• Earnings buoy risk sentiment
  • Risk-reward merits fading BAX and OIS pricing for the BoC’s starting point
  • Australian 10s rally post-jobs
  • China’s nowhere close to its inflation target and doesn’t care
  • Careful with the drop in US claims
  • Chilean peso shakes off aggressive hike
  • Canadian manufacturing reaffirms the rebound narrative

Risk-on sentiment is significantly conditioned around earnings beats. Another round of Q3 US earnings releases posted an impressive array of beats across BofA, Wells Fargo, Morgan Stanley and Citi. We’re also getting a heavy line-up of Fed-speakers today but what we’ve heard so far has been largely predictable.

The USD is regaining ground lost earlier this morning but is still softer against some of the higher beta crosses so far. The gilts front-end is outperforming and was doing so before dovish comments from BOE MPC member Tenreyro. Most sovereign curves are slightly richer through the belly and long-ends with EGBs and Aussie bonds (post–jobs) outperforming further along the curve. Stocks are up by either side of 1% across N.A. and European cash markets after rallies in Tokyo and Seoul with HK shut. Oil is up by another just under 1% with WTI up by about $20/barrel in less than two months. 

By extension, the correlations are such that the Fed’s 5-yr forward breakeven rate and TIPS breakevens across maturities have spiked and are converging toward peaks in May but are not there yet.

Also by extension of the correlated trades to oil, CAD continues to appreciate with USDCAD almost a nickel lower in the past month.

Australia lost 138k jobs last month (consensus -110k) all of which were part-time as full-time jobs were up by about 27k. Australian 10s rallied after the release.

Chilean markets are dealing with the aftermath of Chile’s central bank decision that surprised with a 125bps hike to an overnight rate of 2.75% late yesterday and that exceeded all estimates but was less of a surprise to market pricing. The peso initially rallied this morning but has since reversed and with the November 20th election ahead. The accompanying statement noted that “the policy rate will reach its neutral level sooner than foreseen in the September report’s central scenario” and flagged inflationary pressures as the driver. The neutral level has been guided to be ~3.5%. This suggests another 75bps hike could be offered at the December 14th meeting to get to neutral, but again, we have to get through the election at a minimum.

China continues to maintain tight monetary policy despite being miles away from its inflation target. CPI slipped a tick to 0.7% y/y (consensus 0.8%) in September and core CPI was unchanged at 1.2% y/y. The state’s 3% goal is clearly laughably out of reach. On the heels of yesterday’s release of aggregate financing figures that continue to be on the soft side, plus with among the world’s highest real policy rates (chart 1), China is experiencing soft economic growth in no small part due to its own policy setting. Policymakers are convinced everyone else is making a mistake by embracing QE and they are likely still concerned about risking a repeat of the over-stimulation that was provided in the past and the ensuing imbalances. 

US weekly initial claims fell to 293k last week which is getting close to the 256k rate just before the pandemic struck in March 2020. It’s the first sub-300k print of the pandemic so all things considered it’s a good sign. But why did they fall to such depths? That’s less clear. There were no material estimated numbers across states so that measure of quality was solid. One should always take claims into long weekends, through the ensuing week and the week after with a grain of salt; for instance, maybe folks were more focused upon an early start to the long weekend than they were upon traipsing off to file a claim toward the end of last week. it's also tough to discern the impact of ending the extra payments under the pandemic unemployment benefits through CARES Act provisions. Half of states (in numbers, not share of pop'n) eliminated the extra $300/week back in July/August by dropping out of the Federal provisions and then the rest of them ended by the end of the first week in September. Did claims suddenly fall last week because of the reduced payments and hence less incentive? We’ll need more data beyond holiday distorted periods to tell as so far the evidence since early September is at best mixed.


I’ll offer a BoC comment in a moment, so let’s get one quick point out of the way on incremental information. Manufacturing sales increased by 0.5% m/m in August which matched StatCan’s ‘flash’ guidance and my estimate. All of the gain was in volumes (+0.6%). This fits the rebound narrative alongside other August–September data we have so far including last Friday’s ripping jobs report.

Now back to the Bank of Canada. This almost pains me to say given hawkish personal beliefs, but in my opinion, risk-reward to market participants has shifted in favour of fading contract pricing for the start of BoC hikes. BAX futures and OIS pricing is volatile but generally easing off a bit today, but the contracts are still significantly pricing lift-off around a March–April timeframe. I suppose that’s not impossible, but the money-making business around these contracts likely faces more incentive to fade what I think is a pricing overshoot on the starting point for hikes.

For a Q1/Q2 hike to happen, the BoC would likely have to behave like a very bad boy scout looking to get booted from the program. To date, their scout’s honour pledge has been that the BoC won’t hike until spare capacity has been eliminated. They say this in every statement and speech and here’s the line:

“We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.”

