Back by popular demand, the FX Factor podcast returns with Bipan and Ian discussing important macro themes. This includes the rise in global inflation, how the front-end of rates markets are currently priced, why sovereign rate curves have been flattening alongside what this all means for the currency markets.
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Ian Pollick: Yeah, I think the Fed what they did last week was really smart because they basically gave themselves max degrees of freedom. They could dial it up dollar down as they need see fit. So, you know, I don't think we can just kind of literally say 50 billion a month, and that puts us eight months out before we're done. I think they could speed it up when they wanted to.
Bipan Rai: Hello, everyone, and welcome to another edition of the X Factor podcast. This is our first one in quite some time, and we're back by popular demand and we've got an extra special episode for you this time around. We've got our global head of fixed strategy, Ian Pollick, joining us today. Ian, welcome back. How are you?
Ian Pollick: Good man. How are you doing?
Bipan Rai: Excellent. Excellent. So first things first, there's a lot of really interesting things happening in the raid space, and I figured this would be a great time to bring someone like you on with your expertise in the area. Why don't we start off with what's going on in the short end, men for the non rates focussed audience out there? What's been happening there? What's been the main story driving things?
Ian Pollick: Well, listen, there's obviously been quite a lot of themes jam packed into a really, really short period of time. And, you know, I think you could kind of trace back the origins of the move that we've really seen in global short ends to the Bank of England. Remember, it was the Bank of England six seven weeks ago that really started to talk quite hawkish about inflation, and that really started to put something in the minds of global participants being, well, what if transitory isn't transitory? With high inflation readings in some of the small, open economies actually are going to warrant faster rate hikes. And what ended up happening was that CTAs, which are commodity trading advisors, you can think of them as systematic accounts or programmatic accounts. They basically attacked every single market where there is a lot of premia, and it just turned out that the markets with the most amount of Premia were all the smaller Anglo economies. So whether it be New Zealand, Australia, Canada, the U.K., to a lesser extent, the US and what you found is that that coincided with an IMF meeting at the end of August, early September. And, you know, it felt almost very coordinated because after that point, what we found is that all these central banks turned a very hawkish in a very short period of time, and that's the type of sequencing of events that feeds upon itself. And that's why you saw so much weakness in the short end of the curve
Bipan Rai: And give us an example of how egregious some of the pricing is there. What are markets going to be expecting from the Bank of England and the Bank of Canada right now?
Ian Pollick: So, you know, just for some perspective, you got to a point where you were pricing in four rate hikes from the Bank of Canada before the Bank of Canada met two weeks ago. You know, relative to our own forecast, that was clearly a pace that we did not think was going to be able to be achieved. But then, once the Bank Canada met and actually turned hawkish at one point you had like seven and a half hikes price for twenty twenty two. Now that's come down since obviously global rates have rallied over the past week or so. But what it shows you is what happens when you have illiquidity meeting hawkish surprises or to say another way, when you have leverage and surprises, you create volatility. And the volatility was very much concentrated in the front end of global curves.
Bipan Rai: Right? And does this have anything to do with the fact that we're now, I guess I don't want to say we've completely and permanently shifted to this new sort of macro framework of higher inflation, but certainly it looks like there feels like there's a transition at play here. And would it be accurate to say that there's some degree of volatility with the way the markets perceiving central banks and the reaction functions as we've moved into the sort of new phase? Let's call it of higher inflation.
Ian Pollick: Well, listen, I don't know if I would call it the phase of higher inflation. I think I would characterise it Bips really as a phase of understanding what the word transitory means, because I think that's been the biggest problem this year is that if you can't define something and you're going to use that language repeatedly, and it wasn't just one central bank, it was basically every developed market. Central Bank was using that phrase transitory inflation, but it meant a lot of different things to a lot of different people. To economists, it meant a year over year deceleration in the rate of change. It's that other people meant just to move back to two percent permanently. To some market participants, they started to realise maybe it actually means just a higher price level in general, and maybe that's actually bad for growth. And so when you have this kind of lack of understanding what the word means, you can't use it in a homogenous way. I think the biggest thing for me, the biggest startling realisation over the past really six weeks is just the speed of transition away from what was the reaction function over the past decade since the financial crisis. And really, that was one of low growth, low inflation, which meant patients. And I think that you're now at levels of inflation, whether it's four percent or five percent that are actually far away enough from target. It does create a lot of discomfort from policymakers. And so I think just as equally frustrated we are with misunderstanding or try to understand the evolution of inflation, I think they are as well. And have they been extremely vocal on it? Yes. Have they been entirely transparent? I'd say no. There was a relatively abrupt shift. But I think it's that communication shift, coupled with the fact that no one really understands what the word means. And now we're all understanding that we're coalescing around this kind of higher for longer inflation regime. And that's going to create volatility.
