Royce and Ian dissect the recent US Federal Reserve meeting, calling it a reality check for the central bank. Royce talks about why the hawkish move makes Bank of Canada Governor Tiff Macklem’s life a lot easier. Ian then analyses the market reaction and how trading reflation has changed post-meeting. Royce and Ian debate transitory versus persistent inflationary pressures and talk about how that will affect fixed income pricing. Ian also convinces Royce to roll over their friendly wager on economic data.
Disclaimer: The materials disclosed on this podcast are deemed to be sales desk literature and subject to our client communication policy and code of conduct as well as IIROC rules.
Ian Pollick: Literally my entire life I thought it was cheese. And I had it the other night and I was expecting the cheese and I got this bowl of green vegetables and I was like, well, my belief system is just cracking. Hey, everybody, and welcome back to another episode of Curve. Royce, how are you Bud?
Royce Mendes: Good. How are you?
Ian Pollick: Pretty good, man. Listen, I lost the bet.
Royce Mendes: You did. So Im feeling extra good today.
Ian Pollick: But let me ask you this. Does this mean that we can't roll that over into something else, like I know now we're flat, but can we keep this going? I kind of really want you to come do a Crocodile Mile.
Royce Mendes: I'm sure I'll think about it.
Ian Pollick: Ok, so we have a lot to talk about. Obviously, the starting point is going to be the FOMC last week, largely in line with what you had expected, a bit more in terms of two dots coalescing around that Twenty twenty three lift off. We had seven members of the committee fall into the twenty twenty two time line. That was actually really good for our excessively hawkish call. You know, I was feeling a bit uncomfortable, to be honest with you, prior to it. So talk me through this. Right, because we are hawkish on our view of the Fed. What do you think the Fed told us? Does it change your mind or the Bank of Canada? Let's dissect this.
Royce Mendes: So this was really a reality check. The Fed needed a reality check forecasting that rates were going to remain on hold up until twenty twenty four was just unrealistic at this point, given how the economy has responded as covid has faded, particularly in the US. So it was a little bit more hawkish than we had anticipated that meeting would be. It's sort of the way that we expected things to move. And as you mentioned, we still expect the Fed to pull forward their first rate hike even further into twenty, twenty two, and it wouldn't actually take that many more members of the committee to do so. In terms of what it means for the Bank of Canada, I think it certainly makes Tiff Macklem's life a whole lot easier. When there was such a stark divergence in between the two central banks, we had seen the currency trending stronger, consistently trending stronger and towards levels that were getting uncomfortable. You could see the bank didn't want to say anything about it, but reporters kept asking about it. And now this takes some of the heat off. It certainly makes the Tiff Macklem life a little bit easier in the short term, but also maybe in the medium term, because we also talked about how if there was such a clear divergence between flexible average inflation targeting and what the Bank of Canada does, well, then would that mean that the Bank of Canada was just going to be viewed as structurally more hawkish than the Fed, which would have implications for the currency? It seems like, again, there's not that much difference as we had expected and the Fed did blink and pulled forward the pace of rate hikes. But interestingly, I think something we didn't forecast was sort of the market fallout. Maybe you want to go through what's going on there.
Ian Pollick: You know, I don't know if I would call it fallout per se. Listen, I think that largely I do agree with everything you just said. And the thing to remember is when you pivot from one policy stance to another, whether it's accommodative to restrictive or vice versa, it's a process. And I think what the Fed did was provide a first step in that process. So it's a good thing. And, you know, for the market initially, obviously, you kind of got that very large flattening of the yield curve because people start to reprice that five year sector. That makes a ton of sense. It's a very conventional response not going to happen over the latter part of last week. And then what you saw, you know, over the course this week is that yields were rallying. Initially, the curve move was initially unwound. The question is, why is all this happening?
Royce Mendes: Yeah, particularly, I guess the question is what's going on in the long end.
