Bipan and Ian discuss why the Fed isn’t likely to taper until next year and what that should mean for FX and rates markets. Also, latest updates on the Bank of Canada and the CAD.
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Bipan Rai: This is a great first episode. Thank you so very much for-
Ian Pollick: Whoa, you're not getting off the hook that easy, buddy. You know, this is a podcast dedicated to FX. So I got to ask, what's your favourite trade right now? If you have, let's say a one month timeframe, what's your favourite trade?
Bipan Rai: Luckily I prepared for that question because I knew you were going to ask.
Bipan Rai: Hello, everyone, and welcome to the inaugural edition of the CIBC Macro Huddle. It's The new podcast launched by the FICC Strategy Team here at the CIBC and aimed at audiences with an interest in macro and FX related developments. I'm your host Bipan Rai, North American Head of FX Strategy, and each episode will feature a special guest. And this week we've got an extremely special guest, the Global Head of FICC Strategy here at CIBC, Mr. Ian Pollick. So Ian, lots to talk about. Your space is particularly interesting given what's been happening with respect to the rise in longer dated yields in the US Treasury curve. Walk me through how we're supposed to think about this and what it really means from a cross asset perspective.
Ian Pollick: So it's interesting, right? First off, Bipan, I want to say thank you very much for allowing me to be your first guest on your podcast. I can't wait to hear further episodes. I think it's going to be a huge success. In regards to your question, obviously, what we've seen is this rapid repricing of longer dated yields. And you kind of take a step back and say, well, what's been the proximate catalyst of this? And I think superficially you can say, well, a lot of this is a function of reflation. Expectations that the economy is going to be high pressure, therefore eke out larger levels of inflation than we're used to. But I don't know if I necessarily agree with that story completely. I think that is initially what led us off the low end yields last August to date. But recently what we've seen is there's a growth element to the bond market story that's very important and that growth narrative is really strong and it's coming out of the United States. And what I mean by that is look no further than the retail sales report from earlier in the week. It was an absolutely monster of a number. And what it shows you is that the marginal propensity to consume by the US consumer is much stronger than initially believed. As a result of that, we've had to not only increase our Q1 forecast for the US, but we've had to increase our full year outlook as well. And we're not alone in that. That's happening sequentially across the entire street. And I think what that means now is that when you look at the composition of how interest rates have been moving, a lot of that is being driven by real interest rates rising. And that's not how the selloff has typically happened. I mean, as you know, you and I've talked about this a lot offline, but it's really been breakeven inflation, which for those not familiar with what that is, it's just the market's expectation of inflation over a given amount of time. It's the amount of compensation you get from owning a real return bond or a Treasury Inflation Protected Security. But levels of breakevens are so high right now, two and a quarter on 10 years, that every incremental basis point in the selloff cannot be led or be relied to be led on by inflation expectations alone. Real interest rates are rising and that's really important because that's consistent with the market pulling the Fed forward. And one of the things that I want to ask you about, Bipan, is that we're in a situation now where the Fed is now priced to begin lift off in August of 2023. That is almost six months earlier than where we were a month ago. Why isn't the dollar reacting to it?
Bipan Rai: Yeah, it's a very good question and one that I get often from a lot of our clients. So if the key to remember is we look at the past narrative of what yields have done over the past couple of years and what that's generally meant for the currency. And I think there's an under appreciation for the different regime that we're in now relative to the past. I think first and foremost, we need to understand that the Fed's framework has changed. It changed pretty significantly. So it's not just a story about targeting maximum employment and getting inflation close to 2%. They actually have to overshoot that now. They've committed to that. And really the parameters of that overshoot aren't really clear. So if you're looking at things from a foreign exchange perspective, even from a broader market perspective in general, you look at the Fed's mandate and how that's changing compared to some of the other central banks that have not really matched the Fed when it comes to the shift in framework. So, again, the exchange rates are the natural release valve for that. So you've got the Fed hiking a little bit early, so the market has the Fed hiking a little bit later than most other central banks. And the dollar has reacted to that. The initial move has been for a weaker dollar. Could that change? Potentially. We need to hear the messaging around tapering later on this year if they do elect to consider tapering. And I'm going to ask you about that next. But we also need to see other central banks embrace the sort of narrative while potentially allowing an inflation overshoot. So I kind of took my hand on the next question I want to ask you, Ian. Where does the Fed bend with respect to tapering and do you expect them to do anything later this year, or is that more of a story for potentially 2022 and beyond?
