Ian is joined by Andrew Grantham, and the duo begin the episode discussing the FOMC rate decision. Andrew lays out the logic behind his forecast for a July and September hike, while Ian walks through the implications for the Bank of Canada. Ian introduces his new bond forecasts and talks about why current market pricing for the Bank and the Fed looks so strange compared to prior cycles. Andrew talks about his economic outlook for 2024 and highlights the upcoming weighting changes for CPI next week.
Ian Pollick: Things are coming under control, seem to be reaccelerating again. What did you take out of the report?
Andrew Grantham: Yeah, just as you think you've pushed something else down, which is the core services, the other thing pops back up again, right?
Ian Pollick: Well it's like a balloon, right? You push one part of it in, it pops somewhere else.
Andrew Grantham: (laughs) Exactly. Yeah.
Ian Pollick: Mr. Grantham, how are you?
Andrew Grantham: I'm good. Thanks. How are you doing?
Ian Pollick: I'm good. We've a lot to talk about, so let's get into it. I think we should start with the FOMC yesterday. You know, we had expected no hike going into it. We did not get a hike. When I looked at the survey of economic projections, it was pretty hawkish. You know, you saw the median dot for 2023 rise, incorporating another 50 basis points of hikes. Unemployment rate fell, PCE went up. And so on the surface, it looked like they actually pulled off the hawkish hold. Then, as usual, the press conference happened and it was a little bit less, how we say, as hawkish as we had experienced earlier on. But I'm curious before we get into the nitty gritty of what he said, what your interpretation was of the set.
Andrew Grantham: A little more wishy washy, the conference. I mean, it was really kind of what we expected, which is a rare occurrence sometimes. But as you said, the hawkish hold, they couldn't really surprise the markets. There were so little priced in, so they couldn't really surprise with a rate hike. But, you know, those projections, 50 basis points more from where we are by the end of the year, I think is just a reminder to people that there is still some work to do on inflation. You know, their forecasts, they're basically telling us that they need to almost send the economy into a recession in order to get inflation more under control than it is currently, given their GDP and their unemployment forecasts, and that to do that, they might need another 50 basis points more in terms of hikes. The only thing that I always find weird with these things, if they're trying to get us into this higher for longer in terms of market pricing, there's still no change to the long run dot plot and fewer changes to 2024 and 25, so which suggests a steeper decline in rates when they do come down. So I thought that was a little bit weird, but for the here and now it's-
Ian Pollick: They did add 25 basis points to level of 24 and 25, right? And so they take it higher. So you maintain.
Andrew Grantham: They take it higher by 50, then they take the others higher by 25. It's a steeper.
Ian Pollick: Correct. So it's a little bit steeper. But you're right, that long run dot at 2.5%, you know the unicorn dot, to me, you know, it's a bit weird, right? Because that's kind of your implicit star. And so there's no situation that the Fed's painting to us that it's gone up or not. But let's just take a step back for a second, because, you know, when we saw the after the press conference, there was very little movement in the July meeting pricing. You kind of had 17 basis points priced. You know, when Powell was talking at the Post meeting presser, you know, he used the word skip, then said he wasn't pausing. And so it's a bit confusing from the market's perspective. So do you have any concerns about the July call right now?
Andrew Grantham: But then he said July was live as well, right, so-
Ian Pollick: Just to make it as clear as mud.
Andrew Grantham: Exactly. Yeah. I mean, we're still on board with the fact that, you know, we think inflation is, I think, stickier in the US than it is even here in Canada, and that they are going to need to do a little bit more. So our forecast is for two more rate hikes, July and September. And I still, you know, reasonably confident about the July forecast. If anything after that, maybe the September 1st is a little later, if they kind of skip one and then move and then skip another one. But, you know, I do think two more is necessary in order to really get inflation under control.
Ian Pollick: Well, it's interesting because you kind of saw the market reaction. Just the narrative right now is that maybe this skipping of June implies that the assessment period means they hike much later on in the year. But I think, as we all know, you do get these negative base effects that take inflation higher in the fall. But arguably, the further you allow the economy to progress, the more tightening you're going to absorb. And so if they are going to hike, in my mind, it's early rather than later. What do you think about that?
