Bipan is joined by Global Head of FICC Strategy, Ian Pollick, to unpack last week's Fed meeting and what it means for macro markets. Ian also finds a way to use words like "irregardless" and "universion".
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Ian Pollick: Oh, I think absolutely. Notwithstanding the degree of confidence we have around the House view that there's going to be two hikes next year, I am fairly confident that we'll get at least one. And I'm also fairly confident that, you know, it's very hard to take away the punch bowl and expect nothing to happen.
Bipan Rai: Hello and welcome to another edition of The FX Factor podcast. I'm your host Bipan Rai of CIBC's FX Strategy Team. And with me today, I have a special guest back by popular demand, Global Head of Fixed Strategy, Ian Pollick. Welcome, Ian, how are you?
Ian Pollick: Good man. How are you doing, bud?
Bipan Rai: Good to have you back on. But when I said back by popular demand, I mostly meant your own. (laughs) Sorry. Anyway, it's actually timely to have you back on. We just had the FOMC come out yesterday and there are a lot more hawkish than most of the market expected. What was the biggest thing that stuck out to you from yesterday?
Ian Pollick: Well, it's a good question. When I read the statement and I listened to Governor Powell or Chair Powell talk, to me, there was two things that stuck out. One of them was just the distribution of the hawkishness. And I think we can see that pretty clearly, just in how many people are now looking for a 2022 hike. The other thing, too, that really reinforced the hawkishness was just the rapidity of the turn and the reaction function. I think that's partly a function of average inflation targeting. It makes things move a bit more just in time. And you know, an example of that Bipan is just, remember, it was only a few weeks ago where Chairman Powell said that we're not thinking about thinking about tapering. And yesterday he said, well, we actually want to retire the phrase thinking about thinking. So, you know, things are moving very quickly. And I think that's one of the things that we can expect going forward, is that, this is an FOMC that is struggling with a very unique recovery coming out of a very unique situation, and that's forcing the reaction function to move a bit more violently and more volatile than they're used to.
Bipan Rai: Right. So that was actually going to be my next question on whether or not you picked up on the Fed sort of shifting view on inflation. It was quite different in terms of tone from what we heard from them in April and March. What changed? I mean, is it purely a function of this ever evolving reaction function that you allude to or is it something more to it?
Ian Pollick: Listen, I think there's a few things. You don't have to look very far to start seeing indications of pricing pressures. And I'm not just talking about the official data. I think anecdotally, people are hearing lots of stories about a whole range of services and goods, you know, whether it's cars or whether it's backyard haircuts, everything's a bit more expensive. And when you look at some of the survey indicators as well as CPI, listen, the stamp of price pressures are universally everywhere. Now, the question is, is this transitory or not? And it's one of those things where I feel like, I don't know what your view is, but the word transitory has to be defined because by itself, it almost reminds me of the Pinocchio paradox. Do you know what that is?
Bipan Rai: No, actually, it'd be helpful to hear what that is.
Ian Pollick: Everyone knows who Pinocchio is, right? You know, he's this puppet that came to life. If he lies, his nose grows. If he tells the truth, nothing happens. But if you think about logic, there's one phrase that if Pinocchio says kind of short wires, the entire system. So if Pinocchio says my nose is about to grow now, either he's going to be telling one lie and one truth, because those two can't exist at the same time. And I always feel like that's what we're saying when we talk about price pressures are transitory because transitory isn't just inflation decelerating from 5%. It could also at the same time, it mean that a decelerating year over year rate, but one that stays sticky above the 2% inflation target. So I think it's more of this realization and appreciation for the fact that deceleration doesn't necessarily mean true moderation from target. I think that's one of the big sticking points here.
Bipan Rai: We've spoken a bit about inflation. What about the other side of the Fed's mandate, employment? Did you pick up on anything in terms of slight shift in language from what they said in March and April as well on the employment front?