Ian Pollick: Well, it's a great question, Bipan. And I think one of the natural extensions of having a stronger growth profile is just questioning whether or not you need the tremendous amount of stimulus in the system. And I think what the Fed learned in their 2013 experience was twofold. Number one is you have to be very crystal clear on your intentions and you need to not only discuss normalization of the balance sheet, but you also have to provide some type of calendar based guidance around it so the market doesn't front run it too much. Now, I'm always of the belief that it's the biggest trigger in markets is the announcement itself rather than the act itself. So, you know, what that means is that the day that the Fed says, listen, we are going to start thinking about tapering in Q whatever in the year 2022. The market's going to start selling off. So the question I think is twofold. Number one is, is that going to happen this year? I don't think so. I don't think you actually get the taper until early 2022. But I think the risk here is that we blow past full employment sometime towards the second half of 2021. That's going to be a situation where the Fed's going to arguably have to question the amount of stimulus in the system. And you are often very good at talking about sequencing of events. And from that perspective, I think that you need to signal you want to taper, which is a precursor to you eventually tightening policy. So I think that the risk here is that you can pull the Fed probably into the latter part of 2022 over the next few months if the growth profile is maintained. The second thing we have to recognize, too, though, is how does the impact of the taper impact the dollar? Because when we look back at the 2013 experience, we know that the tightening we saw in financial conditions as interest rates rose were a very big precursor to a much stronger US dollar. Now, I don't know what positioning was then versus now, and maybe you can shed some light on that. But when it comes to the bond market itself, there is a lot of evidence to suggest that the magnitude or the depth of the taper will be a bit more limited. I think that's a reflection of the fact that the Fed is going to be very cognizant to overcommunicate what they're trying to do. But also, when you look at the starting level of, for example, term premia relative to where they were to some semblance of fair value in 2013, they're a bit more normalized today. Plus inflation breakevens, as I was mentioning earlier, are already quite high. So we look at how the taper tantrum actually was facilitated in 2013. You had a repricing in term premia. In particular, it was real term premia. So given that you're starting from a much higher level of breakevens versus realized inflation, I would think that you don't get as large a magnitude. Let's be very clear. We don't know what the actual outcome's going to be. So let me turn that over to you, because I think that's a super interesting dynamic. When the Fed tapers, when they announce they taper, what happens to the dollar and what do you think that sequencing looks like?
Bipan Rai: Good question. Another good one. And again, you hit the nail on the head with respect to the 2013 experience and really identifying what the root cause of that was. And again, I think the situation is a little bit different to where it is now. And more broadly speaking, since we are speaking about FX and it is a relative asset and we have to value the dollar against something, we got to compare what other central banks were doing at that time. So if you go back to 2013, May of 2013, that's when Bernanke says taper for the first time. And then obviously we get that massive selloff in treasuries and the dollar starts rallying. Around that same time, you had the ECB beginning its QE program and the Bank of Japan had just launched its super massive QE program as well. So these are new bits of information that the market was digesting at the time, and that definitely contributed to the dollar's outperformance back then. You fast forward now. I mean, the word taper, it doesn't really carry the same oomph that you had in 2013. If you're right and if we don't get as disorderly of a move in, say, treasuries this time around, it's really hard for me to see the dollar matching the performance that we saw back then. And again, you know, I'm also assuming that by the time we get around to this discussion around tapering, this massive short position in US dollars will be cleared up a little bit or it will be a lot less imbalanced. And if that is the case, that really underlines to me that, you know, this isn't the time to make a case or suggest that the taper will be a tailwind for the dollar over the long term. I think there are still some other really important structural factors that will be important for the dollar. So, again, you know, we're still a year away. The announcement could come sooner, as you alluded to. But nonetheless, I mean, this is going to be something that we're going to need to talk about a little bit more in the coming months and certainly need to pay attention to incoming Fed speakers and what they think about tapering. I know Hal has mentioned a few times that they'll signal that well in advance. But really, I mean, communication is everything when it comes to the Federal Reserve. So I'm sure we'll have this conversation more than a few times. So let's switch gears a little bit, Ian. Let's get out of the United States and let's talk about Canada. And in particular what the Bank of Canada is thinking about with respect to its own QE program. And of course, we've had this conversation between ourselves many times over the past couple of months. What do you think in terms of the Bank of Canada, both in a couple of weeks and also at the April meeting as well?
Ian Pollick: So, listen, our general view on the Bank of Canada is that I think where the biggest gap between their expectations and likely outcomes is just in the pace of growth. And we're already starting to see that, as you know, for example, when we look at the latest round of forecasts from the Bank of Canada, Q4 GDP is looking to be nearly double what their expectation is. And the early activity indicators that we're seeing, for example, hours worked in the labour market report suggests that we may not have as bad a Q1 as they believe. In fact, it may not even be negative. So at the margin, I think what that means is that prior to, let's say, the past two to three weeks, the data that's come out, our view was Q4 is likely going to be strong, which means that when the economy decelerates in kind of Q1, it's just decelerating from a much higher place in that net. That doesn't actually change the trajectory of the output gap. Now the narrative has become, well, actually, not only are we starting from a better place than we thought we would be, the deceleration may not be as steep and therefore there could be a pulling forward of the closure of that output gap, not by a huge amount, but by enough that I think would make policymakers feel a little bit secure in their base case outlook. And implicit in their base case is this idea that, similar to the Fed, do you need the same amount of monetary accommodation or stimulus in the system? And the answer is you probably don't. So we don't really expect too much coming from the March meeting other than to tee up some type of communication, because that's going to be the biggest challenge for the Bank of Canada is to communicate why they're tapering. We've talked about it at length. Really, it's a function that they are too large a part of the market, liquidity is starting to suffer. So the market that they're trying to serve is actually coming slightly undone as a result. But more to the point, if you think about normalization in the future, you are at risk the longer that you suppress very short term rates tied to credit growth because it restricts how high terminal can ultimately get. So I think that's really important. I think that we do see the bank not really saying all that much at the March meeting. And I think when we are determining the balance of risk to our April call for a taper, I think it's part and parcel of the vaccine deliveries. And on that score, I think we've had some pretty good news over the past couple of weeks. We should be seeing a lot of announcements coming soon that are leaning in the right direction. And I think just yesterday what we learned is that roughly 16 million Canadians are on track to be fully vaccinated, both shots of the two mRNA vaccines by the end of June. I think it's a bit faster than the bank had expected. For the Canadian dollar, where I struggle, Bips, is trying to understand, you know, you have a shrinking balance sheet, but the balance sheet was still generally smaller as a proportion of GDP than other central banks. So at the margin, that probably doesn't do all that much. Maybe is the bigger story here that you are at the early stages of a very big cycle in commodities and maybe given what we've seen over the past week, my question to you is, from a correlation perspective, energy in the Canadian dollar, tried and trusted story, people know well, has it changed and how are you thinking about it?
