Ian Pollick and Royce Mendes discuss the surprising CPI report for May, what they learned from Governor Macklem’s first Parliamentary testimony as Head of the Bank of Canada, and walk us through the recently released economic and interest rate forecasts.
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Ian Pollick: Good afternoon and welcome to the 10th edition of Curve Your Enthusiasm. I'm happy to say we're back. It's been a long pause, but we finally got our technology sorted. There's a ton of stuff to talk about. Royce, how are you doing, man?
Royce Mendes: I'm good. I'm good. Hold on a second. I don't think it's just the 10th edition. \I think it's more than that. I actually think it's more than that.
Ian Pollick: Well, I. I'm happy to take it. It's just been so long since we've been in the studio together. The only thing that makes me sad is that I don't get to see your face in person. But I'm so happy that we're bringing this back to everyone. So let's kick into this and start off with the obvious news of the day, which was the downside surprise to the CPI report. There is a lot of expectations, not just from the macro community, but when we look at real return bonds and break evens. There is a huge expectation for a very big number today that would have led to a very big carry month. What happened?
Royce Mendes: This was surprising because I thought going in, we had accounted for a lot of the downside risks to some categories. But the issue wasn't the magnitude, it was that the weakness was far more broad based than I had anticipated. Even food categories showed up soft. Despite the weakening in the Canadian dollar and the issues with food supply change, which I thought should have boosted food prices more than what we saw. Some people have pointed out that this is more reflective of the reality of a severely depressed economy. I'd say that's partially true. Things like rent, mortgage interest costs and cell phone bills were all cheaper in May. And those are definitely things households are still paying for. But the overall index is still far from being reflective of current spending patterns. Of course, we've pointed this out a number of times. The CPI is based on a fixed weight basket. But households have dramatically shifted purchasing habits during the pandemic. That's why the Bank of Canada, along with Statistics Canada, is trying their best to develop an adjusted measure of inflation. I'd expect when that eventually comes out that it will show a higher inflation rate than the deflationary CPI prints of the last two months. Since it won't include things like airfares, hotel accommodations, sporting events and will even down weight things like gasoline given reduced driving of many households, the BOC core common component measure removes some of this by removing some volatile items, but doesn't actually get at the root of the problem, which is the change in the purchasing patterns. For RRB investors, the May reading probably suggests that some categories were weaker than previously expected, but it's still not anywhere close to an accurate measure of underlying inflation. The last thing I'll say on this is that the issues should gradually fade as the economy reopens and buying patterns move closer. Certainly not all the way because we don't expect the economy to reopen all the way anytime soon. But we'll move closer to the fixed weights of the basket.
Ian Pollick: So what I found interesting was, as you rightly say, when I drill down and look at some of the components, obviously food prices really didn't do that much. Meat prices were higher. I think we can all attest to that. Mortgage interest costs seemed to have this very lagged move lower like bond yields have been rallying all year. The bank cut rates, the lower bound in March, and it's only in the latest data that we actually saw interest costs decline. Why is that?
Royce Mendes: It does take some time for banks to pass on lower bond yields or a lower Bank of Canada policy rate to consumers. But, you know, we're talking about mortgage interest costs. We should really talk about rent as well. Rent is a little bit more fundamental because it's all about supply and demand. And what we're seeing now in a lot of Canadian cities is that because you're not allowed to do things like short term rentals. There's a lot of supply and demand is down. You know, there's not a lot of population growth. Immigration has basically been paused and students aren't moving in because we really don't know what's going to happen with the school year in September.
Ian Pollick: For sure. And the last thing that I really wanted to talk about in terms of drilling down to the details, you can see a bunch of very weird readings. For example, beer served in license establishments. I didn't know any were open. It was down six tenths during the month. Wine was up eight tenths and liquor was flat. So when they don't have prices, do we have any idea of what they're doing to infer the next month's prices?