Ian Pollick: Not really. I mean, I can't remember what he actually said, but there's something in the press conference where he basically said that the move in the unemployment rate could be unrepresentative of the actual tightness of the labour market. And I think what that means is that traditionally, if someone were to choose, for example, who is not in the labour market to re-enter or enter for the first time, they may not actually be going on unemployment. They could just be going straight into the employment market. And that's a really important distinction in this cycle. The other thing that I picked up on was this idea that they spent a lot more time talking about inflation and how concerned they are that there's so much variability around their central tendency. So I think that over the past few months, they've rightly been almost solely focused on the employment side of the mandate. And I think now they're paying a bit more tribute to the inflation side, other than just belabouring the point that it's transitory. Did you interpret it a bit differently?
Bipan Rai: I was paying attention to what he was saying with respect to the fact that, look, there's probably a ceiling in terms of the pace of employment gains and the fact that the retirement effect on the labour of supply could last a few years. And it was almost like he was acknowledging that, look, this is probably going to be a little bit more of a slow burning theme for them. And that, to me, lowered the bar unemployment gains. But then, that can mean, I asked others and they didn't really interpret it the same way that I did. But to me, it didn't really change what we're expecting in terms of timelines. But it just felt like he was a bit more acknowledging of the fact that employment might take a little bit longer to get back to where it was beforehand.
Ian Pollick: The question I have for you is, do you think that's a function of the narrative that we've all heard around very generous employment benefits? I know you've done a little bit of work on it. Do you think that's real or do you think that's just anecdotal?
Bipan Rai: In terms of the generous benefits holding back labour force supply? No, I do think there's an effect there. I don't think that it counts for the entire reason why we're sort of seeing the slow momentum back towards the labour force. But I do think it is having somewhat of an effect. I mean, not just that, but you also have to consider as well. And, of course, you know more about this than I would, that it's really, really hard to go back to work when you're receiving generous benefits and you also have kids at home over the summer months, right? And then I think, you know, when we do see some of those federal benefits expire in September, that's also when kids go back to school. And it also helps to make it much more enticing to go back to the workforce as well.
Ian Pollick: I talked a lot about this with Royce on my own podcast, Curve Your Enthusiasm. And one of the things that we were talking about was this idea that once these employment benefits go away, what is the timeline by which people start to re-enter the labour market in force? And is that a situation that potentially steepens the wage Phillips curve? And is that something that the Fed is cognizant of? And one of the things I look at is on the Atlanta Fed's website, they have this measure. And one of the measures they have is the wage gains of basically every combination of worker you could think of. And the one that I look at a lot is job leavers. So those leaving one job to go to the other, and that is running at like a 6.5% annualized rate right now for job leavers. You know, that's one of the highest that we've seen in the cycle. So I do wonder, you know, how persistent these wage gains can get and if they can't get a bit worse.
Bipan Rai: Right. That is something to keep an eye on for sure. I mean, I must admit, I haven't been paying that much attention to that metric. But certainly I would echo your sentiments in terms of that being a metric to keep an eye on, especially as we head towards September. But what we have from yesterday is a very hawkish fact. The meeting in 2023 signaling two hikes. We've got seven FOMC participants suggesting that a hike could happen before the end of next year. What is the timeline for the Fed's order of operations look like to you now going forward?
Ian Pollick: So I think the most important thing to remember here is when you take a step back and you look what happened yesterday and you look at the evolution of the past few meetings. This is a process. All right. And processes start with baby steps. And I think yesterday, rightly or wrongly, was whether it was delayed or not delayed, it was the start of a process. And these are steps in the right direction. And where I thought the Fed could have done a bit more, is this on their inflation forecasts? To me, it didn't look like core PC projections changed all that much. You know, you had a tent increase in 22. Nothing happened in 23. So I think as you go forward, you start to see that acting as a conduit that really starts to communicate how hawkish they are. In terms of the sequencing, which I think what you're asking me, you know, I expect that you get some type of tapering announcement officially as our House view in September. Could it happen at Jackson Hole? Sure. Every year we talk about something happening at Jackson Hole that never does. But by the same token, we always talk about big Fed meetings having nothing happening and look what happened yesterday. So I think it's fair to say in the next six weeks, we'll hear something about tapering. We think tapering begins, actually begins later this year, in December. And that's consistent with our economics group's timeline for the start of normalization in Q3 22.