Bipan Rai: You know, it's one of those things where, like, if you're an FX trader sitting in, say, London or in Tokyo and you're wondering how to trade the Canadian dollar, the easiest way to do so, it's just to look at what WTI is doing. But often, I mean, I kind of push back against that narrative because the Canadian economy is so much more diversified and reflects so many other factors as well. And the one point that I always make with respect to what oil prices are doing is pay attention to the volatility in oil prices, because ultimately that matters for how strong the correlation between the Canadian dollar and oil prices is. So, again, if volatility is rising, generally, that means crude is falling. And that's generally the regime in which you find a stronger correlation between the Canadian dollar and crude. That's not the situation right now. Right now, what we're seeing is that realized volatility is actually somewhat muted. And so the correlation is not as strong as you usually would expect. In fact, we've seen this massive outperformance in crude prices over the last little while, hasn't really been met with the Canadian dollar outperforming. But still, I mean, the Canadian dollar can be classified as somewhat firm. And again, that's the one thing I'll highlight that, yes, crude prices are important in terms of how the Canadian dollar trades, but it's not the be all and end all. And certainly this isn't the regime that really dictates that oil prices should be the sole determining factor for how the CAD does. The other factor that I'll mention is that, look, crude prices today as we're speaking, just broke sixty dollars per barrel. I mean, is that really high enough to drive additional investment in the Canadian oil sands sector? We don't think so. So, I mean, if that is the case, then it really doesn't suggest that the tailwind for the Canadian dollar is as strong as you would think, based solely on crude price pressures. And again, you know, if you were to ask me what the fundamental driver for the Canadian dollar is, I mean, at this point and I think this is going to be true for the coming months, is still what the US dollar is doing more broadly against other currencies. And that's something that we're going to have to consider as well, particularly if we do head into the April meeting at the Bank of Canada and what they do with their balance sheet. That could change things a little bit, but that's certainly something to monitor. And so, again, over the near term, based on our view of what the US dollar is doing, we more or less think dollar CAD is going to remain somewhat range bound between one twenty five to one twenty nine. But again, over the long term, if we look at the narrative, it still suggests that the Canadian dollar needs to be lower because we are thinking that the Bank of Canada will change its approach and potentially target an inflation overshoot. And again, if that does end up being the case, you could easily make the assumption that dollar CAD is going to need to rally and move back towards the one thirty five handle over the longer term. I guess we've gone on for quite a bit, Ian. This is a great first episode. Thank you so very much for-
Ian Pollick: Whoa, you're not getting off the hook that easy, buddy. You know, this is a podcast dedicated to FX. So I got to ask, what's your favourite trade right now? If you have, let's say a one month timeframe, what's your favourite trade?
Bipan Rai: Luckily I prepared for that question because I knew you were going to ask. I like being long carry. And at this point, given what we're seeing in terms of positioning, I don't want to be short the dollar. I want to wait a little bit for that to clear up, so I want to switch funders to euro. So again, being short euro real is a trade I've talked about often with our LATAM strategist, Luis. That's a trade that makes sense to me. And again, if you want to substitute another high carry EM currency that has a reasonably strong story. Again, there's a few in Asia that I would point to. That's a narrative that I think is going to be consistent. Another idea that we still like quite a bit is we long the Chinese renminbi. We talked about this with Patrick as well. Again, as China continues to open up its capital account, you're going to see more flows going in. It's going to be supportive for the currency. So that's a trade, or at least that's a currency we continue to like over the medium term. But again, gun to the head. I'm going to say let's go short euro real for now, potentially look to rotate into being short dollar real once positioning cleans up a little bit.
Ian Pollick: Cool. Thanks, man. Listen, again, thank you very much for having me as your first guest on the show. And I really can't wait to hear how this goes going forward.
Bipan Rai: All right. Excellent. Thanks again, everyone.
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