Bipan Rai: Look, I mean, we did get the Bank of England last week that kind of caught markets a bit off guard with the non hike and especially the communication with respect to them pushing back as to what the market's priced in. And look, there was a bit of a correction there, but ultimately, I mean, we're still pricing in what around just over five hikes for the Bank of Canada next year. We still got egregious pricing for some of the other smaller Angle as central banks as well. What do you think brings this market back to reality? What will what what does market need to see before ultimately realising that, you know, it's not realistic to expect these central banks to hike to this degree?
Ian Pollick: So, you know, I guess the first question I would pose back on you is what do you think would need to happen to validate this? Let's take the counter the counter to this, because I'd be curious from an FX perspective, what in your mind makes all this happen and realise the forwards?
Bipan Rai: Yeah. I mean, If I'm a policymaker and I'm leaning into this move to kind of similar to what the what Macklem did a couple of weeks ago, I mean, I'm really waiting for the data to come out and really materialise and really send the message to the market that look, you know, some of the egregious pricing we're seeing is ultimately not likely right. And I know we talked about this beforehand as well. But if you look back over the past couple of quarters, the Bank Canada is well behind their growth projections for Q2 and for Q3 now. Can they make this up in Q4 and Q1? That's going to be a tougher call to see, and maybe we need to see some more data come out before that's ultimately the market gets the message that, yes, ultimately, while the timing of the first rate hike, you know, may have been brought forward, I think the distribution of rate hikes needs to be reassessed and that comes down to a data story, in my view. I mean, do you see that similarly from your vantage point or would you push back against that?
Ian Pollick: No, I think so. I mean, listen, I've said for quite some time, you know, our view has been that I can't quibble too much with where terminal rates are being priced in Canada. I don't really care about the endpoint per say. I care about the path to get to that endpoint and to what you were saying earlier. You know, you are talking about a very fast sequential pace of rate hikes, and there's a couple of things worth mentioning that maybe could validate at least some of that pricing. On the one hand, remember that yesterday we got news that Statistics Canada had revised its gross series. What we saw is that expenditure based GDP or real GDP on a quarterly basis was actually increased from twenty eighteen all the way to Q2. Twenty twenty one. And what it did was it raised the level of GDP by about four tenths. Now, if you drill down a bit further, what we found is that most of that growth was actually coming from investment. And that's a really important distinction because it means that you could have this higher level of GDP. But it doesn't necessarily do anything to the output gap because in theory, if all the growth is coming from investment, then potential growth should be higher.
Ian Pollick: So I don't think that it means that potential growth or the output gap has closed even further. I just think it means that we entered the recession on a stronger footing and we exited it on a stronger footing as well. The other thing too, I think, to realise, is that when you get closer to twenty twenty two, it's this idea that how do you organically grow out of this pricing where you have to get to every sequential meeting and when you get to those meetings and there's inaction, that's when you're going to start to see some convergence. Now, I don't think you're at a point in time that's going to take all the pricing out right away. Obviously, if God forbid, something happened where COVID turned to a deadlier phase in what we're in right now, that's something that would clearly stop the pricing in its path, but in a very conservative view of the world, and it's a status quo view. This pricing is not likely to go away until you get closer to the meetings and then every meeting you go through, you kind of drop off a little bit, and I think that's going to be very frustrating for bond investors.
Bipan Rai: Yeah, and it could be frustrating for macro traders as well. I mean, if they were talking about every central bank meeting having some embedded event risk Premia priced in, then look, we're going to have to be really, really mindful of what's priced in going into the meeting and really, really have a keen sense of what might be said and how that might impact markets. So very much with you there, Ian. Well, I think so.