Royce Mendes: Yeah. So what they do is that they go up one in the order of categories and use something in that umbrella and try to extrapolate prices. So, I mean, these are not ideal ways to construct a price index at all, but they really are doing the best they can. And unfortunately, this is what RRBs are priced off of. It's not the environment that consumers are actually facing, which we'll probably see in the Bank of Canada report. One thing to note, though, is that some restaurants and I can speak from my own experience from buying alcohol are selling alcohol and beer at reduced prices because you're not sitting in the restaurant, they're actually trying to sell it and be a little bit more competitive with alcohol bought from, you know, government run retailers or corner stores or grocery stores.
Ian Pollick: For sure. And I think that when you listen to the first comments from newly minted Bank of Canada Governor Macklem yesterday, he effectively said, listen, disinflation or deflation is arguably more important than inflation right now. And there is a broken link between actual spending and price patterns and what the CPI is telling us. So I found that was interesting that right off the bat he kind of severed that relationship, which to a certain extent reduces how the market should be treating some of the CPI reports, at least in the very near term.
Royce Mendes: Right. He's worried about deflation. But this is not the deflation he's worried about, right? This is an artifact of difficulties in collecting prices, changing spending habits without a change in the basket. When we move further and further along in this recovery and as the economy reopens a little bit more, that's when we'll really get a sense of what the consumer price environment is and remember, this is extremely important for the Bank of Canada to get a gauge on the underlying pricing environment, because that's their sole mandate is the two percent inflation target. And that's why they're working with Statistics Canada to try to get an adjustment. And as I said, I think the adjustment is going to show that, you know, certainly the pricing environment is stronger than the two disinflationary or deflationary prints that we've seen in the past two months on the CPI measure. So, Ian, I actually wanted to get a sense from you what you found interesting in Governor Macklem's testimony recently. It was the first time we really heard from the governor on his own in this leadership position. Do you have any interesting takeaways?
Ian Pollick: Yeah, I think in general terms leading up to it, I really thought this would be a carbon copy of recent speeches from Governor Poloz, who said more politely that this would have been more of him toeing the party line. But I think that he put a little bit of his own stamp on things, in particularly when he was talking about the balance sheet, when he was talking about QE. Now, he did reiterate the fact that similar to what Governor Poloz had said in the past, the Bank of Canada will continue to buy bonds until the economic recovery was well underway. But he also went a bit further and suggested a couple of things. Number one was that the balance sheet would be used as the conduit for additional accommodation because rates are at the attractive lower bound. And that reiteration of rates being at the effective lower bound really starts to reduce any type of bets in OIS markets that the bank could either go to zero. They continue to issue a negative interest rate policy, but also it really takes the steam out of some people that were thinking that you can have a nonconventional size move like a five basis point or 10 basis point cut, similar to what you see in some regions that were already very close to the lower bound. And I think it's important when we understand when he was talking about the recalibration of QE, because right now, Canadian QE or large scale asset purchases, whatever you want to brand it as, have really been to support market functioning. I think if we look at liquidity in the provincial market, the corporate credit market and the government market, liquidity is miles, miles better than it was at the very start of the crisis. So the big question that I keep thinking about is what is QE evolving into and what is that migration pattern look like at the limit? And one of the things that Governor Macklem suggested was that, hey, the Bank of Canada's balance sheet is actually pretty small on a relative basis. Now, I think that's true proximately when we talk about the notional size of the balance sheet at about 500 billion. But as a proportion of GDP, it's actually not that dissimilar to some other regions. It's about 22 percent of GDP. You know, one of the themes that we continue to harp on and I'm going to say it again, is that when the Bank of Canada first started buying assets during this crisis, their primary goal was to recognize, with very limited policy room left that any cuts that they delivered needed to be properly transmitted through the short end channel. Obviously, the problem was the short end wasn't really functioning properly. And