Royce and Ian discuss whether something is ‘off’ in the recent jobs data, questioning whether the seasonal adjustment process has broken-down. Royce provides his view on what to expect in Budget ’21 next week, while Ian looks ahead to the BoC rate-decision and the likelihood that a taper is announced.
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Ian Pollick: For sure, I'm doing a break dance, giving you the breakdown.
Royce Mendes: You're a funny guy,
Ian Pollick: I am a funny guy. I thought you were going to stop me there and be like, hey, we got to rerecord. You said something crazy.
Royce Mendes: Remember Kawhi? I am a fungi. (laughs)
Ian Pollick: I am a fungi. You're a mushroom. Hey, everybody. And hello to you, Royce. How are you?
Royce Mendes: Hey, good how are you, man?
Ian Pollick: I'm pretty good. Listen, I want to kick off the episode today talking about the recent labour market report in Canada. Obviously, when we look at the numbers relative to the total amount of employment pre pandemic, we're getting pretty close. We're within three hundred thousand jobs of being completely whole. The question I have for you is, do you believe the data? Is there something that we should be aware of? Do policymakers need to be cautious in interpreting this? And I ask that because we're very close to the Bank of Canada meeting next week. And it's quite strange when we look at, for example, vaccine deployment in Canada versus other countries, yet Canada's labour market versus other countries. Talk to me about what you're thinking.
Royce Mendes: Well, even if you look at just the labour market within Canada, you look at one report, which is the labour force survey. It tells you a story about the Canadian labour market, which is pretty rosy. You look at the SEPH data, the payroll data in Canada, and it's much uglier. So there's three things I want to point out here. First is the definitional differences. You can't compare the headline labour force survey to the payroll data. There's different definitions. That I would say accounts for a little bit of the difference, but certainly not all of it. The second thing I want to talk about is the seasonal adjustment process. If we look back to March and April of last year, we lost a ton of jobs. So if the seasonal adjustment process is picking this up and thinking, well, you know, March is a bad month, it's going to artificially boost the raw numbers, which could account for a little bit of that huge surprise that we saw in March. But the last thing is what I would argue could be the most important in answering the question, which is the response rates in Canada to the labour force survey. So we compare these not only to the historical norm of itself, but also across to the US household survey. And what we notice is that in both countries, of course, response rates fell early on in the pandemic. It was more difficult for statistical agencies to get in touch with people, to ask them whether they had a job or not. But in the US, it started rising and it gradually recouped a lot of the lost ground in terms of the response rates. In Canada, it plateaued at a much lower level. So this might lead you to believe that the labour force numbers just in aggregate are less reliable. And of course, you'll remember before the pandemic even began, I used to call this the random number generator because it was so volatile on any month over month change. So, yes, I do question what's going on in the labour force survey because it doesn't exactly match up to other statistical measurements of the Canadian economy. But it also just doesn't pass the eyeball test. You know, as you mentioned, vaccine deployment is much faster in the US. Fiscal stimulus is much larger. The economy has been re-opening a little bit more than in Canada. So it's highly questionable to see the rate of job increases faster in Canada and getting much closer to pre pandemic levels than in the US.
Ian Pollick: No, for sure. You know, the thing that I was looking at, other than kind of, like you said, the eyeball test. When I was looking at the, for example, the education component, you know, why did we create thirty five thousand jobs in education? And then I was like, oh, wait a second, March break was delayed. This is definitely screwing up the seasonals. So, you know, just for the edification of myself and our listeners, when you start to screw up the seasonal process, how long does this last, like when does it normalize to get back to reality on average?
Royce Mendes: Well, the seasonal adjustment process will update itself every year and it'll weight the most recent months higher. But, you know, of course, when you measure employment over a whole year, there's no need for a seasonal adjustment, right? So actually, we should start to tell if part of this is the seasonal adjustment, which, you know, I suspect it could be. I don't think it's all of it, but I think it could be part of it. It'll start to work itself off in the months ahead.
Ian Pollick: So you mentioned something that I want to take a little bit further. And we're talking about fiscal stimulus in the US. Obviously, when you think about Canada, really over the next seven days, we have a huge amount of information that's going to be delivered to the economy. Next Monday, we get the budget update. We get our bond issuance update. We also have the Bank of Canada next week. Let's start off with the budget. OK, so the last update that we got was, I think in October, the fall economic statement showed no sign of a fiscal anchor, but a deficit that was considerably smaller than what we saw in this past fiscal year. Talk to me very quickly, because we haven't seen a lot of leaks to the media yet. What are your expectations for the budget, buddy?
