Royce and Ian take the pulse of the reflation trade. Ian discusses the reasons that some investors are calling the trade dead. Royce talks about why the base case economic outlook remains bright for North America, despite some downside risks that are on the rise. They close the podcast by discussing the expected path for the Bank of Canada’s balance sheet.
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Royce Mendes: Ok, you sound like a reporter when they say one question and one follow up. And you ask four questions. (laughs) Ok, let me unpack one by one.
Ian Pollick: Hey everybody and welcome back to another episode of Curve Your Enthusiasm. Royce, how are you?
Royce Mendes: I'm doing wonderful. Happy to be here with you.
Ian Pollick: I am very happy that you're happy to be here with me. Listen, before we start today, I just want to give a quick shout out to some members of the CIBC FX Strategy team, in particular our members in FX Research team, Jeremy Stretch and Luis Hurtado did an amazing job in the Q2 Bloomberg FX Forecast Rankings. CIBC was ranked number one most accurate forecaster for the Swedish kronor, the number one most accurate forecaster for the Colombian peso. The number two most accurate forecaster for the Mexican peso, the number two most accurate forecaster for the Swiss franc, and the fourth most accurate forecaster for the euro. Good job, guys. Really proud of you.
Royce Mendes: Great job, guys.
Ian Pollick: Royce, it's been a busy week. What's on your mind?
Royce Mendes: It has been a busy week. Let's talk reflation. What's going on? What's the market thinking here? And why does it seem like to my eye, the reflation trade is dead in some investors' minds?
Ian Pollick: So let's talk about that, because you're absolutely right. I've been talking about that with clients literally every single day this week. And it's similar to what you and I talked about a few episodes ago, which is, you know, if you're going to tell me that inflation is transitory, I need you to define the word transitory for me. When I think about it, I think there's three iterations or three understandings of what a reflation trade is. And the first one is, it's a trade based on the idea that inflation is going to heat up and stay hot because the central bank fails to respond with tightening policy rates. That would be a bear steepener. The second iteration that I think is most common is this understanding that it's a trade based on the idea that inflation's going to heat up and stay hot, even with the central bank trying to fend it off with higher policy rates. So that's a bit more ambiguous for the shape of the curve. I think it's more of a parallel move. And the third iteration of what I've largely heard reflation trades to be is a trade based on the idea that inflation will be correctly seen as a threat by the central bank, which will eventually hike rates to sufficiently tamp it down. And that would generally be a bear flattener early on in the cycle, because as inflation moves up, even if it's only going from, say, 0 to 2%, expectations for real rates move higher and then it eventually becomes a bull flattener when you're at the tail end of the cycle. If you looked at what's happened over the past week, obviously we had a relatively large rally that was not expected by many, myself included and the curve bull flattened. So you could make the argument that the market had been removing that first iteration of the reflation trade. But I stand by this notion, and I don't know what you would say, but I really think when I think about reflation, it's that third idea. It's this that central banks recognize it's a threat. They are talking about it. They will slowly start to raise rates. Because let's be very clear, inflation hasn't gone away in the past week. I don't really know where this narrative has come from. So I think it's a lot of fake news.
Royce Mendes: I think you're right. Looking at the data, it's not clear that the economic data in North America is giving any signs that the economy is struggling to produce inflation. So I'm not sure where the trade comes from. Maybe it's from overseas where there's not as high rates of vaccination. Maybe it comes from a little bit of concerns, even in North America, where there are high rates of vaccination, that at some point in the future, the Delta variant may cause problems or some other variant might cause problems for the economy. But the current data that are rolling in look pretty good.
Ian Pollick: So talk to me about that. If I said to you Royce, does the data that we're seeing in the year near term, not like six months out, but say over the next month or two months, do your forecasts reinforce that reflation however you want to define it is here, or do you think that the data has rolled over sufficiently that we can say, well, we're not worried about this anymore?