Ian Pollick: And I think it's this idea of kind of organic remediation. It's like, you can't you can't really dismiss the counterintuitive or the counterfactual just yet. You have to get closer to the time. And you know, I would say that the shift in message from the Bank of Canada was very specific, and they are basically foregoing an earlier closure of the output gap or slack being absorbed rapidly to allow for inflation to come back to target. And I think all the messaging that we've heard is very consistent with a discussion to the non traders, the non strategists, the non economists. It's to the everyday Canadian reminding them that they have inflation under control. And what that practically means, I think, is that they're trying to dissuade unmooring of inflation expectations from becoming something that's a bit more broad based in nature. Now I want to turn this over to you because you're you're obviously the subject matter expert in foreign exchange markets. When I look at Dollar Canada and I look at the relative path of hikes for twenty twenty two. Just from a really simple perspective, because I'm not an FX guy. Why is dollar cad not higher or lower? Why? Why is the dollar not more expensive, right?
Bipan Rai: So that's a very good question. I've been asked that a few times and you hit it on earlier. I mean, it's not just a Made in Canada story, even though we have seen a significant repricing of the Bank of Canada. Well we have to remember is that we're seeing the shift in short rates globally. And that's important because again, remember that the exchange rate fundamentally is a relative asset. So you're really comparing the level of rates in one jurisdiction to the other. And, you know, I don't just want to say that there's only one factor that drives an exchange rate because clearly there are several others as well. And there is this inbuilt or at least built in bias to when it comes to owning U.S. dollars over the coming years as well, given the fact that the narrative is has shifted quite significantly since the June FOMC meeting. So there's two reasons there. One, you have seen a move in short rates in Canada, and ultimately that is going to matter for the Canadian dollar. But also, you've seen a parallel shift or close to parallel shift in the United States as well, even though that spread is still very much in the favour of owning the CAD asset. The other thing to remember is that the market is still very much of the view that the dollar will strengthen in the coming years.
Bipan Rai: And those you have two countervailing forces there that are really helping to keep realise volatility in FX, somewhat grounded relative to what you would expect to see if it was just the Bank of Canada being priced egregiously. So I think that's the predominant reason there. Now I'm going to ask you another question Iann. I think this is a question that a lot of our listeners are going to be very interested in when it comes to inflation. And look, we've all heard the narrative like this is a supply shock. This is driven by really the disruption of global supply chains and maybe a few factors, such as the lack of equity when it comes to vaccine distribution on a global basis that are really driving prices higher. And there's not really much the central banks could do. But what I do think that a lot of policymakers are concerned about is to what degree inflation expectations will be impacted, and I think that has a time function embedded into it. Do you subscribe to that theory at all? Is this the reason why the central banks are getting more and more concerned with, you know, something in theory that they have really no control over when it comes to policymaking?
Ian Pollick: Well, I think so, right? Because, you know, we've heard from academics, we've heard from non academics. And it's one simple message. You know, monetary policy cannot fix supply chain disruptions that cause inflation. And that's true. But it gets back to an earlier point I made. It's this idea that, you know, if we read our economics one on one textbooks, it will say quite clearly that when inflation is rising, you lose your purchasing power of money and therefore you consume at a faster rate. And I think the worry here is that when you look at the price level, that's exceeding income growth is exceeding wage growth. You actually may get the opposite outcome where consumption gets restricted and the bedrock of every macro forecast in the world right now is that you do get a drawdown in this excess savings rate. The Bank of Canada itself is assuming that Canadians drawdown of these 20 percent of their excess savings, and if you don't get that, then all of a sudden your consumption path is impaired and therefore your growth estimates have no shot of actually being realised. So I think it's more that they are concerned the longer this persists, which to be clear, and they have kind of mea culpa this that it is persisting longer than they thought. Even Kashkari at the Fed said he thought that inflation was lasting longer and almost fell off my chair when I read that headline. So I think it's your point. It's just that to not destabilise the inflation making process, they want to be seen as they're getting ahead of it. I think it's as simple as that. Would you agree with that?
Bipan Rai: Yeah, absolutely. I think that's the channel that they're concerned about and very much echo everything you just said there. Now, let's shift gears a little bit because the short rates market isn't the only interesting area in the in the rate space. Let's talk about the dynamics of the long end and again, given the reduction in asset purchases and of course, the Fed announced theirs last week. Why are long end rates so big at this point? Why are we seeing yields move lower and by extension, a wire curves flattening? Even though, you know prior episodes of tapering have really steepened curves and led to more of a premium being built in the long end?
