Carney Capitulates?

News today was that Prime Minister Mark Carney withdrew many Canadian retaliatory tariffs on American good, although some remain. (One report indicated that the withdrawal was for goods covered by CUSMA/USMCA.) This news angered many Canadians, as it is an apparent reversal of the “elbows up” message of the election campaign.

Canadian Curve Comment

Although the Canadian bond bears had some excitement a few years ago, the recent experience has been quite subdued despite a certain amount of macroeconomic fireworks (figure above).

My eyeballing of the Canadian curve suggests that it is pricing a plausible macroeconomic scenario: the economy faces weakness due to a certain someone south of the border hammering out tariff rate posts, but the weakness is somewhat manageable, and possibly only mild cuts are needed. Supply chain disruptions and tariffs might put some upward pressure on prices, but that would be offset by the prospect of weaker growth.

This puts the 10-year Government of Canada at a mediocre valuation level. It incorporates a small term premium against the prospect of mild rate cuts due to weakness, but it does not have a great cushion against a cyclical upswing. Although there is not a lot of evidence of such an upswing, it is entirely possible that a certain someone again chickens out and does not change tariff rates that matter for Canadian growth by that much. At which point, price pressures may start to matter again.

My initial scan of data pointed towards the “mediocre growth at best” story, but I hope to expand upon that impression in a follow up post. Since I have been fairly quiet recently, I wanted to just get this initial comment out first, rather than wait to see what happens with my data filtering. (Statistics Canada changed their website and I was missing Canadian data updates for some time, I finally bit the bullet and incorporated the “stat_can” module to my platform so that I can update again.) If one wanted to take macroeconomic positions, I think Canadian rates are not the best instrument — the Canadian dollar (might) be more exciting, although I am not the person to ask about currency guessing. (I got my first forex call correct, and decided to retire undefeated.)

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(c) Brian Romanchuk 2024

Economic Phoney War

Although the advance estimate of U.S. real GDP shrank by 0.3% in the first quarter (link), I am unsure whether that contraction will stand up to revisions (as discussed below). I still feel that the U.S. economy is in the unenviable state of being an experiment in expectations: current economic activity is actually revved up courtesy of everyone trying to front-run tariffs, but activity is gone over the cliff Wile E. Coyote-style. Meanwhile expectations are caught in a bind — if the tariff policy were credible, everyone would expect gravity to kick in. However, the random nature of Trump’s policymaking still leaves people with the hope that the effective embargo on China will be quickly reversed since only an insane person would view the policy as a good idea.

Canada/U.S. Free Trade, R.I.P.

Trump has declared economic war on Canada, and has done so in a fashion that Canadians can no longer take the premise of “free trade” seriously. The tariffs have not yet come into effect, and there is an easy off ramp for the Canadian tariffs — the Canadian/U.S. border fentanyl trade is nearly non-existent (the formal justification for the tariffs). That said, unless the American stock market collapses, there is no sign that Trump will back off quickly.

Yield Curve Indicator Still Waiting For A Recession

The U.S. 2-/10-year slope inverted in mid-2022, and we are still waiting for the recession that was allegedly predicted by the yield curve. At this point, the yield curve maximalists have to be hoping for a recession triggered by a trade war in the coming months. At which point, the maximalists will argue that the yield curve predicted the trade war in 2022 the same way it predicted COVID-19.

For those of us who are not yield curve maximalists, we can argue that the yield curve roughly predicted what it is supposed to: an end to the Fed rate hike campaign as well as cuts. The problem for bond bulls is that the cuts were relatively mild, and as Friday’s labour market report showed, the economy remains resilient. My favourite labour market indicator — the employment-to-population ratio — is doing nothing interesting, which is consistent with steady growth.

If the United States did not face erratic policy shifts, one could argue that the small positive slope puts bonds in a decent position. There is a small cushion of carry versus the front end, and although a re-acceleration of growth might prompt some hikes, the possibility of some sort of growth accident would trigger deep cuts by the Fed, making the risk profile asymmetric (although the steady growth scenario would be more likely).

Unfortunately, we do not live in that magical world of limited policy uncertainty. Tax cuts are a priority, and even though there are Republican spending cut targets, they are too small versus the hoped-for tax cuts. Using tariffs to keep the CBO happy is easily going to trigger “Transitory Inflation 2.0.” The only major growth/inflation moderating story would be the effect of countervailing tariffs. Although the Fed might attempt to “look through” the immediate price shock of tariffs, their willingness to do will be limited by the outcome of “looking through” the post-pandemic price spike. (I don’t think monetary policy had that much effect on the inflation miss, but I am certainly not on the FOMC.)