So where is slack now? Chart 2 is my guess. It’s likely wider than they had judged at the time of their last forecast round in the July MPR primarily due to negative GDP revisions and forecast overshoots. Recall that the BoC had forecast a +2.0% expansion in the economy during Q2 but revisions to April and May GDP took the quarter down to a contraction of -1.1% and Q1 GDP growth was revised a touch softer. The BoC pointed to distortions such as autos and exports due in part to supply chain issues whereas domestic demand growth was solid in Q2, but it was still a pretty big forecast overshoot. Furthermore, we’re still getting Q3 data, but the BoC went high at 7.3% q/q SAAR for its Q3 GDP forecast back in July whereas consensus is now around 4½% and we’re at about 3%. You’d have to fudge, fake, manipulate or take down a dark alley and really beat up potential GDP estimates an awful lot in order to make up for forecast misses, overshoots and revision effects of that magnitude in terms of how they translate into wider slack. If that were to happen with volatile and frequent reassessments of potential GDP after the BoC said potential GDP growth is 1.8% on average over a three year forecast period when nobody knows what it is then it would just further impair the relevance of the entire output gap framework. Also recall the BoC defines slack in a relatively generous way with two output gap measures and a wide variety of labour market metrics.

On October 27th, I would therefore look to the BoC to reaffirm that slack won’t close until well into 2022 and likely not until H2. It might indicate later rather than sooner within H2. Rightly or wrongly, this central bank puts a lot of stock in its gap framework and views it as a necessity to see slack being eliminated in order to durably land on their beloved 2% mid-point of the 1–3% flexible inflation targeting band. Macklem has softened his narrative around the drivers of inflation compared to sounding rather strident earlier in the year on how it’s all just poofy transitory and base effect stuff. He has not, however, abandoned his insistence that while inflation will overshoot the BoC’s 3% upper bound for a time yet, it should come right back down while reaffirming past forecasts that trend CPI inflation on a Q4/Q4 basis will average just over 2% in 2022–23. We’ll see, but it’s likely going to take a lot more evidence to inform this forecast and policy bias and it’s unlikely that we’ll get that evidence as soon as March/April.

If said gap math is on the mark, then the BoC is unlikely to rush a hike narrative. They are more likely to gently say ‘hold on a second here’ to the markets. I can’t think they’d be overly fussed about the overall path that is getting priced in into 2023, but it’s the starting point that is likely to make Macklem uncomfortable with respect to the risk of being pushed by markets toward such an outcome.

That bias is compatible with embracing a shift to the reinvestment phase of the Government of Canada bond buying program on October 27th. There are two reasons for this. One is I think Macklem’s speech on reinvestment last month teed up such a shift; otherwise, he could have easily waited until later in the year or early next to jawbone reinvestment intentions. Second, the difference in terms of the math behind the bond flows is kind of six-and-one-half-dozen of the other. They could, I suppose, taper purchases by another $1B/week down to $1B from the present $2B/week flow and then tee up a shift to reinvestment at the January MPR. That was once my expectation given the pattern of $1B moves at each MPR meeting back to when the BoC became the first central bank to begin reducing purchases a year ago, though largely for technical and not policy-related reasons at the time. But shifting to reinvestment now would yield a pretty similar outcome in terms of the flows into primary and secondary markets. With the terms of trade lift and revenue beats, the Trudeau administration’s quest to keep the left wing NDP onside and push off another election for 2–3 years will have them spend that out in a Fall statement and/or Winter budget, but at the margin this doesn’t have to accelerate primary market debt issuance. Soooo, the punch line is the BoC could still buy in the high hundreds of millions per week in the secondary market even in the reinvestment phase.

I can think of a zillion things that are more important to the direction that bond yields could take than splitting hairs on a small difference in weekly BoC bond buying scenarios around whether to taper and then shift to reinvestment in January or just move to reinvestment now. The risk management framework likely merits shifting to reinvestment now and flat lining the balance sheet with weekly flows averaging around the amount maturing off the balance sheet next year. That risk management perspective takes out insurance around the fact that nobody can really forecast where inflation is going over the next couple of years to a substantial degree of accuracy and the BoC’s track record at forecast inflation has been pretty weak for an extended period of time. They can say that inflation should fall back, but whether they’ll be right or not is another matter and yet maintaining emergency stimulus on that assumption is a big binary bet that a central bank shouldn’t make. The exit framework speeches by Macklem and Gravelle (back in March) tend to indicate the BoC will remain in this reinvestment phase for some time before hiking and only doing so when spare capacity has shut and they have enough confidence that inflation is durably on track.

That’s what I think they will do.  What should they do?  Oh boy, that’s another separate note for anyone who cares, but it’s what the BoC will do that matters to borrowers and investors.  Sensitive or not, I remain of the conviction that central banks in general are doing more harm than good by retaining emergency levels of stimulus ages after the conditions that warranted fears of deflation and depression passed.  As a group, the unelected officials running central banks are engaged in massive mandate-reach toward things that should be the focus of elected officials and platforms put before the electorate on social and environmental policies.  Unchecked, stability and what you pay for everything you buy will pay the price.

Last, this discussion is separate from the issue of what’s priced into 2s through the belly on the full rate path going forward.  At 2% by the end of 2023, our forecast BoC policy rate remains on the more aggressive side of pricing while we’re nevertheless lower on the neutral rate than swap market proxies. 


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