Royce and Ian interpret the Governor of the Bank of Canada’s remarks on a host of vital issues, including a micro-cut, the effective lower bound for rates, the future of quantitative easing and the central bank’s inflation mandate. Royce also discusses the upgrades to the economic outlook in the latest Monetary Policy Report, and Ian breaks down some of the divergences seen in short-term Canadian rates.
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Ian Pollick: So do you peanut butter on the roof of your mouth? You know one of the things...
Royce Mendes: Can I try again?
Ian Pollick: Yes, you can try again.
Royce Mendes: Hawkish message.
Ian Pollick: Hawkish message. Hi everybody, and welcome to another edition of Curve Your Enthusiasm. Royce, last week, we talked about New Year's resolutions, and one of my New Year's resolutions was to be nicer to you. So I'm going to start off this episode by saying that you absolutely nailed the Bank of Canada call this week. In particular, it's interesting to me that when I look at the forecasts, I look at our own forecasts. You did a really good job, particularly with the scarring impact and the movement potential. So let's take a step back and, Royce, talk to me about the meeting itself, the communication, what the content was. What are your thoughts on it?
Royce Mendes: So a lot of crosscurrent here in a meeting that seemingly on the surface didn't provide any change in policy. We saw the Bank of Canada holding rates at twenty five basis points. But interestingly, the governor sort of alluded that if the governing council had thought that more stimulus was needed, a micro cut was actually amongst the things that the Bank of Canada could conduct. So that leaves us asking the question, is the effect of lower bound 25 basis points or is it lower? And I don't think we got a clear answer about that.
Ian Pollick: Ok, so I just wanted to interrupt you because I did find it a bit confusing because the opening part of the statement, I read it and I said, oh wow they reaffirmed that the EOB is 25. But then in the post presser, they did suggest that, like you said, one of the policy tools could be to lower the effective lower bounds.
Royce Mendes: It's a bit confusing, right. And it's confusing because when you think about the effect of lower bound, you think of it as a technical constraint and lowering rates as a policy choice. And the two are not the same. But in this case, I can sort of see what he's trying to get at. And this is from reading between the lines of the press conference. I believe what Governor Macklem is trying to say is that the effect of lower bound is not stationary. So under different market conditions, the effect of lower bound can be different levels. He said in March and April, when there was a lot of dysfunction in market, the effect of lower bound was probably about 25 basis points. They couldn't have pushed it any lower because it would have caused further dysfunction. Now, as markets have come down, he's saying that maybe there is scope to actually push rates a little bit lower. So I would think of this as an effective lower bound that is related in a countercyclical way to market functioning.
Ian Pollick: So that's an interesting way to put it. But one of the things that I want to delve a little bit deeper on is this notion of calibrating monetary policy within the context of what they said was a structurally weaker US dollar. And in the post meeting interview, which happened I think yesterday, one of the things that Governor Macklem said was that Canada may have to permanently live with somewhat looser policy. And you know I've talked about the fact that a small open economy, very hard to engineer in our star because you have a currency flow through impact to inflation. If we're permanently now in a situation where at the margin, the Canadian dollar is going to be somewhat stronger versus the US, our largest trading partner, does that just mean simply that regardless of where they think our star is, is that much harder to achieve that terminal level?
Royce Mendes: I think that's right. And I think you're sort of signaling that they're going to be as patient as possible in raising rates. But for the meantime, they decided that they didn't need to introduce any more stimulus right now, because as we've discussed on this podcast, the outlook for the next year and probably into 2022 is just heavily, heavily dependent on the rollout of the vaccines and how that affects the virus case numbers in Canada and around the world. Thereafter, I think you could start to see some more important effects from the current strength of the Canadian dollar. But over the near term, you know, you look at their forecasts and any weakness in exports that was stemming from the upgraded Canadian dollar forecast, which was included in the MPR, was completely offset, more than offset by the upgraded outlook because of more confidence in vaccinations. A little bit of a better handoff from the fourth quarter of last year. So at the moment, the Canadian dollar isn't what's going to be driving policy in the near term, I would argue.
Ian Pollick: But here's what's interesting, and there's two things I want to touch upon. The first one is one of the things I think you forgot to mention in regards to why they upgrade the forecasts so heavily was what we had talked about in, I think, two podcasts ago, which was that you were surprised the degree to which the Governing Council slashed their view of potential growth, which is another way to say that they had a more dire view of the permanent scarring effects of the recession. I know that you were pushing against that and you have to look for it in the footnotes. But it does say that there's a more upgraded view or an upgraded view on potential because the scarring effects aren't as big as they had originally assumed.