Ian Pollick: Yes. So, you know, I think that it's just this idea that when I think about what the Fed really did, other than the superficial understanding that, yes, they move the dots, I think in essence they have just removed or reallocated the way that we trade reflation. When you think about how reflation has been traded over the past year, really since the Fed start talking about this high pressure outcome, all this economic uncertainty and inflation uncertainty has lived in the very back into the yield curve. And that's because central bankers have told us, you know, rates aren't moving any time soon. But if you're now telling us that you may be moving a bit earlier and the pace may be a bit faster, then you can truncate that uncertainty in inflation closer to the short end of the curve.
Royce Mendes: Yeah, and a lot of the realized inflation is going to show up in the short term or medium term.
Ian Pollick: Exactly. Exactly. And I think what ends up happening is two things. Number one is you reallocate how you trade reflation. So it just means the curve should be biased, flatter or said differently. It shouldn't actually be a steeper anymore. And number two is that when you think about the role that breakevens have played in absorbing a lot of this, AIT premia, average inflation targeting premium, I think that's largely going away. And I think real interest rates are now in charge and that has obvious implications for the dollar. And that leads back to what it means for Canada, which from the currency perspective, this is what the bank had been waiting for. They needed some convergence to allow the Canadian dollar to reach some type of velocity.
Royce Mendes: And I'll add a point on the short term and maybe medium term prospects for inflation. I'm going to be publishing a paper on Monday on how transitory these transitory factors are. Obviously, by definition, base effect: Clearly transitory. Dairy supply chain disruptions: clearly transitory, surging demand upon reopening: also clearly transitory, but the latter two, it's unclear how long they last. And if they last long enough, they'll overlap with the persistent inflationary pressures coming from a fully healed economy and stronger wage pressures. And I actually think and you can see in the research that comes out on Monday that that's exactly what's going to happen, is that these transitory pressures are not going to fade fast enough that you see a lull in between the transitory and the more persistent inflationary pressures. There's just going to overlap. And that's why I can see that at least short and medium term inflation expectations are the ones that will be most supported here. And you're right, the more hawkish outlook from the Fed now removes some of the risk to the long and inflation expectations in the long end.
Ian Pollick: But I also think what it did is really important is that all of sudden it made the Bank of Canada look a bit less hawkish on an absolute basis because, you know, looking inwardly from abroad, you say, well, why is Canada priced this way? Why is the bank talking like this? And you and I have..
Royce Mendes: Well, how many how many questions have we have we gotten on that?
Ian Pollick: Well, for sure! And like you and I have gone on this campaign telling people that, yes, maybe the Bank of Canada's rate path being priced by the market looks a bit wrong, but the Fed looks even worse. And it's validation, really. And I think what this means is that there is a lot of trades in Canada that try to take advantage of the fact that the Bank of Canada pricing looks so odd. And what we've seen subsequently to the meeting last week is that a lot of these trades have been unwound. And that's actually amplified what the pace looks like, to the point where, you know, if you look at our money market futures, there's three rate hikes priced for twenty twenty two. Now, I don't believe that's going to happen. And I don't think a lot of the market participants believe that's going to happen. But it is a function of what happens when you have a concentrated time frame where trades are being removed in a market that has limited depth, that's being driven by larger moves in the US. So I don't expect that pricing to go away. But, you know, if you are sitting in Ottawa right now, you're at the Bank of Canada, you're looking at what just happened. Do you feel emboldened to continue on with your messaging or do you have to dial it down a bit and make a bit more neutral so that you're more aligned now?
Royce Mendes: Well, I think they're going to have to acknowledge that the second quarter seems very likely to come in below their forecasts. And, yes, in our forecasts and probably their updated forecast, they can build in some more growth for the second half of the year. But those are forecasts, right? This is real data rolling in on the second quarter that is worse than they anticipated. So it's going to be hard for them to become more hawkish. But I would say they can hold the line here.
Ian Pollick: Hold the line!