Andrew Grantham: Yeah, I do. I think definitely July. And as I said, we have July and September in our forecast.
Ian Pollick: So let's switch gears a little bit and let's just talk about the inflation report we saw in the US this week. And you know, to me, one of the surprising things was just the level of core goods. You know, it looks like core goods prices, which was really one of the mainstays of the Fed, saying, look, things are coming under control, seem to be reaccelerating again. What did you take out of the report?
Andrew Grantham: Yeah, just as you think you've pushed something else down, which is the core services, the other thing pops back up again, right?
Ian Pollick: It's like a balloon, right? You push one part of it in, it pops somewhere else.
Andrew Grantham: (laughs) Exactly. Yeah. And I think this just goes down to, you know, things that we've probably discussed before, even though I haven't been, you know, discussing this with you on this podcast for a while. But, you know, the US spending on goods in the US is still very elevated relative to where it was before the pandemic, even though we haven't seen-
Ian Pollick: So you're talking in level terms, not growth rates.
Andrew Grantham: I'm talking in level terms, and I'm talking in volume terms, not necessarily. So even accounting for the price increases. So even though there's been very little growth over recent months, just the level, the volume of spending is still very, very high. And, you know, even though we've seen some improvements in supply chain issues, that elevated volume and level of spending is obviously still causing some inflation in terms of goods prices. Now, the other thing, you know, the services prices that are looking weaker at the moment, my concern there is that they're looking weaker pretty much only because airline fares have fallen for the past couple of months.
Ian Pollick: Well, it's super seasonal, right? Like this whole super core measures is highly, highly seasonal. And so I think when we look at some of these three month annualized changes, they are having relatively large swings.
Andrew Grantham: Yeah. Even when you try and seasonally adjust them, you get down to a level where one very volatile element such as airline fares can have a big weight in on those numbers. And I think that's what we're seeing in terms of this services inflation, it looks to be under control. But in three months’ time, if airline fares go back up again, it's going to look very different.
Ian Pollick: And so I think the Fed has to kind of shift a bit focus in terms of what it's looking at, because as you say, there's some inherent problems in some of these underlying measures. But let's just talk about, you know, you got the Fed right, But let's talk about what you didn't get right. And let's talk about-
Andrew Grantham: Do we have to? Do we have to?
Ian Pollick: We have to do it. The elephant in the room. Let's just talk about the Bank of Canada. So we got a Bank of Canada hike. Obviously, it's not what CIBC was looking for. You know, it's interesting because I think that we both agree going into the meeting that when we look at all of the conditions that the bank had laid out for a pause or to break their pause, they were all violated, right? And so I think the feeling that you had was that the bank would benefit from more assessment of incoming data. Maybe just walk us through, in retrospect, what you think you missed.
Andrew Grantham: It just came down to timing for us. We were a bit confused that they would hike so close to a labour force report like two days afterwards. And also because, you know, there is a very short inter period, a length of time, like only five weeks because of the summer coming up. And in that five weeks you do get a lot of data. We thought that they could risk another five weeks, if they even if they thought the economy was overheated, they could risk that five weeks because it's not long in terms of its impact on the economy. But you'd get a lot more data during that period of time. Obviously, they didn't think that and they acted as and when they did. And, you know, our forecast now is that they will have another 25 basis points of hikes to take that terminal rate up to 5%.
Ian Pollick: I think that's right. You know, central bankers don't get out of bed for 25 after being in bed for almost half a year. You know, on that LFS to me, you know, even though we lost jobs on an outright basis, when I look at the underlying details, private paid employment still looked okay. You know this was all self-employed so that actually wasn't a terrible employment report.
Andrew Grantham: No and it was all youth employment, which can be very volatile in May leading up to the summer as people get or don't get jobs. And it depends on that, the timing of when they start, does it fall within the survey week. So we won't know for another at least month or two if this is the start of a weakening that the Bank of Canada has been looking for, you know, a weakening in the labour market or whether it was just a statistical anomaly this time around.