Royce Mendes: Absolutely. Our forecasts would suggest that the reflation trade is still alive and well. We see the economy reopening further, gaining more in terms of some of the areas of the economy that were hardest hit during the worst of the pandemic, the non-essential services sectors, for whatever reason, the market is discounting that or looking past it. But the immediate future is still going to look good in terms of hiring, in terms of light at the end of the tunnel for businesses that have been punished over the past year or so. Past that, I think it's anyone's guess what the economy looks like in Q4 and into 2022. I think when we lay out these forecasts, you have to remember that we have to lay out a specific path. We can't say there's a 15% probability of this or there's a-
Ian Pollick: No, it's absolute. It's not relative.
Royce Mendes: Right? Yeah. We have one path and we choose it. We choose the most likely path and the most likely path is still that the economy continues to reopen and that it continues to recover ground that was lost during the pandemic. There is another option here. There is downside risk. Clearly, if we look at some of the emerging data on some of these variants, it is somewhat concerning. But on the flip side of that, you know, you talked about an option where maybe even as the central bank raises rates, there's still pressure from the economy pushing inflation higher, and I'm sympathetic to that because of all the money that's already in the system, if you look at the future trajectory of fiscal policy, yes, there's going to be less government spending in the months ahead than there were in the months behind. But in the money that was sent to households and businesses in the previous months has not been spent yet. So it doesn't need to have a whole boatload of fiscal stimulus coming down the pike to boost the economy. It just has to be that those businesses and households have the opportunity to spend that money. So I'm still confident that there is support there to push the economy forward and nudge it forward. And of course, interest rates are still at rock bottom levels.
Ian Pollick: Yeah, I would agree. And let me just ask you a question. Let's spin this a little bit, because there's obviously some narrative in the market that is the opposite of the reflation is dead view, which is a view that we don't subscribe to. What is the likelihood or the probability in your mind that, you know, reflation or the death of reflation isn't really the topic? It's stagflation. What are the ingredients that need to happen to put us in a situation where that becomes reality?
Royce Mendes: Yeah, it's a very specific scenario when you start talking about stagflation, the ingredients that have to be there to get that outcome. It's low growth, weak growth alongside high inflation. So maybe we get past this big boom in economic activity that is stemming from reopening and we enter a period of low growth. But for one reason or another, inflation is still high. I think the reason you're seeing that is that at the moment, you know, if we looked at, you know, early this year, we've seen lower levels of economic activity than pre pandemic, but high levels of inflation. That is sort of a temporary phenomenon, in my opinion. When we look at it, it's driven by base effects, supply chain shortages, booms in spending on services from consumers who have gone without some of these services for a long time and they're indulging a little bit. That's not really, you know, persistent. What you need to get to get that persistent inflation is to really push inflation expectations higher. And if I look at inflation expectations in the market or if I look at inflation expectations in some surveys, they're certainly off their peaks recently. So I don't really think that that is a very likely outcome of the pandemic. But this is an unprecedented time and something we'll be monitoring.
Ian Pollick: Absolutely. So let me ask you a follow up to that, Royce. What would need to happen in the counterfactual where you had demand that had to be strong enough to keep pushing up these price pressures?
Royce Mendes: So one word: opportunity, the opportunity to spend is what matters here. If the economies can reopen enough and people can go out and spend the money that they've saved over the past 15 months, 16 months, then you could see an environment where the economy is persistently pushing up against its ceiling for years and there's still more money to be spent. I don't think that's a near-term scenario, but we could be talking about this, something to keep in mind for the years ahead.
Ian Pollick: So here's the question. Sorry to interrupt you, buddy, but what is the central bank response in that world where you have weak GDP growth that is below trend, but you have persistent price pressures? What is the appropriate response?
Royce Mendes: So the appropriate response would be to move the policy rate higher than they believe the neutral rate is because for whatever reason, in this case, it is the spending of built up savings. There is extra demand in the economy that is pushing it above equilibrium. In that case, you would see central bank rates, policy rates being pushed above whatever their estimates of neutral is.
Ian Pollick: And so that's a situation where I think, I know you say this is maybe not a story for this cycle, but at least within the context of some of the conversations we've had about terminal rates, you have to think that's part of the reason we're seeing such elevated terminal rates in the G7 right now.
