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The Bank of Canada's Dilemma - Views from the North

FICC Podcasts 21 octobre 2021
FICC Podcasts 21 octobre 2021


Disponible en anglais seulement

This week, Fred Nastos, co-head of core BMO’s FICC trading, joins me to discuss next week’s Bank of Canada policy meeting and our favourite trade ideas.

As always, all feedback welcome.




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About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Disponible en anglais seulement

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week, I'm joined by Fred Nastos, co-head of Core FICC Trading. This week's episode is titled "The Bank of Canada's Dilemma."

Ben Reitzes:

I'm Ben Reitzes, and welcome to Views from the North. Each episode, I will be joined by members of BMO's FICC Sales and Trading desk to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.reitzes@bmo.com. Your input is valued and greatly appreciated.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Ben Reitzes:

Fred, welcome back to the show. It's an exciting time in Canada. Rates markets have been volatile, to say the least, of late. Canada has been in the spotlight a fair amount. I know I fielded far more client calls over the past three weeks than I have, in the prior three months, really. It's just an exciting time in Canada, then with the Bank of Canada coming up next week, an ideal time to really focus on them and what we're expecting out of that policy meeting.

Fred Nastos:

Hi Ben, thanks for having me back.

Ben Reitzes:

So, Fred, going into the bank meeting. We've had a big sell off in the Canadian front end. Why don't we just start with something simple? Have we gone too far?

Fred Nastos:

Well, Ben, in the front end, we still have the January meeting priced at around 30% for a hike right now. I think that seems a little aggressive. Macklem last week, he had a chance to be a bit more hawkish and I don't think he took it. And I think, we still have two months of data to come before January, but I think you need two really strong months, two strong months of numbers, yeah.

Ben Reitzes:

Fair enough. I think a January hike seems a little bit farfetched, but I can construct a scenario where it at least becomes a greater possibility. I suspect that might be where we end up after next week's meeting. So, the way I'm thinking about this, there's three different parts, call it, to this meeting. One is Macklem himself. And I think, at this point, given that last week, he had his round table with the press and he came out and, as you said, he had a chance to sound more dovish or change the bank's tone, and he didn't. He maintained pretty much exactly what they had been saying. And so, the fact that he didn't change his tone there tells you he's very unlikely to do so next week. He's more likely to stay the course, I think.

Ben Reitzes:

He noted there is more concern on inflation. It's going to be a little less transitory than they initially thought. Does that mean it's not transitory? No, it doesn't. It just means it's going to last a little bit longer. And he noted that growth is going to be softer than what they had projected in the July MPR. And that's perfectly consistent with what we've seen out of GDP, you had a weaker second quarter, and the third quarter's going to be weaker than they projected in July. And so, I think from that perspective, he pretty much tows the line, stays the course, things stay pretty straightforward there.

Ben Reitzes:

The second aspect of this I'm looking at is the MPR itself. In the NPR, it's going to kind of have offsetting, I think, forecast changes. So one, the inflation forecast is going higher, without a doubt. There there's no way it can't go higher, they were too low in the fourth quarter. And so, they'll have to bring up Q4 into the low four percents, maybe 4.3%, 4.4%, somewhere in that neighborhood likely because you already have today's inflation print, it's Wednesday right now, so Wednesday morning we had September CPI and that came in at 4.4% year over year, the highest since 2003. And so, October is already looking like it's going to be a solid number, as well, with gas prices already likely to be up about 5% or so. And so, that's going to be a hefty addition to CPI. So, you're going to get another strong print there. So, you'll get the upgrade on the inflation front, but as I mentioned, and as Macklem noted, growth is on a slower track than they thought in July. So, you're going to get growth downgrades.

Ben Reitzes:

You have the actual from the second quarter and the projection for Q three is also going to come down from their 7.3% to maybe something in the 4% range, plus or minus a half a percent. And, if that's the case, then it's extraordinarily challenging to believe that they're going to move the output gap meaningfully forward in a hawkish way. What they're more likely to do is actually push it back a little bit. I think the base case is they keep it in the second half of the year, but maybe it's a little bit later in the second half of the year. Whether they specify that or not, I'm not sure, but they can just keep it in the second half of 2022. And given the uncertainty around how big the ELPA gap is, potential growth, the demand and supply shocks, at this point, I think they'd be pretty happy just to leave it that way.