Ian Pollick: So there's a couple of things I want to talk about in the labour market before we move onwards. You know, one of the things that we know is that the LFS, like Canada's main jobs report, doesn't treat population growth as one would expect. You know, instead of in real time, the estimates for the population are slowly drifting over time. And so there's a risk here that the unemployment rate is actually understated and that what you have is really just supply led factors that are boosting the headline level. So can you just walk us through how that adjustment works and what you see the risks going forward are?
Andrew Grantham: Yeah. So I mean, basically we had a big increase in the population last year. It's still increasing this year, but probably not to the same extent. But you know, they can't send out forms to any of the new people that have come in straight away. So what they do is that they tend to kind of, as you said, kind of dribble this kind of population growth in over a few months rather than necessarily exactly when it occurs. Now, what this does is it creates big labour force growth, but it also, you know, kind of flatters the employment numbers a little bit. Employment growth looks very, very strong. But at the same time, the labour force growth, the population growth is very strong and that's the reason why the unemployment rate didn't actually fall during the first little part of this year, despite some very strong employment numbers that we were seeing.
Ian Pollick: And the other side of this, too, and this is something that, you know, the Bank of Canada had released a paper ahead of the June meeting, basically saying, look, every immigrant that comes into the country supplies labour. They demand goods. We have thought that a lot of the strength that we're seeing in the labour market is a function of this additional supply. But on a reassessment, we think it's actually elevated demand in a period of elevated supply. Now you put out a piece of a paper earlier this week kind of talking to that. Maybe just give us a quick highlight and what your conclusion was.
Andrew Grantham: Yeah. So, you know, whenever anyone in this country seems to talk about immigration and population growth, it's always to do with housing. And I think it's a given that housing, we're not building enough homes. We're seeing some inflation in terms of rental and housing prices. But as you rightly mentioned, as the Bank of Canada has mentioned, the supply and demand dynamics from immigration go well beyond just housing. Now, the good news is that we have seen this surge in immigration. It's created a bigger pool of people and it has enabled us to bring job vacancies down. Our job vacancy rate has come down. But in our study, what we looked at is trying to look at and this was from a special pool of data that we got from Statistics Canada, exactly what industries newcomers and this is five years or less were going into within the economy. And what we found is a couple of interesting things from an inflation point of view. Firstly, that they weren't necessarily lining up to where the highest job vacancies were and secondly, that they tended to be in higher paying industries than they were in 2019. The average earning of someone who is new into the country used to be about 20% below the national average. Now it's only 5% below, which is very good from a growth point of view. In terms of growing, the economy may not be quite so good from an inflation point of view.
Ian Pollick: So that's super interesting. And listen, I don't know if you saw it, but Governor Poloz was, he put a post on LinkedIn the other day and it was pretty interesting and he called into question the strength of the national accounts data. He basically said, look, when you look at the pattern of final domestic demand, you look at the strength and consumption, obviously very, very big numbers. And he posed the question, is this exuberance or is this just the new normal? And I think he concluded with exuberance. And basically what he said was and this is a very valid point, I want to get your take on it. He said, look, you know, only about a third of all the tightening has been passed through to the market because when you look at the outstanding stock of residential mortgages, every percentage point increase in mortgage rates reduce disposable income by 20 billion. And, you know, or 1.3% in disposable income. That's a big number. And so as you move forward in time, as more and more mortgages reset in 24 and 25, you end up in a situation where this pace of consumption is unsustainable. Now, we just released our new growth forecast, so maybe just, you know, what do you think about that? I put a lot of stock into it, but I'm curious what your thoughts are.
Andrew Grantham: Yeah, I don't necessarily think it's exuberance. I think that's the wrong word. I think the upside surprise is that we've seen in growth in Canada and in consumer spending in particular come down to a fundamental mistake that forecasters, the Bank of Canada, ourselves included, have made. And this is forgetting about the level of economic activity or the level of consumption and thinking too much about growth rates. Because when you think about growth in terms of consumer spending in Q1, it doesn't make a ton of sense that consumer spending grew so quickly, particularly in areas that are typically interest rate sensitive in an environment where interest rates are very, very high. But then you look back and you look at how what the level of this consumption or the volume of consumption is relative to 2019, you realize that a lot of interest rate sensitive areas like autos, like discretionary services such as travel, things like that were also the areas hardest hit by the pandemic. And then you look at, you think about the level of activity or the volume of activity in these areas. It's still below where it was in 2019. So I think a lot of what we're seeing at the moment and I think a mistake the Bank of Canada is even making in terms of raising interest rates is forgetting about the level of consumption and thinking too much about growth rates.