Bipan Rai: So if we've got a taper starting in Q1, right? And again, we've got the Fed buying assets at one hundred twenty billion per month pace. That's much, much larger than where they've been at before. And if we assume the same timeline or at least the same degree of tapering, we're also calling for two rate hikes by the end of next year. Does that seem like an aggressive timeline to you? And if that does happen, do you see any sort of risks to the markets and in terms of potentially that degree of tightening, having a meaningful impact in the way that risk trades?
Ian Pollick: Oh, I think absolutely. Notwithstanding the degree of confidence we have around the House view that there's going to be two hikes next year, I am fairly confident that we'll get at least one. And I'm also fairly confident that, you know, it's very hard to take away the punch bowl and expect nothing to happen. And particularly if you're talking about the rates market, you can't reprice duration without repricing a host of other asset classes. They're also interconnected and really the basis of it is interest rates. So I think that you have an excellent view here is that risk is just well supported on a relative basis than when we entered this year and where we were at the peak of last year. You can have this situation unfold that's going to require a lot of prepping from asset managers. I could see a situation where you have a stronger dollar and we can talk about that in a moment. But you're going to have weaker equities and you kind of have weaker bonds. That's kind of the everything sell off scenario. And that's not something that any of these 60 40 portfolios have been used to for quite some time.
Bipan Rai: So let's talk about something else that the Fed did yesterday and that was, of course, the hike in both of the administered rates to preserve the integrity of the lower end of the floor. So the IOER, or the interest on excess reserves, that was hiked, as was the overnight reverse purchase facility rate as well. Why do you think the Fed did both? And can you talk to us a little bit about what they do and why the Fed was compelled to act?
Ian Pollick: You and I had talked before the meeting and our original kind of projection going into it was, yeah, they're definitely going to raise IOER. We're not so sure about RRP, and I called you two days ago, and was like, you know what Bips, I actually don't know how confident I am in this anymore. And I say that because I saw the stability and how Fed Funds was trading. And, you know, I think I got a little bit whipsawed by the trees relative to the forest because, you know, what the Fed did was the right thing. At the end of the day, you have a very unique situation occurring where QE is happening alongside a recovering economy. But it's also an economy that's not experiencing a huge amount of loan growth. And, you know, partly is that's a function of containment measures still being in place and a lot of different places and activities still not back to normal. So you're just inundated with this huge amount of reserves. And, you know, if you are a money market fund, even though we live in an environment where credit risk is quite a bit smaller, who are you going to lend money to at zero? A private sector or the Fed? Well, it's going to be the Fed. And I think that's one of the situations that they understand. And unlike most other central bank facilities, to me it looks like the RRP facility is now a first stop destination. It's no longer our last stop destination. And I think that increase in RRP rate is going to be consistent with an increased usage of the program. So I think yesterday, right before we taped this podcast, usage was three quarters of a trillion. And I think we're supposed to get used to some of these numbers. But I think at the end of the day, this is seen as a conduit to smooth out some of the friction in the relationship between too many reserves being put into place, regulatory costs of holding very, very large balance sheets, and a period of time where deposit growth continues to outpace loan growth.
Bipan Rai: So, for the Treasury market, now I'm going to hold your feet to the fire. What do you think happens over the summer and what's your strongest conviction?