Royce Mendes: That's right, so they upgraded this potential growth rate, they didn't actually do it in the numbers that were presented in the tables. Those numbers are set out in ranges, but they alluded to it, as you said, in some of the notes and some of the text. And they did this because, number one, there were actually revisions to the capital stock. So that's just an input. We have also, since the October MPR had announcements from the federal government about higher immigration targets to make up for the lost ground during the pandemic. And, of course, as we've talked about from our point of view, there is going to be less scarring as a result of the pandemic than you would otherwise believe to be the case with a recession of this magnitude. And that's for a few reasons. It's because of the industry breakdown of which businesses have been hit the hardest. It's because of the fact that there has been so much government support this time, which was maybe not as evident post financial crisis in some countries. And we've also seen just the data from last summer. You saw how quickly businesses and jobs returned after the virus was more or less behind us. We had low virus case counts across the country and that has led to less insolvencies now less bankruptcies than maybe we would have expected, given just the size of the drop in activity. So it's very important now looking out into their forecast into 2022, that they're way more in line with the House view at CIBC, which is that the economy not only will grow faster than their October NPR forecast, but has room to grow before bumping up against that potential cap, which means that I don't think the timing of a rate hike has really changed, even though their outlook is more optimistic. And I did see in markets following the announcement that it seemed like a lot of investors were taking this as a very hawkish mess, hawkish meshage. I don't know if that's the way you interpreted it, though.
Ian Pollick: Sorry, do you have peanut butter on the roof of your mouth or something? One of the things...
Royce Mendes: Can I try again?
Ian Pollick: Yes, you can.
Royce Mendes: Hawkish message.
Ian Pollick: Hawkish meshage. Listen, before we talk about the market reaction, the last thing I just want to touch upon this, because we have a bit of momentum here I've never seen before. At the end of NPR, the Balance Risk section contains a statement on the Canadian dollar. So to me, it's interesting that they talked about the not meeting Canada problem with the strengthening currency, yet under risks to the outlook was a strengthening Canadian dollar. How are we supposed to think about that?
Royce Mendes: I think it's talking about Governor Macklem basically said it in the press conference, is that if you start to push it further than where it currently is, it'll start to weigh on the outlook through exports and inflation, such that that it may require a policy move to adjust the level of stimulus, to continue to expect that the output gap is closed in 2023. All that is to say is that if the Canadian dollar gets stronger, then let's say one twenty five on Canada on the bilateral exchange rate, they're going to have to reassess what that means for the Canadian economy's outlook. And it may require them to use one of those tools that they still have remaining in the toolbox.
Ian Pollick: Ok, cool. So listen, I think when we get back to the market reaction, I think the thing that initially started to propel rates higher and the currency to rally a full cent almost in a knee jerk fashion was a couple of things. The first one was the general tone was quite optimistic, particularly given what they were talking about, that they think containment measures, if they're lifted in February, leads to their base case, which is a relatively strong 2022. Governor Macklem to discuss the fact that he thinks that the momentum is quite strong over the second half of the year. But also they made a very small but impactful change to their forward looking discussion on quantitative easing in the last paragraph of the rate statement. And what they basically said was, to paraphrase they change it from just saying that the Governing Council would like to keep yields low across the curve by maintaining the level of purchases of four billion a week to something like will keep things going until the recovery is under way. Four billion a week sounds great. However, we have to think about conditions improving within the context of net purchases, and we'd have to adjust the QE programme accordingly. To me, that was very hawkish because it does imply implicitly that in the Bank of Canada's base case macro view, there is an attendant desire to lower the amount of stimulus coming from QE and that means a taper. And that's why when you saw the market reaction right away, we actually had a much steeper curve. So the 30 year part of our curve is what got unglued the fastest. So the curve stepped up pretty aggressively. But then as you start to read the document, you know, I have first had thought that what they were talking about was net supply is going to be a big driver of their discussion and their reaction function. Because remember, when you get to April, it's a new fiscal year. The deficit is smaller maturities or smaller. Non budgetary items are somewhat smaller and that necessitates just lower bond issuance. So relative to the pace that they're going at, I thought that's what they were talking about. But, it wasn't until you kind of get into the meat of the MPR itself and you get to that second box and what it says is, listen, the balance sheet is shrinking by 40 percent over the next three months, which was very interesting in of itself because it almost fits perfectly with our base case that when these term repos mature, we don't think that banks roll them over. And it doesn't seem like the Bank of Canada does either, because they did talk about this one time drop in the balance sheet. But they also stress the fact that it's the stock purchases, not the pace of purchases that matter. So that net term actually is in discussion with as maturities continue, as a balance sheet shrinks. That's not to believe that stimulus from its overall perspective is any less. And that really makes me inclined to believe that our house view that you do get that taper in April is a good one. But the question I have for you is it's not necessarily clear to me that another tapering in April will be the exact same type of calibration that we saw in October, because remember, in October, they taper, but they extended the average maturity of their purchases. Is the taper that they're talking about doing whatever the next iteration is? Is that another calibration? Do you think? Or is that an outright taper?