Canadian Yields

The fragile state of the Canadian economy has left the Canadian 10-year yield much lower (at the time of writing, 3.5%). This would be upsetting to the many economists who insist that Canadian bond yields trade as a spread to U.S. yields if they were capable of examining their beliefs based on data. (In case it’s not obvious, this is based on multiple conversations I have had with economists over the years. Many point out that the Bank of Canada’s internal models were based on this assumption, without ever questioning whether this point was in their favour.)

For semi-retired Canadians doing some asset allocation shifts at the beginning of the tax year, it would appear advantageous to shift bond holdings to U.S. dollar ones. Unfortunately, the Canadian dollar has not been cooperative, weakening to historically cheap nominal levels.

• If the U.S. dollar bonds are unhedged, the yield advantage could easily be wiped out by a mean-reversion in the currency. Although it is hard to get too excited about the Canadian dollar when Canada is in Trump’s tariffs crosshairs, the U.S. economy itself is in the crosshairs of the same person.
• Hedging the currency — not a trivial task for a retail account — results in (roughly) flat carry, and leaves you exposed to relative growth strength in the United States. There might be an argument that this relative position would have interesting risk management characteristics, but my gut reaction is that most of the volatility will show up on the U.S. rates leg, so the position would end up directional with U.S. rates.

This situation is interesting from the perspective of pop currency trading theories. Since Canadian yields are lower, the dominant theory is that the Canadian dollar will continue to lose value (making unhedged U.S. Treasury longs/Government of Canada shorts irresistible). Although this time could be different, I would point to past history — the CAD/USD traces out an extremely wide trading range, and trade fundamentals will eventually matter. A tariff war might break those fundamentals — but that scenario requires a belief that doing things like trashing the supply chains of the Big 3 automakers and losing cheap Canadian crude is politically sustainable.

The other “interest rates and currency” theory predicts the exact opposite — the Canadian dollar is mechanically priced to appreciate in currency forward markets. This appreciation is referred to as “expected appreciation” — which refers to the expected value in option pricing markets, and is not necessarily a forecast. Some economists appear to be believe that exchange rates are determined by institutional investors arbitraging hedged treasury bills. (Spoiler: this is not true.) The rates market and the currency market are both large markets with largely indirect linkages. Although I respect rate expectations (with some caveats), currency markets can ignore the trade breakeven point (i.e., the forward) created by rate differentials for a very long time.

Although it may have already happened, the situation appears rife for one of the periodic “Canadian bond apocalypse” stories to pop up on hedge fund radar’s. Although some Post-Keynesians also like the idea of bond and currency vigilantes joining forces, my sense is that domestic bond managers would just view any pop in yields a chance to do some duration-matching. If the Canadian economy actually did start accelerating, the Canadian dollar might start performing again.

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(c) Brian Romanchuk 2024

Canadian Recession Watch

I saw a comment by former Bank of Canada Governor Stephen Poloz that suggested that only population growth is keeping Canada from slipping into an “official” recession. (In the United States, the NBER is the standard recession-dating source, in Canada, the C.D. Howe institute aims to replicate that role.)

40 Million Canadians!

The estimated population of Canada has reached 40 million (link to Statistics Canada information). Although reaching that level is not particularly important, it highlights a shift that is somewhat surprising for those of us not paying close attention to Canadian statistics. The figure above highlights the increase in Canadian immigration, particularly after the pandemic dip (which reflects the border closing). I have never needed to pay attention to Canadian demographic data before — since population growth was quite slow due to falling rate of births. Although immigration was a source of population growth, it was not too significant. However, population inflows are a factor that cannot be ignored, and they matter for the “Canadian Housing Crisis” debate.

One thing to keep in mind that I believe the series I plotted above includes net international student flows, which are large. The United States made it more difficult for foreign students to enter, and so there was a hefty reallocation into Canadian universities.

(Statistics Canada has an interactive dashboard of population statistics here, for people who want to take a look at the data presented in way better than I have time to do.)

Housing Bubble (or Not?)

This leads into the status of the Canadian Housing Bubble. Researchers at the Dallas Fed have created a database of international house prices, and I have seen people plot the same chart multiple times, comparing the house price to income ratio of Canada versus the United States. The chart looks crazy, but I believe that it is missing some context. All the versions that I have seen have dumped multiple countries into the same chart, I have instead just shown Canada. I have not had time to look at the data, but it seems consistent with other data that I have seen. (One of the problems with Canadian data is the limited availability of housing data.)