Ben Reitzes:

And the third facet of this that I'm looking at... So first is Macklem, second is the MPR, third is tapering and the statement. So on the tapering front, we're expecting, and this isn't super high conviction, but we do lean toward them moving right to the reinvestment phase and ending QE, the QE portion of the Government Bond Purchase Program. The change would be to keep the balance sheet constant rather than have it growing at a slow but steady pace as it is at the moment. And if they do that, if they go right to reinvestment, instead of maybe tapering once more down to $1 billion per week and then moving to reinvestment in January. But if they move to reinvestment next week in October, the market wants to think to itself and market predictions will say, Well, what's next for the bank?

Ben Reitzes:

Well, the next move is a rate hike. And so, if that's the case, well, maybe we need to price in a little bit more into January. And so, there's a chance that that aspect of the meeting, that move, that change, brings forward rate hike pricing. I also expect, though, in the statement, that they're going to stick with their line that they are not going to raise rates until the output cap is closed. So, it's going to be a bit of a balancing act for them, but I do expect that there's a chance the market could read it as a little bit hawkish, at least in the statement immediately given that we get the press conference a little bit later, if we do get that shift to reinvestment rather than another taper and then reinvestment getting done in January.

Ben Reitzes:

So, that's how I view the Bank of Canada for next week. If they want to be more dovish, again, they can wait on the reinvestment phase. Right after the last meeting in September, Macklem came out and he gave us the details around reinvestment. We're still missing some of the finer details, but he gave us the broad strokes. And, why would they have done that if they didn't want to move to reinvestment soon? And, why wouldn't that speech come after the October meeting? So, it's something I've had a dilemma with in my mind, it's kind of whether will they or won't they go to reinvestment or not. But, we lean toward them switching right to the reinvestment phase, even if it does sound a little more hawkish. They've had an ax to exit QE for a long time. And, on top of that, you got to believe that there is some concern on the inflation front. And so, taking a little bit more stimulus away isn't something they would be opposed to, given the inflation backdrop and risks tilted to the upside there.

Fred Nastos:

So, Ben, I think what you're saying there on the tapering is that there's really just two outcomes that can happen on that point, right?

Ben Reitzes:

Well, yes. I mean, there's always a chance maybe they would cut their purchases by $500 million instead of $1 billion, but they've been pretty consistent on $1 billion at a time. And, so the option, yeah, one of them is going right to reinvestment and the other option would be, they've been cutting their QE program $1 billion at a time. So, first they were at five, they went down to four, that was more of a tweak than a taper. Then they went from four down to three, that was tapering three to two, where we are right now, $2 billion in bond purchases per week. And so, they could cut that to $1 billion in purchases per week.

Ben Reitzes:

But that looks very close to reinvestment in that when they do finally get to that reinvestment phase, Governor Macklem said that it will be them buying $4 billion to $5 billion per month, which is $1 plus billion per week, Government of Canada bonds. There are some differences there, there's some primary versus secondary purchases. There are some differences there, and I'm happy to go into those with any of our listeners, if they want to reach out to me. But, the similarity there is what creates a little bit of ambiguity and maybe creates some communication issue, and maybe that would be one reason why they want to skip right to the reinvestment phase.

Fred Nastos:

So Ben, where should we expect the out gap closure to move to in next week's MPR?

Ben Reitzes:

I think given the growth disappointments we had in the second quarter and the downgrade that's coming to the third quarter, it probably stays exactly where it is the second half of 2022. Maybe, they say later in the second half of 2022, because the math tells you it really should get pushed back. But, I think, again, given the uncertainty around potential growth and the supply and demand shocks that we're trying to work our way through and that they've highlighted the uncertainty around the output gap potential growth. I think they'll be happy just keeping it in the second half of 2022 for now.

Fred Nastos:

I, noticed that in the last MPR, in their CPI projections, they really do have it coming down by the end of 2021, right? So, they definitely have to revise that higher.