Royce Mendes: I would agree with you that it doesn't seem like it's a calibration from the comments that it would come in the context of the economy evolving in the optimistic way that they laid out in the MPR. It suggests that it's going to just be an outright taper. How much of a taper? We don't know. But I think it's a key point here because it contrasts with happening in the US, right. Where basically I think you and I would agree that the QE programme is going to last at least until the end of this year. So I can see why the currency then was reacting to some of the statements, not so much about maybe the improved outlook. That's part of it. But to some of the technical language surrounding QE, net purchases, things like that.
Ian Pollick: Yeah, I fully agree with that interpretation. And one of the things that struck me, too, is that it took the bank. Usually if we go back to historical precedent, if there was a market move that was counter to what the bank was trying to message to the market, they would come and they would further discuss what they actually meant. But when we saw the post meeting interview, whether it was the Q&A following or what was the Bloomberg interview the following day, there didn't seem to be any deviation from the initial message.
Royce Mendes: That's right. So we have now a Bloomberg interview, which was subsequent to the governor's press conference, and the governor prepares for that press conference. He's got a list of questions that he's pretty sure the media is going to ask him right. And so he's got prepared remarks. These aren't just coming off of the top of his head. So he's thought about them and that's the way he's wanted to present the information. One aspect of what I was surprised that maybe was missing a little bit from the MPR and the announcement yesterday was that there was no real discussion about these dislocations in short term rates. And maybe you can lay out, first of all, what's happening. Explain it to us. But then also what you think the Bank of Canada could do to tie things back up again.
Ian Pollick: Sure. And listen, this is one of those things where it's a super micro development, but it has such big ramifications. And what we've been saying is that very short term interest rates have been so dislocated relative to the overnight rate that the concern was if they did cut interest rates, presumably Canada may have technically entered into a negative rate environment just given the preexisting starting point. And if you take a step back and say, well, what's happening, really? We want to talk about CORRA, which stands for the Canadian overnight repo rate average. And that's just the rate at which general collateral, whether it's Treasury bills or Governor of Canada bonds trades and the repo market between counterparties and nine times out of ten we don't really pay too much attention to it because historically any deviations that are seen in that market, meaning if repo rates trade above or below the overnight rate, the Bank of Canada has the ability to come in and push and pull that rate back to where they want it. The problem is that we are now in an environment where we're living with very large excess settlement balances, and that's really a function of quantitative easing. And that's just a really fancy way to say that as the bank kind of comes and purchases all these bonds, all that cash has to go somewhere and it's been building up, building up, building up in our payment system. And what it means to is that because the Bank of Canada has such a heavy footprint in the government of Canada, a bond market, a lot of the bonds that are trading between counterparty in the repo market are being transacted at rates that we call special. And those special rates simply mean that there's more demand and supply. And when someone has to go and grab those bonds or source them, it's done at a much more expensive level, depending on what side of the market you're on. And that's the proximate reason why CORRA's declining. But really what it is, is symptomatic of a much larger issue. And the issue itself is that, as I was just saying, you just have so much excess liquidity in the system because, you know, to do a counterfactual exercise, if we go back to late 2011, 2012, remember, that's when the US was downgraded. And that was also a time where we saw a huge amount of reserve diversification really benefit Canada. We had a huge amount of inflows into our market. That's when central banks really start to pay attention to our provincial market our CMB market. And a huge amount of bonds in the three to five year sector of the Canada market were purchased up. And we had this persistent specialness in the repo market that lasted almost two years. But during that time, we really didn't see CORRA deviate all that much from the target rate. And so that leads me to believe that a lot of people that may be pinning the dislocation on the amount of bonds that the bank owns are somewhat missing the point. And again, when you have so much excess liquidity, it is pushing down short rates because what you have is a misalignment of liquidity. There are some counter parties in the market that are benefiting from both quantitative easing, meaning that