Royce Mendes: No, I do think that this is a conversation for this cycle. I just don't think it's a conversation maybe for today because the market is moving for whatever reason in the opposite direction.
Ian Pollick: For sure. And, you know, there's been a lot of asset classes that have been totally disconnected over the past few months. You know, for example, Canada's money market curve has been selling off as the bond curve basically everywhere in the world has been rallying. And we've got to a point last week where we were pricing in the first rate hike in March 2022, a little over three rate hikes for all of 2022. And this is at a time when the Canadian dollar is selling off and oil prices are ripping.
Royce Mendes: Yeah. So why don't you talk a little bit about that? I mean you're looking at oil prices and they're consistently rising. And I understand it's driven by supply and low inventories and only partially driven by demand. But you're not seeing the expected reaction in the Canadian dollar. You're also not seeing the expected reaction in breakevens. Is there any reason that you can see for that?
Ian Pollick: Yeah, let's take them in turn. I think if you start with the Canadian dollar, there's really three things to remember. The first one is, is that just like most currencies correlations, the correlation between the Canadian dollar and oil is not stationary. It does change over time. And starting points obviously matter quite a bit. The second thing I think is that when you think about correlations, it's not to the absolute level of oil that matters. It's the Canadian dollar's sensitivity to oil is largely facilitated through the correlation to oil volatility. And in a trading market, volatility just collapses. So I think that is another way to think about it. And then finally, we don't have today that you had the last time you saw these huge moves in oil prices was capital expenditure intentions for the oil sands. If there's not going to be a lot of investment in the energy sector in Canada, then it's not likely you get this big M&A transaction where there's a huge demand for dollars for example, Canadian dollars. So that's how I would think about why the Canadian dollar isn't performing as well, given the move in oil. When it comes to breakevens, it's obviously an interesting question and it's one where it's hard to look at the absolute level of breakevens relative to the absolute level of delivered inflation, because we know delivered inflation is somewhat transitory to the upside right now, i.e. over time we do see it decelerating back above target, but not hanging around that 4% level. When you look at breakevens, I think there's an important question here to kind of narrow down. And it's what part of the breakeven curve are you looking at? When I look at the very short end of the breakeven curve, you could argue that it should be the most sensitive to near-term inflationary spikes, whereas the back end of the curve should be a bit more sensitive to persistent energy price gains. If you just regress the level of either five year or 30 year Canadian breakevens the level of oil, since let's say 2016, so you kind of capture that low oil price environment, they're basically both about 10 basis points too cheap. I think the way that I look at it, though, is the shape of the breakeven curve is relatively inconsistent with the move we've seen in energy prices because that breakeven curve remains inverted. And I would think that in an environment where we are talking about somewhat persistent upside in energy prices, you should probably not have that inversion at all. The other thing, too, and we talked about this a couple of weeks ago Royce, is that what I think the Fed did, intentionally or unintentionally, is very much change the way that we trade this notion of reflation and when we see legitimate price appreciation in assets that we know will filter into CPI like energy prices, gasoline prices, that uncertainty no longer has to live at the very back end of the yield curve. So it's got migrated further up into the belly of the curve. But what it means, though, is that by definition, breakevens probably don't have to be so high in the shorter end. And that kind of reinforces this uninversion because it's real interest rates that have led this rally and I think it's real interest rates that will lead the sell off. Does that make sense?
Royce Mendes: Yeah, that does make sense. One last point on the reflation trade and looking at it in the context of longer term bond yields, Avery and I published a paper last week on the topic of the 10 year interest rate in the US. And looking at it in the context of output gaps, looking at it in the context of neutral rates, what we realized is that in this cycle we're going to close this output gap really quickly, a lot faster than we would have in previous cycles that were really driven by natural recessions. This was, I would say, a very unnatural recession. And this is a restarting of the economy, sort of turning the light switch back on and things are happening in the factory again. In this case, we could see that the general trend in most cycles is that as that output gap closes, the 10 years starts to rise towards the neutral rate of interest. And if I'm thinking about the economy more broadly, I'm taking a step back and thinking about the long term potential of the economy or the long term neutral rate in Canada and the US. I would say that those rates, if anything, have been very stable, they haven't fallen. We're seeing actually less scarring after this recession than many had expected early on in the pandemic. And so those are still around 2.5% for the neutral rate in each country. And if we're looking at the 10 year, what are we hovering around, one thirty today in the US? There's a lot of room there to sell off to get back to that neutral rate. And this is sort of an economist way of thinking about interest rates and output gaps and neutral rates, but wondering if you agree with that?