Ben Reitzes:

So, the bank's going to have to upgrade their inflation forecast. They were looking for 3.9% year to year average in Q3. And it went two tenths above that, it averaged 4.1 for the quarter. And, given that September's at 4.4%, in October, again, it looks like it's going to be a strong print. That's going to be in the fours, likely, low fours, like somewhere between 4% and 4.5%, probably closer to 4.5% than 4% for Q4. And, then the bank did have it coming down. So, they had 2022 Q4, they had headline CPI back at 2% and then it picking back up because they were leaving things a little stimulative for longer than they usually do. I guess the question here is does that 2% for Q4 2022 stick? Probably not. I suspect it's going to be a few ticks higher and then maybe the 2023 Q4 number comes down a little bit.

Ben Reitzes:

Part of that is space effects. But part of that is the fact that the supply chain disruptions are going to last at least through the middle of next year, in some cases. The auto side of things is going to be a pretty big challenge. And then there's other sectors that are challenged, as well. And if you consider something else demand for goods has been really strong in the recovery phase of this pandemic, as people still can't really consume as many services as they want, and maybe their preferences have changed. And, so what that's done, and if you get our AM charts from economics.; You'll see I went in there on Wednesday, late Wednesday and early Thursday, highlighting how goods inflation has really picked up and you had the highest year over year goods inflation since 1984 or the early '80s, can't remember the exact year.

Ben Reitzes:

And even if you say, well, maybe that's all food and energy. Well, it's a big part of it for sure. But even excluding food and energy, goods inflation is the highest in since the early '90s. And so, there is pretty notable inflation here and that's a big switch from what we've seen for the past 20 years, where goods inflation has been really, really subdued and all the inflation's been on the services side. So, that's a pretty big shift and whether that sustains itself, whether you get ongoing goods inflation, I don't know the answer I wish I did.

Fred Nastos:

It would be hard to believe that that we're going to get a long lasting change to consumer patterns from COVID here, right?

Ben Reitzes:

Well maybe. But, it's hard to tell, one. Because it's been a couple years of this, it may be a longer lasting. It may not be permanent, but even if it takes a couple years to unwind itself, you have kind of excess demand, call it, in goods products for a lengthy period of time. And so, that creates a little bit more persistent inflation pressure. It probably fades a little bit over time through that period, but it might persist for longer than people think. And there are some other aspects of this. Something I've been on for a lot of years is you had a huge influx in global labor supply in the 2000s, in the '90s and the 2000s, really. And that really continued for a couple of decades as China rose in prominence and they became the shop floor for the world and so on and so forth.

Ben Reitzes:

And, you know the story. But there is no other China out there. We're not going to find another billion people to make stuff cheaply for the rest of the world. And so, maybe that means there is a little bit more inflation going forward because that low cost producer isn't quite as low cost a producer as you thought. And, I've talked about this in past episodes, but the energy side of things, as well, for green energy. And the more pervasive it becomes, especially if it happens very quickly, that comes with probably inflationary consequences. Higher energy costs flow through into all production costs. And so, that's definitely a big challenge.

Fred Nastos:

Yah. I think we agree that the green energy revolution's actually going to be quite expensive. It's just not that cheap to replace all those fossil fuels with alternatives.

Ben Reitzes:

But not only is it not cheap, you're actually getting no productivity. You're not enhancing the productivity of the economy. You're just producing fewer greenhouse emissions out of what you're making. And so, that is a positive, but it's an externality that we actually don't measure. Fred, moving back to the bank, we are pricing in about a hundred basis points, you said. We're looking on the cheap side here at the moment. What kind of trade should we look at going into the bank? And, do you have any expectations for what's going to happen to the market coming out of the bank?

Fred Nastos:

Well, Ben, I think the idea that we're going to hike six times over six MPR meetings is a bit aggressive. In 2010, the bank started hiking from 25 basis points to 1% and paused for a very long time. And then, in 2017, they hiked twice in a row and then paused for about four months or so before resuming what I think is a very slow hiking cycle. They hiked in January of 2018 and then didn't hike again until July, right? So, I think that the idea that we get the overnight rate above 2% is a bit farfetched. And, I think the market might price that in.