Ian Pollick: The most important thing that I believe occurred yesterday is that the narrative around reflation may not have gone away, but the way that financial markets are trading, it will have shifted. And we've seen that in the reaction of the yield curve over the past couple of days where we've had a flatter curve because in effect, you are truncating this inflationary response into very, very short periods of time. That's going to coincide with higher policy. And that's going to have an implication because no longer will reflationary trades be centred around, for example, market based inflation compensation, i.e. breakevens. I think it moves into the realm of real interest rates. And we saw front end real rates in the US have moved 20 basis points in the twenty four hours right after the Fed meeting. I think that's probably the biggest change. And what that does is two things. Number one, by shifting how reflation expectations trade in the bond market, it also changes the shape of the yield curve. And as the shape of the yield curve changes, I think it puts a lot of pressure on the shape of credit curves. So whereas we've seen this huge amount of issuance from corporate America, corporate Canada, corporate G10, the outright level of spreads in corporate world, I think is going to get a little bit stressed "irregardless" of what you think about default cycles. It's just, I think, a function of how the yield curve is shifting. And you and I have talked about this quite a bit, when you start to reduce the velocity of liquidity in the system, what you also end up doing is destroying correlations. So if we move to a more normalized correlation environment, I think it's a really good thing once it reaches its kind of equilibrium. But what it does, it just adds more diversification to portfolios. Where I think this gets interesting and I'm going to turn this over to you, is if we believe that we're in a flatter curve environment and we believe that reflation no longer trades as just higher breakeven rates of inflation or steeper yield curves, what does this all mean for the dollar? Because if you do, for example, get this broad repricing in commodity prices, I think that you could have this kind of equidistance scenario arise where you have pockets of inflation but very different assets telegraphing it. So what do you think happens to the dollar? Because that's the really big question here.
Bipan Rai: You hit the nail on the head. I mean, if we are seeing this flatter curve environment driven by maybe real yields outperforming, or sorry underperforming breakevens, to me that suggests that the dollar should be higher, right? And again, if we look at next step positioning in the FX market, the most popular trade over the past year has been to be short dollars. The immediate near-term effect has really been this sort of, this positioning adjustment that we've seen play out. And this is something that could last a little bit longer, because I do think that the narrative around the Fed has shifted a little bit. And certainly if we compare the Fed to other central banks, I think we're past the point of peak divergence between, say, the Fed and maybe a hawkish central bank like the Bank of Canada or some of the other ones out there. The argument of being short the dollar, because the Fed does switch to an average inflation targeting framework, to me has become a lot less compelling and, you know, that sort of environment, and if we continue to see this narrative play out over the course of the summer, I think the dollar has more room to move higher. And that's partly a story on positioning and also partly a story that we said earlier with respect to breakevens.
Ian Pollick: So let me ask you this, Bips. What is your preferred way to play it? Because I know a couple of days ago you put out an awesome trade rec. Well, talk to us a little bit about that. You saw this huge rapid appreciation of the vol that you took into consideration. How should investors think about this? Is this a gamma story? Is it a spot story? And is it just a G10 story? Do we start thinking about EM as an expression?
Bipan Rai: That's a very good question. And to be honest with you, I think we need a little bit more time to see how the market digests this. If we want to sort of extend this more towards an EM theme, because I have noticed that EM central banks have been pivoting towards the hawkish direction as well. And, you know, this sort of environment where yields are operating off a low base, I'm not sure how FX is going to respond to that. So, I mean, in terms of trade, I still think that some of the popular positions that we've seen put out over the last couple of months, like being short dollar CAD, are going to be unwound, right? And again, like if we think about things from a CAD perspective, I think know fairly appropriate degree of hawkishness from the Bank of Canada has already pretty much in the price. What I'm not sure is and the price is the degree to which the dollar could still lift off here. And so, again, you know, I went long a one month 124 strike. That's already performed reasonably well. Do I think there's more room to the upside for dollar Canada? Sure. I mean, I would have picked a better or at least a higher strike. The one thing I am somewhat concerned about is what oil prices do going forward. And I do think that there's a lot of that risk in the coming months that could sort of sap the tailwinds for the long dollar CAD trade. So I want to be a little bit more conservative on that front because I do think the CAD is going to be a bit of a lower beta play. On the other end, I do think that there could be some downside with respect to euro and swiss, where we do think that policy rates are going to be lower for longer. And I'm not sure that the move higher in euro dollar based solely on this sort of fiscal integration story was justified enough. And so can we see a move in euro dollar towards 116, 117? I definitely think it's in the cards and something that you could probably still look at as an idea to capitalize on.