Ian Pollick: And that's pretty consistent with what you were talking about in the US earlier. And so let's just talk about some of the forecast changes. So you mentioned earlier we're going to add another hike to the Bank of Canada in Q3, you know, July, September, but then the rate cuts have been pushed further back. And so I'll be honest with you, I get a little bit nervous about this idea that you start from a higher level, therefore the higher for longer can run even longer. Because it's true that an economy's always the tightest before a recession. And so while I do believe in this idea of higher for longer, do you think that you've pushed out rate cuts too far in the future?
Andrew Grantham: I mean, anything's possible in this in this situation. But I think the timing of rate cuts, which we pushed out to June of next year, I think that's okay. We do have interest rate cuts when they start being a little quicker than we had in our previous forecast. So we had a fairly gradual pace of cuts starting in Q1 before. What we have now is cuts starting in June, but at a little bit quicker pace. So the level of interest rates at the end of next year isn't too far above what we had in our previous projections. So I do think in order to cut interest rates, central banks obviously, and we're learning a lot about their reaction function just from the fact the Bank of Canada hiked interest rates again recently with just one little upturn in CPI. They're not going to cut interest rates until they think they have inflation under control. And in our forecast, inflation gets to 2% or at least close to 2%. It's not until the middle of next year.
Ian Pollick: And I think the risk here is obviously that gets delayed further into the future. And so absent additional rate hikes, the risk, I think, for the bank and what we'll hear in the monetary policy report in July is that could have been pushed into 2025.
Andrew Grantham: So with the, you know, with all these changes in terms of our rate forecasts, if people are buying in or markets not quite buying in still the higher for longer. You know what about our bond forecasts? Where do you think there's opportunities? Where do you think the market's got it right or wrong in terms of pricing at the moment?
Ian Pollick: Well, listen, I think that what we saw coming out of the US banking sector stress that really characterized the better part of March and the middle part of April. That was kind of offset by, you know, what I would call another policy distraction, which was the debt ceiling. And so you've kind of moved past both of those obstacles. And obviously you have central banks. The Bank of England looks now at hiking above what markets had expected. The Bank of Canada obviously hiked. The Fed, regardless of the hawkish hold, dovish presser, looks like they're not stopping also. And so I think that's a painful reminder that when we think about the level of interest rates, you know, duration is not out of the woods yet. And so what we've done is we've taken the level of rates a bit higher than our prior forecast. And so the peak in the front end obviously reflects the additional hikes. So, you know, we had to take bond yields up by 40 or 50 basis points in the front end, but in the back end of the curve as well, you know, you do have additional issuance coming in the US now that the debt ceiling has been resolved. You do have this idea that ultimately if central bankers are going to eventually stop hiking and inflation stays relatively sticky, well, that matters for longer term rates. And so we've taken the level of longer term rates higher by, let's call it 25, 30 basis points. What we're left with is two things. Number one is we have a curve that's going to stay flatter for a little bit longer than we had anticipated. We don't really see the sustainable steepening beginning until the end of the third quarter of this year. But the second thing that we're seeing, too, is that on a relative basis, when we think about the behaviour of Canadian interest rates vis a vis US interest rates, we do expect the Canadian interest rates to be somewhat weaker than our prior projection. And that's just a function of the fact that the policy differential that we had in our mind, bank Fed is now narrower than we had anticipated.
Andrew Grantham: Let me just ask you one more question on that policy differential. You know, you said narrower than we previously expected. It is going to be historically narrow. Typically, the Federal Reserve does in hiking cycles, hike, let's say, maybe 75 to 100 basis points above the Bank of Canada. Do you think someone's getting this wrong? Either the Bank of Canada has gone too much or the Fed hasn't done enough even with our forecasts? And if so, which one?