Ian Pollick: Well, I think it's really interesting because one of the things that you and I talked about when you were writing the paper was there was a period of time in the early 2000s where even during easing cycles, policy was probably still too tight because your neutral rate was falling faster than policy adjustments, and that created a very weird situation for nominal rates because they were kind of the back of the roller coaster. So the roller coaster goes over the hump and they're the last one to feel and they get dragged down very, very quickly. So I generally agree with you, but-
Royce Mendes: Delayed.
Ian Pollick: But delayed. Exactly. So it's like rates are cut, neutral rates are falling. You're at the back of the coaster and then all of a sudden, boom, you feel the air in your stomach. But it happens after the front of the coaster has already reached the trough. So Royce, one of the things I wanted to ask you was that in the research that you did, did you ever look at the time it took, if at all, for policy rates to converge to the estimated level of neutral at that time? Does it happen?
Royce Mendes: Actually, there's not a standard path. Yes, the policy rates that we looked at, which were the Fed funds effective rate in the US did converge towards the estimates of the neutral rate, but over varied time horizons. After the 1991 and the early 2000s recession, took about five years to get back to neutral for the actual policy rate. After the global financial crisis, of course, it took almost 10 years to get back. So you can see the differences in recessions. It matters about how deep the recession was, how much scarring was going on. And this recession was very deep, but of course, not a lot of scarring from that depth. A lot of the activity could and can be restarted once virus cases are low enough and people are comfortable going out and doing things. So it's possible that you rise up to the neutral rate much faster in this cycle than you did certainly in the last cycle. Now, I want to switch gears here and talk a little bit more about the Bank of Canada. I want to nail down what you think the plans for tapering are for the rest of this year of asset purchases. And then what you think about the balance sheet heading into 2022 and maybe even if you have something to say about 2023.
Ian Pollick: For sure. So we've been saying it for a while. And we think that the Bank of Canada will taper their government bond purchase program again this week on Wednesday. We think that the pace of purchases is going to go from three billion a week to two billion a week. In terms of how that's going to be conducted, very similar to what we saw in April. It's almost a pro pro-rata move, a status quo move, a one size fits all move. So we wrote a paper about it that we released this morning, just talking about the new sizing. And it's just proportional to the decline that we saw the last iteration of the taper. Over the balance of the year, we look for another taper to happen in October again for another billion. And that will leave the active purchase run rate at about a billion per week. And that billion per week is really important because if I were to draw out for you the maturity distributions of the Bank of Canada's balance sheet, say, over the next two years and just average up what it amounts to every week, it's more or less about a billion a week. And if you remember what Deputy Governor Gravelle told us, he said the bank from a sequencing perspective would start to reduce its active purchases, get to a point where your net purchases are neutral to the size of the balance sheet. That's just another way to say that they're going to get to a number that just completely offsets the maturities. So that's going to happen, we believe, in October. In effect, that is the de facto start of the reinvestment phase. I'm sure it'll take on a little bit of a different twist as you get into 2022, i.e. maybe at some point they just stop altogether telling us about the active purchases. They may just use the allocation from their auctions, because remember they buy 13% of every auction. They may just use that because that actually could be enough to completely offset the balance sheet. And I think that would be enough until the balance sheet moves back into a situation where historically its growth was liability led, i.e. as currency and circulation grew, so did the balance sheet. But you're in a situation now where there's just so much cash, I don't think that's going to happen until 23.
Royce Mendes: So talk to me about the assets that were purchased under other programs other than the QE program. And then also talk to me about what you think about the potential for selling off assets, whether it be from the QE program or other programs or what you think of just letting them roll off eventually. Or as you said, maybe it just happens organically, that the economy grows enough so the balance sheet no longer looks so large.
