Bipan and Ian Pollick, Global Head of FICC Strategy, talk rates – including why yield curves are inverting and whether this is a reliable signal for assets in general. Also covered are expectations for the Bank of Canada and the Federal Reserve and what this means for FX markets going forward. Ian also goes over why we shouldn’t expect a ‘soft landing’ at the end of this cycle.
Bipan Rai: And what are the odds that central banks do end up achieving a soft landing? I mean-
Ian Pollick: Zero!
Bipan Rai: Right. (laughs)
Ian Pollick: (laughs) I mean, listen, I don't want to make fun of it, but, you know, it's hard enough to try and move this giant Titanic of an economy, but to say with any precision that you could deliver this many hikes and allow for just a very small growth recession is nonsense.
Bipan Rai: Hello everyone, and welcome to another edition of the FX Factor podcast. Today we're going to talk rates and of course, talking about rates, we can't not ignore what's going on with the yield curve. And of course, our expectations for what the central banks, both here in Canada and in the United States are going to do for the coming quarters. And who better to have on our podcast than Ian Pollick, Global Head of FX Strategy here at CIBC? Ian, welcome back.
Ian Pollick: Thanks very much, man. Glad to be here.
Bipan Rai: Excellent. So let's start off with the yield curve. Firstly, which is the one we should all watch?
Ian Pollick: So listen, I think what you're really trying to ask me is not which one to watch because we like watching yield curves, but which one should we watch for inversion. And you know, there's a lot of discussion around the inversion of the yield curve and how in the past that has been a good indicator that a recession is coming. You know, typically people would follow the twos tens curve. If you ask a central banker, they'll tell you they watch the three month, ten year curve. And, you know, sure, in normal times, those are probably two really good curves to look at for some sign that the economy is in trouble when the curve inverts. But I don't think that we're in normal times right now. And I say that because, number one, when I think about some of the inversion that we've seen in Canada, in the US, remember in the US, we're talking about the cash curve. fives tens is inverted. In Canada, tens thirties is inverted. Our fives tens is flirting with inversion on a daily basis. I'm not taking a huge amount of signaling from it and I'm not taking that much out of it because number one, remember, we just went through a shockingly large QE program since the start of the pandemic. That's obviously super important from the perspective of just removing so many bonds from the market. The second thing that's really important to remember is that what's unique to this cycle is inflation. And when you think about where inflation premia typically live across the real yield curve, it's always in the back end. But because of how high inflation is right now, all that premia lives in your two year and five year sectors. So we've seen this very large inversion in the breakeven curve, which is just the difference between a nominal bond and an inflation linked bond. So because the expectations of inflation are so high in the very near term, this inversion in the breakeven curve does matter because there's a gravitational pull to the nominal yield curve. So I would say just to answer the question, you know, typically it would be three month tens, twos tens, but right now, I don't actually care all that much.
Bipan Rai: Okay. So you kind of alluded to my second question as to why the twos tens curve has flattened so aggressively. Would you say it's predominantly because of the breakeven curve and ergo because of inflation expectations? Or is there something else at work here from a supply demand perspective?
Ian Pollick: Well, I don't think it's supply demand, to be honest with you. I think it's just a reflection of the fact that we have not had a lot of pushback from any of the regional Fed presidents or the core of the committee. And therefore, the market's validated to a degree in trying to price what it's pricing in for the Fed. In particular, when you think about some of the more dovish members of the FOMC, like Kashkari, who is the dovish dove out there, even he's talking about seven or eight hikes this year. So if I'm a two year bond, I get very nervous. And therefore, I think some of the flattening we've seen, number one, reflects just concerns of how fast and how far the Fed's going to go, but also just reflects some of the factors that we talked about earlier.
Bipan Rai: Okay. So notwithstanding what we've heard from FOMC speakers of late, and of course, Kashkari being one of the more notable doves out there and his comments are certainly very interesting. Are there any other macro reasons that you could point to for the selloff we've seen in rates this past quarter?
Ian Pollick: Sure. I mean, let's just be very mindful that over the past kind of week or so, rates have actually been rallying. And that's more or less consistent with our profile. And just to put it out there, you know, we see the peak rate in ten year yields over the cycle at 2.75. It's not a huge amount from where we are today. We see them finishing this year around two sixty again. Not a huge amount from where we are today. In general, I think the primary reason we've been selling off on a quarterly basis just reflects, like we said, just general discussions from the central banks. But number two is the perception that, you know, you have the European conflict created a huge move in commodity prices, that's inflationary, that exacerbated some of that inflation premium story. You've had to reprice accordingly. But also, if you think about the spill-over from European rates, you know, when you take European yields that have been negative for a very long time and they're no longer negative, that creates more of a global competition for capital. And therefore, you need to see rates move higher globally. And that's meant a lot for North American rates in particular.