Fred Nastos:

If we do get a bank that starts talking about being hawkish like you've seen in some other markets, we're going to get a very low terminal rate priced in. In the near term, I'd say yield curves are a bit too flat here. In past hiking cycles, when the bank starts hiking rates, curves like tens thirties tend to be around 35 basis points or so. And given that we're sitting around 40 right now, that normally coincides with a very imminent hike. So, I kind of feel like that's a little bit too flat if you don't think January is sort of in play. How about you, Ben? What do you think in terms of ways to express reviews here on the market?

Ben Reitzes:

So, I think curve wise, I generally agree. We've had a pretty strong flattening run here and it's been an aggressive and fast move. And so, a little bit of retracement heading into the bank I think makes a fair of amount of sense, because we don't really get any major data points, we get one more, we get retail sales, but unless it's kind of either a blowout, we already know it's going to be strong, because the flash was good. I doubt you're going to get a huge monster number in the next flash given where good spending already is. And so, there's nothing to really drive the market to price in even more aggressive pricing from the bank. So, I think the front does a little bit better very near term, and we got a little bit of steepening, just over the next kind of week or so heading into the bank.

Ben Reitzes:

When we actually get to the bank, I think that's a little more challenging. Bigger picture, I agree with you, Fred. I think that probably the curve is headed flatter over time. We are just counting the days down until we get that eventual rate hike. When it comes does matter, and so that's why maybe you get a little bit of steepening because maybe the rate hike doesn't come until July of next year. And if that's the case, then you probably need to be a bit steeper than where we are now and slowly but surely trend flatter. But, looking just at the very front of the curve and going back to what I said earlier, if the bank moves directly to reinvestment and the market says to itself, Well, what's next for the bank? Well, if the next step is a rate hike and guess what? If they're done QE, then I guess January is now live, maybe you get a little bit more of what the rate hikes priced earlier in 2022.

Ben Reitzes:

I'm not saying that means we're going to hike in January, I don't think that, that is way too fast. But, it at least introduces the possibility to the market, it opens up that as a real possibility. And so, you might get some of the very front of the BA curve flattening, just a little bit, some weakness in the front contract and Z2 being probably unchanged as you keep a hundred basis points in the year, but you pull forward a little bit of those rate hikes. And so, I think that's a decent possibility, and you can express that a number of ways. You can do that through BAS, as I just mentioned, or you can pay January and March meeting and receive October or something like that of next year in the OS market.

Ben Reitzes:

So, I think that's a decent risk reward trade heading into the meeting. And in that case, if they are very dovish, you are going to see rate hike pricing pull back. And so, that receive further out the curve is going to do pretty well and there really isn't that much priced into the front, at the moment. But, bigger curve, flatter for sure, over time, I think it's very difficult to get away from that. And, when you get bouts of steeping, like I think you're going to get now, you want to fade that, you want to put on flatteners.

Ben Reitzes:

All of that could change next year, and all of that could change if Central Banks one day say, You know what? I'm okay with this inflation. I really do think it's transitory and I'm sticking with my thesis, even though we have 4% plus number for 6, 8, 10, 12 months, that could cause the curve to steepen in that you get fewer rate hikes close to the front, but at the same time, the long end wants some inflation risk premium, and so, maybe that ends up steeping. But, I think that's a story for maybe the first half of 2022, if Central Banks stay on the sideline and you get inflation pressures continuing.

Fred Nastos:

You just reminded me of a topic I wanted to get your thoughts on. Looking back at the past year, and this is more a comment to all central banks, not just to the Bank of Canada, but could the bank have been a bit more transparent about what transitory meant to them?

Ben Reitzes:

That's difficult. The difficulty is transitory means anything you want it to mean.

Fred Nastos:

Or instead of being more transparent, maybe I should have said less vague.

Ben Reitzes:

Yeah. I mean, putting a timeline on it, though means that you're putting strict boundaries on what you think is acceptable and -

Fred Nastos:

Well, I don't think need timelines. I think, though, they get the opportunity to sort articulate their thoughts in an MPR every few months, they get to do press conferences. Could they have articulated what they were thinking in terms of transitory, or at least try to quantify what that meant a bit more, right?