Royce Mendes: They are well positioned to continue the messaging, to continue on autopilot for tapering of asset purchases and to continue suggesting that the second half of next year is when you should expect to see the Bank of Canada's policy rate target nudged higher.
Ian Pollick: I think it's a good point. Right. So what you think if I'm just going to reiterate this in simple language, is that a BY-PRODUCT of the Fed meeting last week allows maintenance of what the hawkish narrative already was for the bank. And, you know, when we think about the Q2 profile, correct me if I'm wrong, but let's have context for our listeners. The Bank of Canada was looking for, I believe three and a half percent growth in Q2 current tracking is coming in pretty meaningfully below that. It's very hard unless you get this just massively blockbuster June to start closing that gap. April data hasn't been great. The May Flash estimates pretty mixed, but I'd say skewed lower.
Royce Mendes: Yeah.
Ian Pollick: Is this going to be, because remember this is an NPR that we're coming into on the 14th of July. Does this mean that any Q2 weakness or marking to market gets offset by a very strong Q3?
Royce Mendes: I think in the forecast it does, and maybe even some is built into Q4. But again, like I said, those are forecasts versus the reality of the situation is that the second quarter is coming in weaker than they anticipated. And as we've seen in the US, that it doesn't just have to be concerns about whether demand returns as quickly. It can also be things like supply constraints. They can hold back GDP. You know, if I was sitting here and there were no supply constraints that we could see in the US, which is ahead of us in reopening, I would be tempted to nudge up the second half of the year even more for Canada just because of the progress on vaccinations. However, you know, these supply constraints are an important factor, not just in driving inflation. We know what it can do for inflation, but also in holding back real activity, because if there isn't enough supply, we're not going to be able to have that activity counted in GDP.
Ian Pollick: No, for sure. And we still expect to taper to happen at this meeting. I think that's broadly the outcome that we would expect given the maintenance of the line. And when you think about the path that you just talked about, we should be feeling relatively comfortable that the output gap closes again in the same time frame. So the calendar based adjustment is not risk, is that correct?
Royce Mendes: Yeah, that's right. I think that's fair. I even with a slightly weak. Q2, as I said, I think they'll nudge up subsequent quarters in terms of the level of activity to make up for that and still have the output gap closed in the second half of Q2. But, you know, one of the interesting things is what I talked about on the inflation front, there may be a little bit less need to make up for inflation because I think that some of the transitory factors will just hand off into the more persistent factors. So you're not going to have this severe undershoot of inflation for a long period of time heading into a closed output gap or a fully healthy economy both in Canada and the US. So I would argue that once you start hiking, I still think and I've mentioned this before for other reasons, but I still think that the pace of hiking could be faster than what the market anticipates.
Ian Pollick: Well, the market's anticipating a pretty brisk pace. So I don't know if I..
Royce Mendes: In Canada.
Ian Pollick: In Canada, so I don't know if I entirely agree with you there. But I think in the US, that's right, because there is a structural component of CPI. There's also this transitory one. And I think, I just want to finish the point, because it's so important for the market. It's this idea that we talked about this last week. What is your definition of transitory? If it's just deceleration, then yeah, sure, it is transitory, but if it's deceleration but persistent moderation above that two percent target, I think that argues in your favour of a more rapid pace.
Royce Mendes: Yeah, I guess I'm not even thinking about just the near term pace of rate hikes. I'm thinking about when we get towards neutral and and I don't know, correct me if I'm wrong, it still takes up until twenty twenty five or twenty twenty six to reach a terminal rate of about two percent in both countries. Is that right.
Ian Pollick: Listen, the process shifting around a little bit and we can argue that the swap curves all screwed up anyways. But yeah, I think that's probably correct. Basically you do not get a zero percent real rate until twenty twenty five. And that's too low in my opinion.
Royce Mendes: Yeah. First of all, it's too low of a terminal rate, but it's also probably taking a bit too long as well.
Ian Pollick: Yeah, for sure. And you know, I want to switch gears. I want to switch gears.