Ian Pollick: That's a good rundown of what's going on. And from the investors that you've spoken to in the past 24 hours, 48 hours in the FX market, are there big surprises or big thoughts outside of the main ones that we've outlined today?
Bipan Rai: Not that I've seen. I think everyone was sort of waiting for this dollar corrective move, but I'm not sure, or at least the sense that I'm getting is that they're kind of a little bit more reluctant to call it corrective now. I think there's more of a sense that what we saw at the FOMC was, I hate using the word game changer, but it certainly feels like it's moving in that direction because, again, to your point, it really feels like the reaction function is a little bit more jumpy based on the average inflation targeting framework. And really the degree of comfort with being short dollars has been mitigated, I think, by a significant degree. And I think that's the one thing that I've noticed from some of the discussions I've had.
Ian Pollick: That's interesting.
Bipan Rai: Last question for you, Ian. The CAD rates market, now you put out a pretty interesting piece on what the takeaways were for CAD rates. Can you just highlight them again for our audience on this podcast?
Ian Pollick: Absolutely. You know, I think you alluded to it earlier where all of a sudden, you know, the story for Canadian rates on a relative basis has been, why is there so much price for the Bank of Canada? Why is the short end of our curve look so steep in comparison to everyone else? So I think this does and you mentioned that Bank of Canada hawkishness is largely in the price of the currency, but would say it's largely in the price of the shape of our front end curve. So I think what this does is it makes the Bank of Canada pricing look a bit less odd. And by making it look a little bit less odd, it means that those forward points in OIS just stay very sticky. And that's really important because there's been a lot of activity trying to harvest what appears to be a lot of excess macro premia. But now that you have convergence, slow convergence to Bank of Canada pricing, because remember, there's two hikes priced for the bank in 22, two hikes priced for the Fed in 23. I think over time those two things kind of meet in the middle, but it just means that the bank doesn't look as aggressive on a relative basis. So that means that CAD rates don't have to reprice all that much and by an extension of that, when I think about the rally in the bond market, say over the past month, we've seen terminal fall 40 basis points in Canada, to around 215 today. So I think if you get a repricing of terminal, which I think we'll see everywhere, well, at least in North America, then it puts a lot of weakness on the five year point of the curve. So we hate five years. We really don't like them. We think that cheapens up versus everywhere else and that really supports this kind of flattening bias to the long end. And that's really interesting because Canada has had this really transformational supply shift where the government is now issuing a lot more bonds in general, but also a lot more bonds in the very long end of the yield curve. That had been one of the main reasons why our curve had been steepening over the past few months, but now I think that it's largely socialized. And I think if we believe that the story here is one where real interest rates start to really become the lead singer as opposed to the drummer of the story, then what ends up happening is that you get this "uninversion" of your breakeven curve. And in Canada that is between twos fives is between tens thirties. So I think that there's more reason to own very long term real yields as opposed to very short term ones. So I think that also supports the flattening. But I think what you're also seeing is being borne out in basis markets that kind of intersect both of our worlds between FX and rates. And I think cross-currency basis can continue to get a bit cheaper, i.e. less negative. And by extension, I think that means FX OIS spaces can also turn positive in the very short dates.
Bipan Rai: Excellent. Thanks again, Ian. Always a pleasure to have you on. I can't wait to have you back in a couple of months to explain why you're right.
Ian Pollick: Thanks, buddy. I really appreciate you taking the time and thanks again.
Bipan Rai: Excellent. Thanks, everyone, for joining us. And we'll be back on in a few weeks with the next podcast. Cheers.
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