Ben Reitzes:

I don't think they know. I think that's simple answer is that transitory means a lot of different things and maybe it lasts longer than they thought, but it's still transitory in their mind. And, I get it. If anyone ever listens to all of our podcasts, you know that I'm more concerned about inflation than the average Joe, especially than the average market Joe. But, I get where they're coming from. We're in a really unique situation and given the past 10 years, it's hard to say that things have fundamentally changed. And so, do you want to rush to tighten when you have six strong inflation prints? We've only had six, don't make any mistake here. It's six months of inflation.

Fred Nastos:

You say only six. Other people will say, Oh my gosh, there's been six months of high inflation.

Ben Reitzes:

Yeah. But, I mean, what if it comes down next month? It's not going to because gas is strong. But, the year over year numbers should fall in the first part of the year. January was a monster in 2020, so that year over year, that that base effect, should pull the year over year number down. February and March were a little bit middling, not overly strong. I mean, they were good on a not seasonally adjusted basis, but seasonally adjusted, they were kind of middling. But then you got really strong prints in April and May. And so, I think of by May, you're still looking at 4% plus then you want to have the conversation about this is not transitory, sure. 100%, I think that's when you'll know, until then you can't know.

Ben Reitzes:

There's no way we can know, because we've never been here before. We've never seen goods demand like this, we've never seen supply shocks like this, we've never seen demand shocks like this. And so, how can you say with any type of certainty that you know where we are? And the bank is looking very intently at inflation expectations and they put questions, specifically, they added extra questions, one to the business outlook survey and one to the consumer expectations survey, asking the folks that had inflation expectations a little bit higher than kind of at the average. So, on the business side, it was those seeing above 3% over the next year, they asked them, do you think this is transitory or is this higher inflation going to last? And the majority of businesses and the majority of consumers said they believe this is transitory.

Ben Reitzes:

And so, as long as that's the case, the bank's going to say, You know what? We're okay. We're not saying we're comfortable, we don't like 4% inflation. We don't like 3% inflation, our target's 2%. But we believe this is going to fade over time and we don't want to tighten prematurely because there's not much we can do about some of this inflation. I can argue the other side as well, where demand really is quite strong in a number of cases, housing would be the best example there and that's helping drive inflation, and maybe that's why they should be tightening. But they're in a tough spot and, and if growth doesn't do well in the first part of next year, and in the next few months, it's going to make it even more difficult on them, because it's not like that inflation story is going to fade in the very, very near term.

Fred Nastos:

So, the bank does have quite a dilemma. We've seen how the media's latched onto the inflation story and I'm guessing that we're going to see this sort of narrative continue until either the bank moves or the bank is proven right and it is transitory because it's really because it sells newspapers or it sells clicks. But, I think we're going to hear a lot of people calling for higher rates in the next that short while.

Ben Reitzes:

That's certainly plausible. And, it's a dilemma, not just for the Bank of Canada, but really for all Central Banks and you can kind of go through them all and see how they have their own specific set of circumstances. With respect to the media, the one thing I'll say before we wrap up here is what I'm watching, probably a little more closely, isn't the inflation stories, per se. And so, on CPI day and the day before and the day after and the week of, you have a little burst of inflation stories.

Ben Reitzes:

It's when you get those inflation stories in media, like The Globe or The National Post or something that kind of every day folks read, it's not just a market newspaper like The Wall Street Journal, when those stories pop up on a more regular basis on kind of non-CPI weeks, that's when I think you'll start to see a little bit more concern. That's when you'll start to see expectations maybe moving a little bit more. So, that's something I'm watching for. I haven't really seen it yet. You get a lot of stories on inflation week, a lot more than you used to, for sure, but they don't last all that. So, if next week you see a story on Canadian inflation, that probably means a little bit more than the one that you're seeing this week. And I think on that note, Fred, if you have nothing else to add or anything else to ask me, I think it's time to wrap things up this week.

Fred Nastos:

No, Ben, I think that covers more or less what I want to ask about next week's bank meeting.

Ben Reitzes:

All right, then let's wrap it up here. Fred, thanks for coming on the show. As always, much appreciated. And thanks to our listeners for tuning in this week. Have a good week, everybody, and good luck at the Bank of Canada meeting next week.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated and BMO Capital Markets Corporation, together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including, without limitation, any commodities, securities or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 2:

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Speaker 2:

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Benjamin Reitzes Directeur, spécialiste en stratégie – taux canadiens et macroéconomie

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