they can sell their bonds to the Bank of Canada, but also benefiting from the fact that they can deposit that cash at the Bank Canada too, where there's another subset of counterparty that can only benefit from asset sales. And what that means that you have a huge amount of cash in the system that tries to find a home and in trying to find a home, what we've seen is there's now a net scarcity of very high quality liquid assets like Treasury bills. And there's really only two ways that you could fix this. One way is that the Department of Finance, when they think about issuance plans for next fiscal year, they issue a tremendous amount more Treasury bills that would allow all this excess liquidity to find a home. And it doesn't have to be done such that it is putting downward pressure on the repo market. The second way they could do it is take a playbook from the Federal Reserve, which is to help control your overnight rate by introducing some type of reverse repo programme. What that really means is that the Bank of Canada, in theory, would extend out the amount of counterparties that they would do business with and they would give bonds to these counterparties to take cash from them, remove cash from the system and help to raise interest rates and thereby really trying to get a hold and start to maintain a bit more control on the short end. But what's very interesting is that when you think about it in theory, when you think about the collateral that a lot of financial institutions have pledged with the Bank of Canada for their term repos, for example, traditionally the reason that you tend to see balance sheet declines being associated with higher repo rates is because you're taking one high quality liquid asset that's declining, which is the central bank reserve, and you're swapping it for another high quality liquid asset that's increasing, which is a government bond. And that process is what ultimately forces repo rates to adjust as you convert one to the other. But in Canada's case, given that at the start of the crisis, we opened up collateral, which really was for highly illiquid assets, you now have this collateral transformation from high quality liquid assets to somewhat low quality liquid assets. And that, to me, isn't very clear that it's going to actually raise repo rates. So what we've seen in most of the markets that's going to work. I don't know that the natural progression of this balance sheet roll off is going to do anything to actually raise some of these short term interest rates.
Royce Mendes: Sorry, can you just repeat that last part again about the transformation, about moving from low quality liquid assets to higher quality liquid assets.
Ian Pollick: So, for example, when the Bank of Canada decided to do term repo operations with the financial system, one of the things they did was they reduce the quality of collateral allowed to be pledged for these repos. Right. And typically, we would think of, you know, securities, whether it's provincial or some US Treasuries or government of Canada bonds. But what they did was in certain instances, they started to allow covered bonds, own covered bonds, non mortgage loan portfolios. These are not securities. These are pools of loans. So what you're effectively doing is you are now taking a very high quality liquid asset, like a central bank reserve, and you're swapping it for a very low liquid asset, like a non mortgage loan portfolio. And that means that you're not actually providing more assets into the market when this balance sheet rolls off. In fact, you're doing the opposite.
Royce Mendes: It's interesting. Correct me if I'm wrong. This is very, very similar to what happened in the US in the aftermath of the financial crisis. And it was a few years after when some of these non eligible counterparty who trade in these short term markets were not eligible to come to the central bank and park their cash there. So we saw these rates fall below the target for the Fed funds rate and eventually they had to introduce a new facility.
Ian Pollick: No, absolutely. And I think for me, the time that I think of is in 2015, because, remember, that's when you start to have a lot of reserve start to roll off. And the question was, well, what is the was the threat level of reserves were part of the demand curve are we on? But at the same time, you had a huge reduction in Treasury bill issuance, and that's when you start to see very short term interest rates like interest on excess reserves diverge meaningfully enough so that the Fed had to step in, put repo rates to zero through the reverse repo facility. But also that's when they start to tweak their IOER. Now, that is something potentially the Bank of Canada could do. The problem is, is, you know, how much of a fixture is this type of policy narrative going to be going forward? If it's not going to be permanent? The bank may not want to enter that realm. And I mean, you tell me like we're in an environment now where we know what the policy response would look like in future crises. QE probably not going away permanently or absolutely any time soon, even if we do get reductions. Do you think that monetary policy in Canada shifted a little bit in terms of how it's conducted?