Bipan Rai: Okay. So a question that I'm sure you get asked a lot, how useful is the yield curve as a predictor for a recession?
Ian Pollick: You know, like I said, I think in normal times it's a good indication that markets are concerned that something bad is going to happen around the corner. And that's typically why you see long term yields fall more aggressively than short end yields, because typically central bankers are slow to respond to that. And so, like I said in your first question, you know, I don't think right now it's terribly useful.
Bipan Rai: So I don't recall the last time we started off a rate hike cycle with the yield curve being this flat. I mean, what do you think the interpretation here is for markets?
Ian Pollick: Well, I think it's really consistent with what we've been talking about this whole episode, right? It's this idea that you enter this cycle with a very large repricing of the bond market in general, and we can break it up into certain waves. You know, the first wave, if we go back to August 2020, that was the cyclical low in yields. The market start to reinterpret how inflationary the pandemic was. And that meant that longer duration assets like ten years and 30 years actually led the sell off. So you had this very big bear steepening of the yield curve. When you got to early 2021, just after the US presidential election, you know, there was all this discussion about the blue wave, what fiscal policy was going to do. That started to move real interest rates. You know, real interest rates really like to respond to growth dynamics. That created, again, this other repricing in yields. But as you went over kind of through the balance of 2021 and really in particular in the second half, that's when the central bank narrative really started to kick into play. That's where the policy error mea culpa started to really be discussed globally, start off by the Bank of England. And when you couple that with the fact that QE is still ongoing, has been very large, it just stops in a market like Canada. That really just meant that ultimately at the end of the day, you know, you are starting the cycle at a very low level of yields and the location of where inflation premia lives also exacerbated that.
Bipan Rai: So what are we expecting from both the Federal Reserve and the Bank of Canada for the coming quarters? Can you walk us through what your expectations are?
Ian Pollick: Yeah, absolutely. So we see both central banks moving sequentially. They have already started and we don't think they stop for a while. You know, in Canada, we have the bank finishing this year at 2%. We have, or 1.75, I should say. We have the Federal Reserve finished this year at 2%. You know, I think the big question after the growth numbers that we got in Canada yesterday was, do we expect a 50 basis point hike to be delivered? For the Fed, we do. We do think a 50 basis point hike is coming in May. For the Bank of Canada, while I don't necessarily think that they need to, they probably will. We'll wait to see what the Business Outlook survey looks like. We'll wait to see what the jobs numbers look like next week. But I think given that the market's already priced, you know, it's not a heroic assumption to believe that the bank could deliver that non standard size hike.
Bipan Rai: And what does the market take away from a non-standard sized hike from either central bank? Do you think that's cause for panic in either the rates or any other market out there?
Ian Pollick: Not anymore. You know, I think it was. But we're priced, right, like, we are most of the way there in Canada. We are all the way there in the United States. So therefore, from across asset perspective, I think what's been interesting is just the move in stocks and I'm definitely not the first person to make that observation. But, you know, I think that the validation of what the market is pricing in, that may be enough to distort some other asset classes. But for the rates market in particular, the validation of what market pricing is just means that you don't actually have to reprice the forward strip.
Bipan Rai: And how do you see QT process going forward from both the Bank of Canada and from the Federal Reserve?
Ian Pollick: So the Bank of Canada could be the first one to actually formally announce quantitative tightening. We think that happens in two weeks’ time at the April MPR. Very different than what the Fed's going to do. You know, this is going to be a totally passive program. They're just going to allow bonds to roll off their balance sheet and mature. There's going to be no reinvestment, there's going to be no maturity caps. And it's going to be very transparent because we already know what the maturity distribution looks like. In the US, it's a little bit different because you know, they conducted QE using both treasuries and MBS. So we have to pay attention to two markets. We think that it's very similar to the playbook in the prior QT round, meaning that there will be what's called maturity caps, so anything in excess of a certain number will be reinvested. We think the caps initially start around 45, 50 billion. They get increased until such a time that they think that they've calibrated the level of reserves in the system.