what that meant was the bank was taking on a hugely disproportionate amount of very, very short dated assets like term repos, treasury bills, provincial bills, banker's acceptances. And that was great because mission accomplished. And they did the right thing. The problem, of course, is that when we look at the maturity distribution of the balance sheet, you have a lot of assets that over the next, really year and a half, will mature. And we've done the work and 70 percent of the balance sheet through natural attrition, were organically run off. And I think that's a really interesting point because it has a couple of really important implications. The first implication is in FX markets. And you're in a situation now where administered rates globally are at the lower bound, rate differentials are very minimal, and more importantly, the variability of those rate differentials is quite small. And what that means is that what's driving FX right now isn't rate differentials. It's partly the broader risk environment. So you do have risk currencies like the CAD and the Aussie that benefit when you have a really big day in the stock market. But the other thing that really matters is the relative pace of expansion of the balance sheet as the size of GDP. So because you have all these assets that are maturing, you don't need to replace them one for one in nominal dollars. You just have to replace the risk that's falling off. And for context, for every one billion dollars of bills that rolls off the balance sheet, you only really need to buy 50 million worth of 10 year bonds. So if you believe that without an additional re upping of QE, it's very likely that we're very close to reaching the peaks and the proportion of the balance sheet is a percentage of GDP. And that means the Canadian dollar can actually run a little bit hotter here than most people expect. And getting back to what we are saying about CPI, I think that has some negative implications in the near term. The other thing that surprised me a little bit was this idea that you have to calibrate QE to maintain your inflation goals. Well, I don't know how to interpret that. My gut reaction was to say maybe this is called QE with a purpose. Maybe that's some type of yield curve control. But I'd really be interested to hear how you interpret that statement.
Royce Mendes: Well, first of all, I agree. He put his spin on things, and I think the question of calibration comes to, back to the point that he made, in alluding to his assessment of the economy, which he made some reference to, a deep hole which was going to take a long time to dig out of. That was certainly more a realistic assessment of the state of the economy than Governor Poloz was saying at the end of his term. I will say that I think that the calibration is about understanding how much the economy is going to simply rebound as a function of just reopening the economy and how much it's going to need coaxing for people to go out and spend dollars even if the economy is open. He did his best at the testimony not to take any monetary policy decisions, but when push came to shove, he acknowledged that rates were going to be stuck at the effective lower bound for years, not months.
Ian Pollick: Yes, and that was a weird forward guidance that Canada is not used to from its central banker.
Royce Mendes: Well, I think he was going to unveil, or he is going to unveil, formal forward guidance at some point, but he didn't want to do it in that venue. Look, I mean, I don't think there are a lot of people listening to that testimony outside of you and me and some other people who pay a lot of attention to what's going on at the Bank of Canada. But, you know, a formal conditional commitment is a form of monetary easing if it brings down expectations for the future path of interest rates and Canada, oddly enough, is one of the places that the OIS curve is actually pricing in hikes, correct me if I'm wrong, at some point.
Ian Pollick: Well, it's true. I mean, it's not that the OAS curve by itself is pricing in hikes, per say. It's more that when you look at the slope, what's the difference between, you know, one year, one year OIS versus spot OIS. Or, you know, better said, if you look at the money market futures curve, the shape of the curve between the end of 2020 and the end of 2021 looks wildly inconsistent with pretty much every G7 country. And I've yet to speak to any investor, whether it's real money, fast money, official money, pension money, life insurance money that actually believes Canada will have a repeat of 2009 where they're going to exit the recession first, exit hot and be in the situation where they're going to run miles above other countries. And I think that's an interesting point, because when we think about the new forecast that CIBC Economics released, you don't have that type of profile baked into the cake. Maybe it's worthwhile just sharing with everyone, what are we looking forward now, given the information we have and understanding that these forecasts could be more variable in terms of us changing them than they ever have before?