Royce Mendes: Well, it's so funny. I actually was just going to segway into discussing Governor Macklem comments on the inflation mandate review, and he's saying that, you know, the conditions are very different now than when inflation targeting was first introduced and the bank is more concerned about undershoot than an overshoot. You know, they think that these unconventional monetary tools that they have at their disposal can help, but it's far more likely in future crises that you're going to reach the effective lower bound and you're going to have to use these unconventional monetary tools. And we simply don't have a lot of experience with how effective they are. We don't have a long term history of the effectiveness of these tools. And I think he was saying that to maybe imply that the likelihood of adopting a new mandate, which could be average inflation targeting similar to the US, is more likely than maybe it was, let's say, a year or two ago. And he said that the announcement will come towards the end of this year and they're going to engage with the minister of finance in the second half. But, you know, there has been a lot of work going on. And I think the research also suggests that maybe the bank needs to reconsider its overall framework. I do think, though, let's say they don't. Let's say they continue with this current inflation targeting framework. We've discussed this on this programme a few times before. I believe that the Bank of Canada can use the one to three percent band and it's sort of risk management approach where they're more concerned about an undershoot than an overshoot to be a quote unquote pseudo inflation targeter. so they can let the economy run a little bit hot. And they're basically telling us that they're not going to hike rates until inflation is sustainably at two percent. Monetary policy works with a lag. It means that it's very likely that for a period of time, inflation is going to overshoot the target. I think what they need to do now is clarify for how long and in what magnitude they're willing to tolerate.
Ian Pollick: So just correct me if I'm wrong. We as a firm, our house view is that we do believe that the bank will move to average inflation targeting at the end of the year. Is that correct?
Royce Mendes: I think we're sort of inching in that direction. It's seeming more likely, especially with the latest comments, that they are going to be in a position to recommend average inflation targeting by the end of this year.
Ian Pollick: Well, you know, it's funny you say that because, you know, I tend to agree and it's something that I was struggling with to get on side, not just because I like to disagree with you, but fundamentally, we already operate in that environment. So what's the point of rubber stamping and saying that we're doing it anyways? I had a very astute client asked me quite recently, well, why would they do that? If they're already operationally conducting themselves as a average inflation targeting central bank, why mandate yourself to do to constrain yourself? And then I started thinking about a lot of the discussion around the Canadian dollar, the structural rigidities of a falling U.S. dollar and what that presents for the economy. Right now, markets are pricing the Bank of Canada to move first, and they are pricing the Bank of Canada to go further. And the most common reason is very simple and somewhat elegant by saying, listen, if you look at Canada versus the US, the Federal Reserve, we don't know what to look back window is, but they have an added constraint. And that constraint is they're not raising interest rates until inflation reaches some threshold over a certain period of time. The Bank of Canada does not have that same threshold. All they care about is sustainably reaching that inflation target. Therefore, by definition, they will be moving ahead of time. When you bring that back to the currency, I think over time on a cyclical basis, that could add more undue strain. So moving to that average inflation targeting mandate may help to alleviate that and somewhat short circuit that narrative in the market. Would you agree?
Royce Mendes: Right. And even in the near term, I would say just being more explicit about the fact that they are sort of pseudo average inflation targeting at the moment would help or they're going to try to do some make up strategy, would help the market digest that. Because, you know, you and I have been talking about it on this podcast for quite some time, that it seems like that's what they're doing. But we're still not seeing it priced into markets. I think the biggest benefit from being an average inflation targeter is not necessarily the inflation you generate...
Ian Pollick: It’s the room that you give yourself.
Royce Mendes: Right. Or even the nominal income that you generate. It's the room that you give yourself exactly right to cut rates in the future because you're able to take nominal rates to a higher level. It's that simple.
Ian Pollick: You know, it's really funny. I'm going to win this down. By the way, you know what's really funny? I was listening to our podcast the other day because while I like to listen to it once in a while and I didn't realise that you can actually play your podcast at double speed or half speed, and I played us at half speed. Dude, you sound amazing at half speed. If you have speed in real life, I think you'd be a superstar.
Royce Mendes: Is that a compliment or?
Ian Pollick: It's not. Thank you very much for taking the time in listening to us today. We'll be back next week. And remember, there are no bonds harmed in the making of his podcast.
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