Royce Mendes: What they showed in the fall economic statement, I would argue, is going to be pretty close in terms of the dollar amount of the deficit for last fiscal year and this fiscal year to what should actually show up. So the economy outperformed in the fiscal year of 2020 2021 relative to the forecast. So maybe instead of a three hundred and eighty billion dollar deficit, we get a three hundred fifty or three hundred sixty billion dollar deficit. But this year the pandemic has lasted, I would argue a little bit longer than they anticipated back then. But again, GDP is starting from a higher point, so maybe that cancels each other out and we get still a deficit, which is pretty hefty of one hundred and twenty billion dollars, but the most important thing here is to ask, what does this mean for fiscal sustainability in this country? A lot of people will be pointing to that higher debt to GDP ratio. But we wrote a whole paper arguing that that is a ratio that cannot be relied upon to consistently tell you how sustainable federal fiscal finances are. We're going to be looking at that debt service ratio. And in all likelihood, it's going to remain low, historically low because interest rates are low, right? And we did some-
Ian Pollick: I just want to stop you here for one sec, dude. Because one of the wildcards, I think, in the budget was, remember, there is kind of that asterisk in the fall economic statement that said, here are the deficit numbers, but here's an additional hundred billion that we'll spend over the next three years. I was taking a look at the parliamentary budget office and their assumption is basically like a third, a third, a third over the next three years. Where in your mind are you allocating that additional stimulus? Because that matters, obviously, for the deficit.
Royce Mendes: Exactly. We don't exactly know. So the deficit numbers I quoted would be excluding that one hundred seventy to a hundred billion dollars. But I would agree probably a third, a third, a third. If we're looking at our economic forecast, that's the way we split them up. But let me get back to that deficit to GDP number because it's extremely low. And we actually tried to shock it. We tried to say what would happen if interest rates rose, and you helped out with this analysis, up to 4% over the next five years. What would happen if interest rates rose to 4% tomorrow? Unlikely double probably what the Bank of Canada's neutral rate is. And you know what it showed us? It showed us that there was still room to breathe at the federal level. So I think what's important after all of this is to look back. The pandemic was a huge shock. We had a huge fiscal response, but we're still exiting the pandemic in a pretty solid fiscal situation. But I'm going to transition a little bit because we're talking about forecasts to the Bank of Canada's announcement next week and there will be, of course, economic forecasts in there. So let me just run down a little bit of where I think we need to see changes in those projections. So first of all, they were last forecasting only a 4% growth rate for 2021. Obviously, that's going to have to be ratcheted up pretty significantly. We're at about 5.5% for 2021. Some of that will steal a little bit from 2022. But that's a much better position. They're going to have to acknowledge that. And the big question for me is, what do they do with the timing of that first rate hike? Do they leave it in 2023 or do they pull it forward into 2022?
Ian Pollick: I think we've talked about this, right? And you know, one of the things I want to guide you on in your answer is what are you going to do with potential? Because that's obviously the most important factor here when we're thinking about the output gap just given, we know GDP is stronger than anticipated.
Royce Mendes: Right. Well, mechanically, we think that they were sort of in early twenty, twenty three before these changes to their forecasts were required. So just mechanically, if they made no change to potential GDP, then they'd probably have to pull it forward into twenty, twenty two. The problem is, is that we don't really know. We have no insight into what they're going to do with potential. You know, maybe they could raise a little bit because past economic performance, particularly things like business investment, were a little bit better than they anticipated to the capital. Stock is better potential is a little bit higher. But it's a question that I would say we won't know until they come out and tell us what they've done with it, because it's more subjective than just plugging numbers into a model. I do want to ask you, though, in terms of what we do expect for next week from the Bank of Canada is that they taper their bond purchases. Talk to me about how much we're expecting them to taper and what it means for the market for sure.
Ian Pollick: So, you know, as a starting point, one of the things that we've been saying for a very long time is that the Bank of Canada, at some point, you know, they need to taper their bond purchases. And I think, you know, we've always characterized it as this is really a technical adjustment as opposed to something that's really based on deep fundamentals. I think that's really the messaging that's going to come out next week. It's our expectation that they reduce the pace of purchases from four billion a week to three billion a week, and that one billion dollar reduction is largely going to come out of their two year and three year sector purchases. Call it seven hundred and fifty million of that billion. You'll have about another hundred and fifty billion coming from five years and then a dual one neutral type of reduction across the curve. I think the main messaging that the bank is going to have to get across is why now? They kind of told us in the January statement, again in the March statement and again in the Gravelle speech, that if they have confidence in the recovery, that they will begin to question the degree of stimulus in the system. But obviously, Canada is in the third wave right now. Optically it may look a little bit strange, but again, I would say this is much more technically led than fundamental. And that technicality is really just a function of their footprint in the market. It's quite large. It's getting bigger. You know, we breached 40% a few weeks ago, I think around 42% right now. When I look at the market pricing, it's hard to see where this taper should be allocated. If you believe in our base case, Royce, that most of it comes out of the front end and you kind of look at asset swap valuations in the two year and three year sector, you look at where some of these bond rules are trading, I would argue a lot of it's in the price. And that would really be my main message to the bank is that I think the market's giving them a green light here. The window is open. You shouldn't see too large of a response after the fact. So you might as well do it. I think the bigger question, though, is how did we get here? And I've been asked a lot, why is the bank being almost mechanically forced to reduce the pace? And I'm curious to see if you agree with this, but my answer has been that when you look back historically at the academic literature, almost every major thought leader in the field has said, listen, it is the stock of purchases that matter, not the flow. But Canada started with neither a stock and it had no flow. So you had to have a very rapid pace of acquisition to lead you to a very elevated balance sheet. That's how I think we got here. So I don't fault the bank at all for the process. I just think it's time to rightsize the program. I don't know if you would agree with that.