Royce Mendes: Sure. A couple of the main conclusions were that the economy has indeed, in the near term, avoided the worst case scenario. We've seen it in the Statistics Canada data, but also more real time data from credit card transactions so that, you know, things like retail sales have actually recovered quite nicely. That's not a change from our last forecast, just more of a confirmation that the economy is evolving, at least in the near term, as we expected. That said, since the last time we published forecast, we've learned that restrictions on movement and physical interactions will likely be with us for longer than previously anticipated. So while we're still calling for a roughly seven percent decline in real GDP in 2020, we've lowered our expectations for 2021 to roughly five and a half percent GDP growth from more than six and a half percent in the last round of projections. Now, you talked about how Canada is unlikely to be a leader in terms of the recovery and more likely to be a laggard. And that's because of what I've been calling pre-existing conditions. So first of all, Canada entered the crisis with high household debt levels. So when you ease monetary policy, one of the things that you're trying to do is you're trying to induce spending and borrowing and, you know, lower the propensity to save. In a place like the US or the Eurozone, household debt ratios are relatively low. In Canada, they're so high, it's not likely that people are going to be able to take on a lot more debt. A lot of the spending and housing market growth in recent years has come from immigration. And as I said, you know, we've basically hit the pause button on immigration. Now, when we think about trying to transition the economy away from housing markets and household spending towards business investment and exports, we see a problem. First of all, we're heavily reliant on the US. And while in our base case forecast for the US economy, it doesn't fall as much in 2020 and it grows quite nicely in 2021. That's a base case forecast. And there are wide uncertainty bands around that because, of course, the American economy is being opened at a far more aggressive pace. And, you know, just from looking at it, you can pretty much tell that there's a higher likelihood of a second wave in the US, which we're seeing, unfortunately, in some states already. So with Canada so reliant on the US, if it does stumble, our exports and foreign demand are going to take a big hit. The second issue on that foreign demand is that unlike 2009, in the aftermath of the crisis, when there was an emerging economic superpower in China, hungry for commodities, this time around the only reason oil prices have rebound is because production has been cut so severely. Yes, we're seeing more signs of activity and there are more people driving. So relative to April, there's no doubt there's more demand for oil and gasoline. But looking ahead, you know, the medium term, it's really difficult to say that there's going to be a strong rebound in demand because every country around the world, emerging market, developed market, has been hit by COVID-19 and Canada still having a relatively large share of its production and exports devoted to commodities makes it a little bit of a disadvantage. You know, in terms of what policymakers can do to change this dynamic, I'd say there's not a lot. That's just the way the economy entered this crisis. Business formation takes time to fully fill the gap opened up by companies that went out of business. But what policymakers should do is take a do no harm approach. The Bank of Canada should leave interest rates on hold through 2022 and augment their current monetary policies with, as we talked about, a conditional commitment, a fine tuned quantitative easing program. Fiscal policymakers should certainly leave austerity for a later date. We all saw the negative consequences of some economies which raised taxes or cut spending too early in the recovery from the financial crisis. That's obviously a different playbook than what economists would have recommended in past decades. But this is a starkly different environment. I mean, just look at the 10 year government bond yield. It's trading between 50 and 60 basis points today. That's probably a good segue into, maybe Ian, you explaining our updated rates forecast.