• The top panel shows nominal house prices (according to whatever series they used) and nominal disposable incomes. I have rebased both series to 100 in the first quarter of 2000, for reasons to be explained. The immediate problem with these data is that they are indices, while the sensible initial comparison is nominal house prices to nominal incomes.
• The bottom panel shows the ratio of the two indices (rebased to 100). Since this is a ratio of an index to an index, its level has no economic significance; all we can so is see whether it is rising or falling.
• I chose 2000 as the rebase point because that is roughly when Canadian house prices took off, forming a hockey stick chart. (The house price data chosen by the Fed researchers puts the hockey stick somewhat later.) However, that level was not a “fair value”: house prices in Canada (outside of a few localities) was cheap. Winnipeg and Montreal (the two cities I have mainly lived in) essentially saw no nominal house price between 1980 and the mid 1990s (working from memory on the CREA house price series that I no longer have access to). We bought our first house (a 3 bedroom townhouse) in Montreal at the end of 1998 at a price that was about 150% of the median Canadian after-tax household income. I believe that a closet in London (England, not Ontario) would have cost about the same at that time at the prevailing exchange rates.
• The cheapness is not obvious in the chart above, but one may see that the bottom panel ratio shows it is roughly the same in 2000 as in 1980 — and interest rates were considerable higher in 1980.
• Real estate is local, and there were two large pockets of high house prices — Vancouver (and Victoria) and Toronto. Vancouver is easily understood — it is one of the few places in Canada where old people are not risking hip injuries stepping outside of their homes in January, and construction is confined to a handful of valleys amidst a mountain range. Vancouver house prices have been notoriously (relatively) expensive since the 1970s. Toronto has more open space around it, and what has happened there is that people have been forced to commute longer and longer distances to the city centre. It is not surprising that house prices close to Canada’s financial centre are high. Both Toronto and Vancouver had a condo bubble and bust in the early 1990s (coinciding with one in the United States).
• The hockey stick after 1998 was the result of the progressive loosening of mortgage insurance standards. (All mortgages with loan-to-value above 80% must have mortgage insurance, which must conform to a minimum standard.) This loosening allowed the rest of the country to emulate the experience of the United States where subprime lending became a force in the early 1990s, and also put more fuel into the Toronto and Vancouver markets (which bumped into maximum mortgage sizes).

The above background is aimed at the chart that I have seen reproduced multiple times that allegedly indicated that Canadian house prices were more “overvalued” than American in the mid-1990s. Putting aside Toronto and Vancouver, that was not true until the American housing market broke in the Financial Crisis.

I have been bearish on Montreal house prices since the mid-1990s, and I was concerned after 2010 with what I saw as excessive construction and the collapse in lending standards for mortgage insurance. However, the lending standards were tightened, and the immigration wave blew my “excessive construction” fears completely out of the water.

Grab Bag of Comments

• If one wants to dig into the state of the Canadian housing market, one needs to look into metrics of borrower vulnerability. That has been a topic on policymakers’ minds since the Financial Crisis, and there is now more data available. I have not had time to dig into these new data sources.
• Housing bears need to learn to be patient. As long as the labour market is in decent shape, nothing interesting is going to happen. My concern has always been that there will be a nasty self-reinforcing feedback loop: the high level of employment in construction means that if the housing market tanks, it feeds into the labour market. However, that has not happened, and the immigration wave has been enough to absorb any excess supply.
• There are pockets of silliness, possibly buoyed by dubious cash inflows from overseas. However, this is a story aimed at condo markets in some city centres, and we could just end up with a localised blow up (as in the early 1990s).
• I find that analysts spend too much time worrying about house prices. Unless you are buying or selling a property, the important concerns for housing economics are debt service and construction activity. What I am seeing locally is that there is such a backlog of construction and renovation projects that there is limited sensitivity to house prices.
• As for the drop in house prices at the end of the chart, I looked at the Teranet-National Bank House Price Index™️ and I see a roughly 10% round trip up then down from 2021 to 2022 to present. This is not incredibly surprising given the behaviour of interest rates over this period. Although the chart looks ominous, in the absence of another rate hike campaign, a “sideways correction” is an entirely plausible outcome. Conditions were unusual and 2022 and they unwound — which does not necessarily lead into “the bubble is popped and the housing market is taking the express elevator down!”
• Rising interest rates creates a strain on household finances — particularly since the longest period interest rates can be locked in practice is 5 years. However, a spike has already happened, and the Bank of Canada is well aware of this vulnerability on a forward-looking basis.

Ever since the Financial Crisis, there has been periodic excitement raised by foreign analysts predicting the collapse of the Canadian housing market. Unless the business cycle is upended elsewhere, I would remain cautious.

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(c) Brian Romanchuk 2023

The Canadian "Fiscal Crisis Of 1994-5"

I have now arrived at the part of the preparation for my panel that I have dreaded: the Great Canadian Fiscal Crisis of 1994-1995. This is an event that Canadian Establishment figures will talk your ear off about if you bring up Modern Monetary Theory (MMT). My problem with this crisis is that I spent my working life staring at charts of yields, economic data, and exchange rates, and never even noticed anything unusual during that period in Canada. It was only much later that I heard about this alleged crisis. (I was out of the country until August 1994, and too busy teaching my first course as a postdoc in engineering to notice what was happening in the markets or the news.)

