started past recoveries. We're starting with a boatload of cash in the bank accounts of Canadians and a boatload of cash in the bank accounts of Americans. So you have to ask yourself, what will that do to the trajectory of interest rates, the interest rates needed to reach equilibrium between, of course, savings and investment? That's the way you sort of come up with a neutral rate. Right. The way the Bank of Canada looks at it is that they look at the long term neutral rate, and that is, after all of these headwinds and tailwinds have passed. And sure, that may be true in 30 years, that this extra savings that we've built off might have been spent or whatever. But in the next cycle, this amount of savings that is sitting in bank account is going to matter. It could mean that in the near term, people just go out and spend like crazy. That would mean that obviously near-term inflation is going to rise. That could unanchor inflation expectations. That's one path it's probably unlikely. More likely path could be that simply over the next ten years, households that have a large stock of savings don't build up as much savings every month as they would have pre pandemic. So the savings rate is lower and the likelihood to spend income is higher. That means you need a higher neutral rate to keep everything in equilibrium. So that's why I'm not going to push back maybe as hard as you are on the pricing in the market of the terminal rate, because I think this cycle could be different. And we're going to publish some research on this, hopefully next week to give you a little bit more detail. But that's the way we're sort of thinking about. There are different paths, very uncertain which path the economy actually takes, but it's too easy a task to say that, yes, once all of the headwinds and tailwinds have dissipated, this is what the neutral rate is. That's not really helpful in the coming 10 years because the headwinds and tailwinds have not passed.
Ian Pollick: So where I would disagree a little bit with you here, and I see your point, and I think we're going to coalesce around something that's relatively in line with one another. But, you know, use the word boatload a lot. And I would argue that there's a boatload of debt and Canadian economy. And if you remember when I originally joined CIBC and we were in the middle of or at the start of the hiking cycle in twenty seventeen, we came up with a chart that basically said a rate hike in twenty seventeen is much more impactful than a rate hike in twenty ten. And I would argue that given the starting point of leverage in the system, it's incrementally harder to generate a higher level of terminal because each hike is more impactful than it was even three years ago.
Royce Mendes: Look, when I look at household debt ratios, they're actually not that different than prepend. You're thinking of debt in terms of mortgage debt. And yes, a lot of mortgage debt has been taken out over the past 12 months. But there's also been a lot of consumer credit. So credit cards, lines of credit loans that have been paid down during the pandemic. So there's a little bit of an offset there. So the starting point on debt is not all that different, but the starting point on savings for households is very different. And what that fuels in the future, does it fuel a big wave in spending in the near term? Does it feel a little bit less savings over the long term or do people just park it and leave it there
Ian Pollick: And save it there, which puts downward pressure on our star
Royce Mendes: The Bank of Canada's expectation is that people just leave it there, move back to their pre pandemic demand for savings each month. And that doesn't affect anything in terms of the equilibrium interest rate that's required. I'm not sure that's right. I'm not saying it's wrong. I'm saying that's one scenario and I'm not sure that their expectation is most likely scenario.
Ian Pollick: The last thing I want to talk about very quickly is when you think about a small open economy and you think about calibrating a real neutral rate. One of the things we've often talked about is that in a country like Canada, it's hard to have our star without FX star. So when we look at the NPR yesterday, there is not a lot of mention of the Canadian dollar strength that sounded too concerning. And you actually found something that was super interesting. You want to talk to us quickly about that?
Royce Mendes: Yes. So the bank said that the increase in demand from foreigners, specifically the US, I think they were talking about, will far, far outweigh the restraint on exports from the higher or stronger Canadian dollar. And that, to me, sort of confirms what you and I have discussed on this podcast before, which is that in the near term, it's going to be very difficult for the Bank of Canada to figure out how much of a headwind the strong Canadian dollar is to non energy exports, because there's going to be so much of a rebound and a recovery over the next few years just from getting back to prepandemic levels of activity or even moving past prepandepic levels of activity. Because the US, for example, is enacting a lot of fiscal stimulus or something like that, which is going to spill over into Canada through exports. The question is, and I think the way you might be able to figure out if the Canadian dollar is weighing on non energy exports is through the market share. Are we losing market share in the US to other countries,
Ian Pollick: Which we have been for a long time,
Royce Mendes: Which we have been exactly. Now, that might be the way you see it happen. Is the Bank of Canada willing to delay a hike based solely on that or to space out their hikes based solely on that, or to go slower based solely on that? I don't know.
Ian Pollick: And just to remind everyone, I think what Royce is actually trying to say in English is that in this recovery, you have less reliance on external demand because of all the pent up potential savings that needs to be consumed. So there's more of a domestic led recovery. Is that in effect what you are saying?
Royce Mendes: No, that's absolutely not what I'm saying. I'm saying I'm saying that, yes, one separate factor in this recovery is that domestic demand will be very strong. Another separate factor will be that exports will be strong overall because countries are rebounding and that's going to show up in export growth. It will not show up. It will outweigh the Bank of Canada is saying any sort of headwind from the strong Canadian dollar. That's what I'm trying to say. Is that better?
Ian Pollick: What I'm trying to say is I think so. But I'm also getting to the point where I need to stop this because we've been so cordial and polite to one another that I can see this going downhill very quickly. Royce, it's good to see you. I want to speak to you next week to all of our listeners. We hope you're well. And remember, there are no bonds harmed in the making of this podcast.
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