Ian Pollick: It's interesting. If you put me on the spot like you just did, I would say that I think the Fed probably should have hiked yesterday. You know, when I think about some of the risks that are potentially creating vulnerabilities in the system, a lot of them seem to be somewhat benign right now. And so I understand that obviously with monetary policy, you have lags and credit contraction also has lags too. But I think the Fed's probably the one that's further behind relative to the bank, and that's for a lot of reasons that we talk about too. And really just the composition of where borrowing rates live in that economy, which is in the back end of the curve. And so right now, when I look at our forecast, we have the bank finishing the cycle effectively 75 basis points below the Fed once they both stop hiking interest rates. But on the other side of the easing cycle, when we have that easing cycle completed at the end of 2024, we still have maintenance of that 75 basis point differential. And I look back and I said, okay, well what is the average differential when either the Fed has stopped for the bank after a hiking cycle or the bank after the Fed in a hiking cycle, and it's about 75 basis points. So it's pretty bang on historical averages. And what's interesting about that is in an easing cycle, what you tend to see is the Bank of Canada is about 25 basis points above the Fed. That to me was a bit surprising. And I think maybe it's a function of just the subset of data since 2000, but I kind of get it, right? We have a much more levered economy and therefore it's symmetric, right? You raise rates high and it hits the economy very quickly or in theory should. But on the other side, they don't want to juice up the economy all that quickly given the level of inflation. And so, you know, for me, where I get concerned about market pricing is right now, the market has to the end of next year, you know, let's call it 60 basis points of cuts for the Bank of Canada and 160 basis points of cuts for the Fed. And so you almost end up with this policy rate end of next year that Canada's 75 basis points above the Fed. And to me, from my perspective, that is the clear mispricing in the market where the Fed needs a little bit less and the bank probably needs a little bit more.
Andrew Grantham: Yeah, no, I agree. I mean, when you said the differentials during cut in cycles previously, you know, the previous two, you know, early 2000s, Canada didn't have a recession, the US did, and obviously the financial crisis was a much bigger recession in the US. So it makes sense to see that. But maybe that won't be the case this time around.
Ian Pollick: And it was a little bit distorted too, because remember in 2002 you had the Fed easing and the Bank hiked rates and then they quickly abandoned that because it was very clear that was a policy error. So I kind of excluded that just from the averages. And so I think that is really the biggest mispricing in the market because in essence, the market is putting more stock that the Bank can maintain a higher for longer relative to the Fed. And that divergence really starts to kick in in the start of 2024. So, look, we've been talking for 21 minutes. Is there anything on your mind that we want to talk about that you haven't really talked about? There doesn't seem to be a lot of data in the coming week.
Andrew Grantham: That's not too much. We have a reweighting of CPI before the Canadian inflation numbers seem to be delayed until a week later because the typical because we do have the release of new weights, that's going to be kind of a continued return to normal, I guess, getting rid of some of the pandemic weighting and returning somewhat closer to 2019. So that will be interesting to watch.
Ian Pollick: Well, let's just talk about that for a second, because we've gone through two iterations since the pandemic that they've reweighted the CPI index. And so the first iteration was, you know, it was pretty crazy to me because it reflected people's patterns and habits when they were basically locked down. And yet this occurred at a time when the economy was wide open. And so it was almost understating the degree of CPI. But then they did another reweighting where, correct me if I'm wrong, but they reduced the sensitivity of the index to higher rates, but they increased it to the level of housing. And so based on your understanding, what is the new iteration going to look like?
Andrew Grantham: So again, it's going to get closer to the pre-pandemic level because the spending patterns within the economy last year were closer to 2019 than they have been for a couple of years. So it's going to be a slight reduction again on housing with the exception of mortgage interest costs, because obviously they rose, you know, fairly significantly last year and it's going to be an increased weight in on some of these areas that were still reopening last year. So that's, you know, airfares, travel, things like that. We're going to get a higher weight again. So I don't know. I think it's going to be kind of neutral, but it's going to be something to look at just in case when they when they update those weights.
Ian Pollick: All right. Well, listen, Mr. Grantham, thank you very much for being on the show. And remember, there were no bonds harmed in the making of this podcast.
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