Bank Of Canada Goes Just Plain Nuts

OK, the title might be too dramatic, but the hike of 100 basis points on Wednesday was somewhat out of the ordinary. Since I am not interested in selling any particular forecast, my interest here is the angle: what does this mean? Unfortunately, the answer to that is not entirely clear. The Bank of Canada (BoC) seems to have fallen in with the crowd that argues that rate hikes ought to be done in one massive hit, and then we wait to see what happens.

Canadian Protest Comments

I have seen a large amount of bad takes on the protests in Canada. This article covers concrete issues as briefly as possible before turning into political analysis. I divide the article in three parts — economic impact, some background points that many seem unfamiliar with, and then the political side. Unless something radically changes, I do not see much of an economic impact at the national level.

Interest Rate Policy Versus Alternatives

One of the ongoing arguments about Modern Monetary Theory (MMT) that I run across is the general disdain for monetary policy among MMT proponents. (At one extreme, Warren Mosler argues that interest rate policy works in a way that is backwards versus the consensus.)

Bank of Canada Comments

The Bank of Canada released its October 2021 Monetary Policy Report, and I just want to make some brief comments.

I would summarise the report as follows: the Bank of Canada has ended its balance sheet expansion (“Quantitative Easing/QE”) in order to have the capacity to raise rates if needed in 2022. Although the bond perma-bears that dominate “serious” economic discussion will welcome this, this can also be seen as a statement of the obvious. Inflation has been running above target for some time, and that is not immediately expected to turn around. If inflation is not back closer to target by the end of next year, it would be very hard for the BoC to claim that it is an inflation-targeter. However, for the bond bears to have anything other than short-term vindication, inflation indeed has to not settle down in 2022.

Canadian Shelter Inflation Poses Difficulties

The July CPI report for Canada, and as expected, the annual rate of inflation remains high courtesy of comparisons to lockdown pricing in 2020. I am largely on the side of “Team Transitory”: the punchy annual inflation rates will subside once we are past weak comparisons, and some of the supply disruptions are cleared.

Sustainability And Canadian Housing

Economic data are starting to recover from the distortions created by the pandemic, and so lazier analysts like myself can get a better handle on the current state of the economy. Although I have an interest in inflation, I want to also see what is happening in the real economy.

Rising Interest Rates Is A Good Thing For Governments

Worries about the effects of rising interest rates on government finances is a standard feature of editorial pieces. However, a floating currency sovereign should not be analysed in the same way as a household or business. An individual should reasonably worry about the effect of rising interest rates on their finances; if they face financial failure, the side-effects are not enough to affect macro outcomes. This is not the case for a central government: interest rates reflect macro outcomes, and the analysis needs to take into account why interest rates are rising.

Canadian Establishment: "Deficit Myths? Yes, Please!"

The Canadian Establishment has launched a full-court press against lax fiscal policy of the Trudeau government. It would be only a slight exaggeration to say that they are calling for austerity (at least not immediately), but rumours of policies like Universal Basic Income are causing alarm bells to ring. The Canadian economic establishment is very much wedded to sound finance beliefs, courtesy  of the Great Canadian Fiscal Crisis of the early 1990s.

Comments On Canadian Inflation Risks

There has been a cabinet shuffle in Canada, with the Finance Minister position moving from Bill Morneau to Chrystia Freeland. Newspaper reports hint at philosophical changes, moving towards a more free-spending strategy. Although the messaging might change, I would lean towards changes in practice being incremental. It is entirely possible that economic differences were played up to move attention away from other political concerns about the old finance minister.

Although supply disruptions might be tied to a bump in the price level, telling a story about sustained price increases -- inflation -- seems awkward, even with looser fiscal policy.

Moving To New Steady State

My argument has been that economies would return to a steady state path, with certain industries crippled (e.g., mass tourism), but other industries able to operate. My guess was that Canadian provinces would show some dispersion based on how they handled the containment of the virus. That guess so far was incorrect, as Canadians actual behaviour seems relatively uniform, and the virus appears relatively well contained. Instead, the American states are more likely to show deep divergences (which appears to be a consensus view).

Moving Into The New "Normal"

My local economy appears to be moving towards what is best called the New "Normal:" a state of muddling through in such a fashion so as to keep the spread of the coronavirus under control. From an economy-watching perspective, the closest to clean data for Canada and Quebec will appear in June. Since the latest official unemployment rate data (above) is for April, the implication is that it will be considerable time for the data to catch up.

Bank Of Canada: Repo Printer Go Brrr!

The Bank of Canada has completely restructured its balance sheet in response to pandemic stresses, causing it to resemble that of the Federal Reserve (above figure). The size of the balance sheet has exploded, creating yet another time series terminated with a vertical line. If we look at the assets, we see that repurchase agreements ("repos") went from a nearly insignificant asset to about half the balance sheet (as happened in the Financial Crisis of 2008).