Ian Pollick: Yeah, I mean, the latter point you made is probably what the end goal here is, is over time you can kind of grow your way out of it as the economy opens up. And over the course of the cycle, you end up with this currency circulation that starts to offset how lopsided it is and not really reallows them to sterilize their purchases if they ever wanted to. But in terms of the other assets on the balance sheet, remember that a lot of the response early on in the crisis was to target short dated assets and a lot of those assets have written off. What's really left is you have a little bit of commercial paper, you have a little bit of Treasury bills, you have obviously a lot of Government of Canada bonds, you have about 18 billion worth of provincial bonds. But what was interesting is last week I wrote a paper on this because for the first time the Bank of Canada, so to speak, opened the door for us to see the transaction level data for a lot of these facilities that we had never seen before. And what we found in particular for the provincial purchase program is that 50% of that 18 billion was actually securities that were between zero to three years. So, you know, over this normalization cycle, you get this organic shrinking of the balance sheet as a lot of these assets will just organically return. I think that obviates the need for active quantitative tightening, which is something I don't know if the Bank of Canada has ever really talked about. Remember, the Fed is starting their own, I guess, quantitative tightening next week with the active selling of their corporate bond holdings and their ETFs. I don't think that the bank would want to necessarily do that. We're a much smaller market. And particularly on some of the more liquid names that they bought on the credit program. But I think that the terminal kind of balance sheet level around three hundred, three hundred twenty five billion is probably something we should target over the cycle. Now, you know, obviously, we talked about the market aspect of the bank's decision this week, but there's a few other things happening. It's Monetary Policy Report. So let me ask you this. In terms of the forecasts, what gets upgraded, what gets downgraded? We're going to see Q3 for the very first time. And do you think that there's any risk in this statement that the calendar based guidance where the output gap closes in the second half of next year gets brought forward to the first half of twenty two?
Royce Mendes: Ok, you sound like a reporter when they say one question and one follow up. And you ask four questions. (laughs) OK, let me unpack one by one. So for the Monetary Policy Report in the statement, I think there's reason to see some upgraded language. The jobs report last week was great, at least from the headline reading for employment. Not so great on hours worked, but still showing progress on those sectors that were hardest hit by the pandemic and should be responding to the reopening. We saw some good news on oil prices with regards to the Canadian economy and the Business Outlook Survey, the Consumer Survey were both optimistic. I think they will include some language to say that the outlook is progressing as expected. Good things are happening because good things are happening with the pandemic and vaccination rates. However, I'm not sure it'll be enough to actually pull forward the timing of the output gap closing from the second half of next year. I think they were vague in that statement. They say that that's when they'll hold rates at the effective lower bound until. But they didn't say that that means that they're going to raise rates as soon as that period is achieved. Looking at some of the risks around the scenario, which we talked about, particularly about these variants and what they mean for economic activity this fall and winter, I think there's enough uncertainty for them to be cautious. Looking at the numerical forecast that they made in the April NPR, we've talked about this before. They were very optimistic. They are looking for 6.5% growth this year. I don't think they need to change that. I don't think they need to upgrade that. Things are coming in roughly in line with what they expect. Where they'll need to change some of their forecasts is on inflation. Of course, they weren't forecasting the types of inflation rates we're seeing at the moment. And I think they'll have to upgrade them just to mark to market. But also in light of some of the supply chain bottlenecks, some of the labour shortages that at least anecdotally we're hearing about at the moment, there's reason for them to show a slightly faster pace of inflation for this year. But with inflation falling back down towards the 2% level next year, which will indicate that these are transitory issues. So nothing really to worry about. I think for the Bank of Canada right now, they don't want to make any quick moves in one direction or the other. There's enough uncertainty still out there that they would like to be as steady at this meeting as possible and just sort of fly under the radar.
Ian Pollick: Well, listen, it's going to be an exciting week. And what we've seen recently in Canada is expect the unexpected. We hope you enjoyed the episode. And remember, there were no bonds harmed in the making of this podcast.
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