Ian Pollick: Yes. So, listen, I think that it's obviously been as tricky as it's been to do macro forecasts. It's pretty hard to do a proper rates forecast with much conviction. And what I wanted to show in the forecast that we just produced is a couple of things. The first one is to try and understand how asset allocators are thinking about the bond market. And I think the binding constraint, when you think about asset allocation and you think about rates, it's the fact that you have liquidity growing at such a high level. Cross asset correlations are incredibly high. And what that means is that the diversification benefits of a lot of assets are de minimis. And in particular, if you think about your traditional balanced mutual fund, you have 60 percent invested in stocks, 40 percent invested in bonds. It's been proven time and time again that that is the minimum variance portfolio that offers the most amount of diversification. Now, if you were to overlay the variance of this portfolio versus the level of rates today, I think the main observation that you would find is that when bond yields approach zero or when the starting point is close to where we are today, the variance of the minimum variance portfolio actually increases. And what that tells you is that diversification benefits are slipping. So I think traditionally where you would see a 60 40 portfolio, we could be in a situation where you move into a 70 30 type of environment. So I think allocation and demand generally decline. Now, does that matter to the level of yields outright? As long as the Bank of Canada continues to buy rates at the scale of which they're doing, I don't think it does. The other thing to be very cognizant of is that your total return profiles are very asymmetric and very limited. So, for example, we were just talking about 10 year bond yields at 55, 60 basis points. If 10 year yields went to zero basis points today and I ran a fund that didn't take any leverage, I'm only talking about a four and a half percent return. It's hard for me to justify allocating so much of my portfolio to government rates, given that I can make concertedly more upside in credit or in equities. So the broad theme with the new forecasts is financial repression is here to stay. We don't see two year yields or five year yields really doing anything over the balance of the year and for context, we have two year yields and five year yields finishing 2020 at thirty five basis points each. 10 year yields, I see them rising a little bit. And the reason I see them rising just gets back to the fact that Canada is a small, open bond market. And when you think about the yield curve, you do have to bifurcate it in terms of global impacts. And we know that the sensitivity of every tenor on the curve is obviously very high to European and US interest rate moves. But particularly now the long end the curve is where you're going to start to acutely price global tensions and whether those tensions are tomorrow that we're going to get the vaccine, hopefully, or it's supply indigestion or if it's a breakout of inflation to the upside, that isn't going to be felt in 2005. It's going to be felt in the very long end. So when you look at the new forecast, what should pop out to most people is that we do have a net steeping bias over the balance of the forecast horizon. That's out to the end of 2022. And for context, we see twos tens finishing the year at forty five basis points, it's about 20 basis points higher than today. And we see the tens thirties curve staying around current levels until you get to the middle part of 2021. So why is that? I think it's increasingly likely that the longer we maintain the current regime or the current range of rates, you're bubbling for a tantrum. We are going to get a tantrum at some point. If it is one that is truly organic, that's led by a vaccine that reduces the shackles of what the C-19 crisis has imposed on the world, then it's one that's probably less worrisome in terms of its persistence. If you do get one, though, that's just a function of expectations, then the damage here is that you may have a massive rise in rates, a very large bear steeping of the curve. But it's one that in the forecasts have been very cognizant to show gets retraced because we don't have policy rates moving until 2023, is that correct?
Royce Mendes: That's absolutely right. We don't think that the Bank of Canada is going to be able to move off of the effective lower bound until 2023. Look, even in our 2022 forecasts which we didn't publish, there's still slack in the economy. And what we've learned is that, you know, monetary policymakers see this as very asymmetrical, and it's the right way to see it. If you move off the zero lower bound or effective lower bound too early, you can stifle inflation and it's very difficult to get it back. We've had a lot of difficulty raising inflation and inflation expectations to their targets. Conversely, if we waited too long and inflation heated up a little bit too much, we could always raise rates a little bit more aggressively to bring inflation back down towards target. So that's why we have the Bank of Canada on hold for so long. I mean, if you look at the best research I've read in the US, it's that the US economy, even without a pandemic, a financial crisis, a stock market bubble would be at the zero lower bound for 30 to 40 percent of the time or three to four years in any 10 year time period. Well now we're facing a pandemic and the largest shock since the Great Depression. So I think it's pretty safe to say that we're going to be on hold for a very significant amount of time.
Ian Pollick: I would agree. And I think, you know, policymakers also have to get their heads around the damage that's been done to r-star. In addition to what's been happening already in terms of demographics and natural trends. Listen, I'm going to put the pin in this, Royce, because I'm working from home. It's sunny outside and I want to go outside and play with my kids. I am so happy to be back with you. It's a great discussion and we're going to be back every single week. So don't worry. There's lots of stuff to talk about. And remember, no bonds were harmed in the making of this podcast.
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