Royce Mendes: Yeah. Yeah. Let's completely switch gears and..
Ian Pollick: Let's go on the other side. There's been a lot of discussion about the Bank of Canada's renewal of its mandate later this year. There's a lot of speculation that, you know, their framework, which to date has allowed them to taper twice, they're going to taper a third time because of it. But there's been some speculation that the Bank Canada's mandate can shift to include, you know, an employment component. Can inflation specific mandate change for either price level target or something else? But, you know, Bill Dudley wrote a really interesting op ed the other day and he basically said, stop focussing on the framework, focus on how central banks actually target and conduct policy, which..
Royce Mendes: The implementation.
Ian Pollick: Implementation, which may not just be saying that I think the overnight rate should be X, let's rely on the levers and the short end of the curve to push and pull to get to that level because those levers are less effective today than they were before. And, you know, Dudley basically says, listen, stop targeting the Fed funds rate, start targeting interest on excess reserves, start targeting other short rates that you can actually arbitrage away, take reserves out of the LCR calculation.
Royce Mendes: You know, the interesting thing is this is not a new discussion. This has been a discussion since I was at the Bank of Canada, which was seven years ago. So this is not a new discussion.
Ian Pollick: Oh, really? I didn't know that.
Royce Mendes: Yeah, this is not a new discussion, it's a discussion that comes around every time the excess reserves balloon to new, incredibly large levels.
Ian Pollick: But let me ask you this. There's a lot of thought that goes into communicating inflation targets to the general public. I personally don't think that the general public needs to be as aware and versed in how the overnight target is set. Therefore, I would support a move to the more esoteric targeting of rates that most people have never heard of. Do you think that it would make a difference? Do you think it would be worse off? Would you agree generally with that line of thinking?
Royce Mendes: I'd agree generally from a macroeconomic point of view, it has very little difference.
Ian Pollick: Yeah. So, you know, in Canada, remember, you know, we think that the balance sheet can stay at very high levels for a very long period of time. There's a lot of cash in the system. So when you look at our own repo rates in Canada, it's not as disconnected as the US money market and the overnight target. But it is going to matter. And, you know, when you think back to your time at the Bank of Canada, this is something you think that we'll be talking about in twenty twenty one, or is this more of a twenty twenty two and beyond story?
Royce Mendes: Well, I mean, maybe you can talk about.. As you mentioned, it's not as much of an issue here in Canada. Right. So it could be something that we discuss if it starts to show up as impairing the functioning of money markets here in Canada. But at the moment, correct me if I'm wrong again, but that's not much of an issue.
Ian Pollick: I mean, yes and no, it depends what you want to define as a range. Our overnight rate that we should be talking about is CORA, which is the repo rate, and it has been pretty disconnected from the target rate. And that's because there's a lot of cash in the system and it's almost pushed it perpetually through. But as you know, we're of the opinion that we're about to head the other way. We think that the Repo rate can trade above the overnight rate as we get to the end of the year, and what that reflects is largely regulatory impacts. I think that OSFE will allow the banking system to redeploy capital through share buybacks, higher dividends, and that cash has to come from somewhere. And I think it comes from cash sitting at the bank. So you have this withdrawal of liquidity within the system that can push things higher. But also, if your growth forecast is accurate, then we're in a period where credit growth is going to increase, not from the household side, but on the business side. And as that occurs, I can see a situation developing where there's just generally more demand for funding.
Royce Mendes: Well, there you go. So I think both of us agree. The conclusion here is that the Fed has made their decision on their framework for monetary policy and they have to move ahead with it. Whether it's good, bad or ugly. They can now focus on some of these more technical aspects of implementing monetary policy in Canada. We have to pass the first hurdle first, which is figuring out what we want to do with the framework for monetary policy. I would argue that flexible inflation targeting, flexible average inflation targeting is not the way to go. We can see that it clearly causes market uncertainty. A dual mandate is not the way to go. How do we know what full employment is?