Ian Pollick: Well, it's a great question. Let's just back up a little bit, and let's just talk about the curve and what it likes to do ahead of a hiking cycle. If you kind of look back and really in any market in the world, roughly nine months a year prior to the beginning of a rate hiking cycle, yield curves flatten. And that's simply because all the pressure is on a repricing a very short term interest rates that occurs between your five year point of the curve, your two year point in one year point, but the back end of the curve you're 10 year yield, your 30 year yield, those really collect the average policy rate over a much longer period of time. So it's almost like a cash flow where you change a very, very backdated cash flow. It doesn't actually do all that much. And typically we would expect curves to flatten in. The problem is, you rightly say, though, is that long end yields are actually falling and it's moving in such a way that we will characterise as a bull flattening move, which just means that the curve is flattening by longer term interest rates rallying more than short term rates. Typically, when you see that happening, that's a signal that growth is about to slow down, that there's concern about the health of the economy, which is in stark contrast to how the front end of the curve is talking.
Ian Pollick: So it's almost like there's this inherent tension between the back end of the curve, the short end of the curve. Because every time that we've heard a hawkish speech, there's been a hawkish innovation coming from a central bank meeting. We've seen this dynamic where the back end of the curve actually outright rallies. So when we think about it, it's almost as if the front end is telling central bankers to hike. The back end is telling them they're making a policy error. So how do you square that difference? You brought up a good point, right? And if you look back at most instances of prior QE reductions or tapering episodes, the curve is always steep. And the reason the curve has steepened is because you've needed to rebuild term premium, which is just really a way to think about how you compensate investors for owning very long duration assets. And the reason for that is because you're just effectively removing or you're transferring a supply from the public sector to the private sector. The difference this time is that when the Fed announced their tapering programme, the supply being transferred from the public sector to the private sector actually declined because issuance on the gross level had declined because tax revenues are coming in better.
Ian Pollick: Now, if you compare, contrast is to the twenty thirteen tapering episode. You found that when the Fed tapered in twenty thirteen or talked about tapering, the amount of duration supply that would have to be absorbed by the private sector was much, much larger than it is today. So I think there's some concern that number one, the policymakers are making a mistake by hiking too early, but at the same time that there may not be enough bond supply for the private sector to absorb because issuance is falling, call it 12 to 15 percent in twenty twenty two. Now these are all really nice stories. In theory, I don't know how much they hold up in practise, and I think practically, if we're going to be a very, very conservative in our analysis, I simply looked at positioning. And what we found is that of all the positioning right now in U.S. rates, the biggest amount of shorts being taken back in the very long end of the curve. So it may just have been very bad curve positioning people expecting steepeners. they're starting to take back that steepening trend. They're starting to own more longer in duration. But I agree with you, it's a very confusing signal, right?
Bipan Rai: So I'm going to ask you now, doess this trend to continue over the over the coming months? Or do we see some degree of increase in term premiums as more supply is released back into the market?
Ian Pollick: Well, look, I am very biased in the near term to expect the curve to steepen out because I think we've entered a bit prematurely into the hiking cycle at very flat levels. And when I look at levels in Canada, I look at levels in the U.K. The risk, of course, is that because you're starting from such a flat level that you could actually be in an inverted yield curve environment partway through the hiking cycle. It doesn't make sense on a few reasons. Number one is we know that, for example, the health of the financial sector is very much aligned with the term premium in the yield curve, and that just means that net interest margin in term Premia kind of move together. And so when you think about maturity transformation, credit intermediation, it becomes that much more difficult in an inverted yield curve environment. I don't think that policymakers would want to support that type of move. Number two is when you think about what the Bank of England has told us, what their intentions are from a sequencing perspective, they've drawn an arbitrary line in the sand in terms of a policy rate that they will have to reach before they actively allow the balance sheet to roll off and another arbitrary level to which they start to actually do active quantitative tightening, which is to sell assets.
Ian Pollick: Markets are not appropriately priced for that type of outcome in other markets, and I think particularly when I look at the Bank of Canada's balance sheet, the Fed's balance sheet, there's not enough tribute being paid to a potential mid-cycle pause. And it's that mid-cycle pause that allows the balance sheet to roll off bonds to be sold organically or inorganically. That actually introduces more turn to the curve. So I would say in simple terms to answer your question, I don't think there's enough price right now in terms of that mid-cycle pause, and therefore I see the path of least resistance in the very near term to be a steeper yield curve. But as we get into twenty twenty two, it goes back to this modus operandi where you enter into a hiking cycle and the curve is supposed to flatten out. Now let me ask you this from a rates market perspective, we often wonder about how does the shape of the curve impact currency valuations? Does it impact currency valuations?