Bipan Rai: Okay. And how will QT dynamics affect deals across the curve in both countries?
Ian Pollick: It's a good question, right, because, I mean, in theory, the idea of a passive quantitative tightening program doesn't mean all that much to the shape of the curve. It probably matters more for the level of yields. But again, you have to calibrate where the level of yields will get hurt the most relative to where issuance is. So in a market like Canada, for example, we know that the Government of Canada made the decision, the right decision, a couple of years ago to extend its duration. It now issues more ten year plus maturities than ever before. So from that perspective, when we are shrinking the balance sheet, it just means more bonds to the private sector. It should hit our back end more than it should in the US. In the US, it should actually be the opposite. It should really be that kind of 2 to 7 year part of the curve.
Bipan Rai: So two part question here. What's your outlook for inflation going forward and how successful do you think each central bank will be in taming price pressures?
Ian Pollick: Well, thankfully, I don't do the inflation forecast at CIBC. You know, that's a job for our partners in economics. And, you know, I think what's ultimately happening is we are seeing this rolling series of one off shocks that are all effectively delaying the normalization of inflation. And for anyone to make money this year, really the only thing you have to get right is to understand by the end of the year is inflation between 2 to 3, 3 to 4 or four plus. The problem is, is that we should already be in the time where we're past the base effects from last year and therefore we should be starting to moderate. The problem is, all of a sudden you had the European conflict, so you had this huge move in commodity prices, but you're also in a drought in many parts of the United States. So food prices all of a sudden are starting to get very expensive. We haven't seen that play into the basket dynamics yet. And then most recently, West Texas is in a drought and that matters for cotton prices, which matters for clothing prices, which seasonally matters as we go into the summer months. So my concern here is that right now it's very hard to pin the tail on the donkey in understanding where ultimately inflation is going to moderate into what range by the end of the year. We still think it's going to be a situation where you are in kind of that three and one half percent plus range in both Canada and the US. If you are higher then obviously you're going to get an attendant policy reaction. But remember that our partners in Economics put out a really interesting paper yesterday just talking about the terminal rates in Canada and the US and they made a really interesting observation. The observation was you typically don't see the peak in inflation until on average five months after a recession has started. So it's not to say that you can't get this concurrent growth slowdown at the same time that inflation is rising. That's not stagflation, that's just history. So I largely reject this idea that you could get a movement in inflation higher. At the same time, growth is decelerating because that's just normal cyclical dynamics. For us to talk about stagflation, which is a totally different argument and really warrants its own episode. I don't think we'll see that in 2022 and we won't really understand how those probabilities skew until 2023.
Bipan Rai: Okay. And what are the odds that central banks do end up achieving a soft landing? I mean-
Ian Pollick: Zero!
Bipan Rai: Right. (laughs)
Ian Pollick: (laughs) I mean, listen, I don't want to make fun of it, but, you know, it's hard enough to try and move this giant Titanic of an economy, but to say with any precision that you could deliver this many hikes and allow for just a very small growth recession is nonsense. You know, I think that ultimately what I get very concerned about is a much harder landing. And it's not just on the business side. It could be jointly with fiscal and the household side. And those are recessions that take a long time to recover from.
Bipan Rai: Right. So I'm going to put your feet to the fire here. What are the odds, and feel free to respond in a way you want to quantify these odds, of a recession late next year?
Ian Pollick: Well, I think that if we were just to think of the world as being kind of a modal outcome environment that I would say there's at least a 30% chance that we're talking about a real recession by the end of 23.
Bipan Rai: Excellent. And from an FX perspective, I think Ian touched on this earlier. When we think of prices and how they move relative to rates, we should really be focusing on the front end of the curve. Again, as Ian said, with a large chunk of central banks well priced, really we should be looking elsewhere outside of rates potentially for the next big FX driver. So that means looking at tactical things such as positioning and also portfolio flows and also paying attention to some of the other key macro drivers out there, including commodity prices. And for the next episode, we'll definitely have a commodity specialist on, but right now we're paring back our bullish view on the US dollar and we are expecting the US dollar to come under a bit of pressure against some of the funders, at least for the next couple of weeks as the second quarter of the year starts. So that being said, let's wrap up today's episode. So thank you, Ian, again for joining us and we look forward to having you on again.
Ian Pollick: Thanks very much, Bips.
Bipan Rai: All right, cheers. Until next time, everyone.
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