Ian Pollick: Like what is NERU in Canada? It seems the last person that tried to estimate it was actually Stephen Poloz in the early 90s.
Royce Mendes: No, but that's the issue, right? It's like you have to put a numerical number on NERU when it could be vastly wrong as the Fed figure it out in the last expansionary cycle or recovery from the financial crisis. Every time they put a number on NERU, it would fall much lower and there was no inflationary pressures.
Ian Pollick: And that led to the Phillips curve discussion, which also led them astray because you needed to have more employment relative to inflation that was produce. So you're right. It trips you up.
Royce Mendes: Exactly. It just adds confusion. The Bank of Canada has a clear two percent inflation target. We can measure inflation very simply and directly and implicitly it does target things like employment and overall economic activity because it's looking for a closed output gap. And I still think this framework, while it's been in place for a long time and is very simpler, much simpler than the US framework, it's a more efficient way of operating monetary policy.
Ian Pollick: So I'm a bit confused. I thought you started off saying this, that you don't like the flexible inflation targeting mandate, do you, or do not?
Royce Mendes: I don't think that it's helpful to flexible average inflation targeting mandate, which is not what we have in Canada exactly. We have a two percent target. The flexible average inflation targeting framework calls for some overshoot of some magnitude for some period of time, which the central bank in the US is not telling us what the time frame is for the overshoot, what the magnitude of the overshoot is. And that's why I think you've seen some extra volatility in markets around some of these decision days, because everyone's trying to calibrate their expectations for what the Federal Reserve's reaction function is. And I don't even think the Federal Reserve knows what the reaction function is.
Ian Pollick: No, and I think the the rapidity of the move and the reaction function is a bit scary. You know, it was just six weeks ago where Chairman Powell said, you know, we're not thinking about thinking about tapering. And then all of a sudden he said it's time to retire that phrase. Well, it's only been alive for two months, man. Yeah, no, listen, I generally agree. And I think what we're seeing in the United States and I'm putting out a piece next week that talks about this is if you were to just price or model a 10 year yield relative to an underlying reflationary basket of assets, whether it's copper gold ratio, whether it is select commodities, whether it is certain currencies that are used as funder's during periods of economic growth, what you find is that there's almost this persistent premium to actual interest rates relative to where they should be. And that's the average inflation targeting premia, which says that monetary policy is going to be delayed by X amount of years. You take that many years as a proportion of where they see their long term dot, and that's almost a perfect kind of misevaluation. Like right now, we calculate U.S. 10 year yields are about 40 basis points too low relative to our basket of reflation assets. Tells me they should be. And I think you may get a benefit of that initially, but over time, I think you're right. I think it complicates market messaging. And what it leads to is more variability, more volatility.
Royce Mendes: Well, uncertainty like that just means that the allocation of capital is less efficient.
Ian Pollick: It's inefficient, it's inefficient. I want to end here because it's been a pretty good run. You haven't annoyed me. I don't think I've enjoyed too much. You know, it's really interesting. If I asked you what is Swiss chard, what would you tell me it is?
Royce Mendes: It's like a green leaf or something.
Ian Pollick: Oh, you knew that.
Royce Mendes: Its like a leafy green.
Ian Pollick: You know, I thought my entire life I thought it was cheese.
Royce Mendes: Cheese, yea it sounds like cheese.
Ian Pollick: And I had it the other night and I was expecting cheese and I got this bowl of green vegetables. And I was like, well, my belief system is just cracking right now. Anyways, this was a good episode.
Royce Mendes: This is what you learnt during the reopening of the Canadian economy.
Ian Pollick: Exactly. This was a good episode..
Royce Mendes: Went out for dinner.
Ian Pollick: I hope everybody has..
Royce Mendes: Figured out that Swiss chard isn't cheese.
Ian Pollick: Yes, yes, yes. And it's not wine either. I hope everyone has a great weekend and remember, there are no bonds harmed in the making of this podcast.
Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s), except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.