Royce Mendes: I don't know if that every influential academic has said it's the stock versus the flow. I think at different times, particularly during the different rounds of QE in the US, different people said different things. But for the sake of this conversation, Canada, you know the question of why now? I think one thing you haven't really spoken about is that the answer also has to do with what's been rolling off the balance sheet and, you know, the change in the pace moving forward.
Ian Pollick: Yeah. So you've gone through this huge period where the often cited term repo maturities are basically almost done right now. You've seen excess settlement balances decline by about one hundred billion over the past few weeks, and you haven't seen an attendant increase in repo pricing. You know, that was one of our main contentions. We took a lot of flack for it because typically when you get a balance sheet roll off, you're effectively just replacing each QLA like a reserve for another, which is a bond, and you have to reprice repo accordingly. But our argument the whole time was that, listen, there's not a lot of collateral pledged here that when it comes back has to get funded. And that's kind of exactly what's happened. And that's why short rates are disconnecting from where the overnight rate is. But when I kind of look forward and say, well, where is this distribution of the balance sheet going? I'm very cognizant that the Bank of Canada itself has made a delineation between facilities that it deems market functioning in nature versus those that are, you know, achieving a policy objective. If we stick with just the policy objective facilities, it's really the government bond purchase program. If I draw out those maturities and you kind of say, well, I'm going to take those amount of maturities, let's say on a calendar year basis, and I'm going to divide it by the amount of weeks to say, well, what does that equate to per week? It's about a billion dollars per week. So I think what that helps inform us is that when the Bank of Canada moves eventually to a reinvestment only, they're going to be reinvesting about a billion dollars a week on average. So that tells me that, you know, there is considerable room relative to the pace today. You could stop QE. You need to reduce it a few more times by about three billion. So I think that you get that billion this week. There's no need to go bigger, although it's a risk. But I think over time you get to the end of 2021, if your macro forecasts are governing reality, then I think we're going to get another larger taper and move into a reinvestment phase by mid early 2022.
Royce Mendes: Right. So the order of operations here is taper first, end QE, but still have this reinvestment program ongoing even into a probably when you hike rates. You agree with that?
Ian Pollick: I do. I don't think there's any reason why you need to have a shrinking balance sheet as you start to normalize rates.
Royce Mendes: Ok, we've talked about the budget. Let's talk about issuance. Let's talk about all the things that might affect the long end of the curve. I notice in the rates forecast we're looking for the Canadian long end to sell off a little bit more than the US long end in the short term. You want to give us a little bit of a breakdown of why that is?
Ian Pollick: For sure. I'm doing a break dance, give you the breakdown.
Royce Mendes: You're a funny guy.
Ian Pollick: I am a funny guy. I thought you were going to stop me there and be like, hey, we got to rerecord. You said something crazy.
Royce Mendes: Remember Kawhi? I am a fungi. (laughs)
Ian Pollick: I am a fungi. You're a mushroom. You know, the thing that's characterized the backend for a long time is that there's been no supply. You know, Canada is a very LDI mandate, heavy market, meaning that there's almost a constant demand for very long duration. And in a typical year, the government of Canada would issue less than five billion long bonds. Now you're issuing north of thirty. So I think you've more than satiated any residual demand from that investor base. And at the same time, you have growing provincial issuance, which traditionally lives in that part of the curve, too. So the forecast really speaks to this idea that you're removing a lot of the structural riches in the backend because your supply's normalizing in a very big way.
Royce Mendes: Ok, look, I think we did a good job today. Let's wrap it up and end it before we do something dumb.
Ian Pollick: Ok, on that note, I would say that I hope everyone is doing well. We hope you and your families are safe. And remember, there were no bonds harmed in the making of this podcast.
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