Bipan Rai: Not frequently, no. I think what matters, mostly in terms of a pass through to the currency market is really what's happening at the front end. The thing to remember about foreign exchange is that at the end of the day, it's a residual asset. You really you have to be a macro analyst. You have to understand what's happening in the rates market. You have to understand what's happening with respect to flows and equities and whatnot. And it's really that the net result of everything and understanding really what factors are most important at a particular time. You know, that's how you get a sense of how the exchange rate is going to move. So it's not so much what's happening with respect to the shape of a curve. But if you're telling me, you know, over the near term, we expect the, you know, the Treasury, the front end of the Treasury market to underperform relative to, say, the Canadian yield market, then that to me tells me that I need to go long dollar cad. Or at least there's a factor in favour of being long dollar Cad. And usually what we see is that the closer we get to central banks lifting off, it usually is the front end of the yield curve that emerges as the most important driver of a particular currency pair. So let me answer your question in in simple terms, it's really all about what the front end is doing a couple of questions for you. Let's do some rapid fire here. And what are you expecting in terms of rate hikes from the Bank of Canada next year? Actually, let me start off with this. When do you expect the Bank Canada hike first and how many times are they going to hike in twenty twenty two?
Ian Pollick: So right now we're looking for the Bank Canada start lift off at the July MPR. We think they follow up again with the secondary rate hike in October. You know, I would say that in my gut, I may be a little bit late. I could see a move as early as April, but I do think that it could be a two hike year, not a three hike year.
Bipan Rai: Ok, my next question actually, what are the risks that? So what needs to happen in order to shift that from, say, July to April?
Ian Pollick: Listen, I think there's two things, right? We saw the labour market data. It continues to come in relatively strong hours, worked, looked very good. And that portends that the weakness that we've seen in the last two quarters of growth output could change quite abruptly as you get into Q4 and Q1. So if you are in an environment where you do get a slowdown in business investment and potential is as low as the Bank Canada says it is and you make ongoing gains in the job market and even the CPI hangs around here. I think that could augur for an April hike, potentially. And once you introduce April, it's very hard to dissuade the market from pricing in three four hike year.
Bipan Rai: Ok, now what about the FOMC? When's the first rate hike from the Fed and also, how many are you expecting for 2022?
Ian Pollick: So I feel a bit more comfortable in my projection for the Fed. We as a house, as you know, see two hikes from the FOMC next year, the first one coming in June, the second one coming in September. I think that's probably early enough. I think this is a fed that is counting seeing patients and given just the shift that we could potentially see brainer take over as chair, you know, not advocating for that whatsoever. But obviously, if that were to happen, that's a bit slower. And therefore I'm actually pretty comfortable with our calls. I find it very difficult to pull that forward at this point, right?
Bipan Rai: And I mean, does that matter that we have the Fed entering its tapering programme by June and then immediately starting rate hikes? Are we OK with that call?
Ian Pollick: Yeah, I think the Fed, what they did last week was really smart because they basically gave himself max degrees of freedom. They could dial it up, dial it down as they see fit. So I don't think we can just kind of linearly, say, 15 billion a month, and that puts us eight months out there for we're done. I think they could speed it up when they want to.
Bipan Rai: Ok, excellent. And what trade do you like to capitalise on those views?
Ian Pollick: So, you know, for me, I like the idea of curve divergence between Canada and the United States, and it's this idea that you have so much price for the Bank of Canada. It's very hard for our curve to price some more. And therefore, if you do enter into a sustained flattening trend led by the U.S., Canada should under flatten. So it's a relative steeper in Canada, it's a relative flattener in the U.S. I really like those trades. I also think that once we put some distance between some of the front end volatility that we've seen really over the past two or three weeks, it starts to put a lot of focus into, well, what is the by-product of tapering your bond programme? And for me, it's all about swap spreads. I think the build in net supply and in a jurisdiction like Canada just means that swap spreads should be much narrower. And that obviously has an implication when you think about some of the cross currency basis. So our position for a flatter swap spread curve in Canada.
Bipan Rai: Excellent, This was this is great. Thanks again for joining us and let's have you back on again sometime soon, Ian.
Ian Pollick: Thanks very much. Be Well, thanks, everyone.
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