In this episode of Northland's - The ARTISAN Video Podcast: Explore with us the topic, "Will the Fed or BoC Ever Be Able to Raise Rates?", with Northland's Co-CIOs Arthur Salzer and Joseph Abramson and our guest speaker, Alpine Macro's Chief U.S. Bond Strategist Mark McClellan.
Key issues to be discussed on this podcast include:
- Fed and BoC rate outlook?
- What happens if Alpine is correct and the Fed can't raise rates?
- Will the Canadian housing bubble get far larger before bursting?
Mark McClellan is Alpine Macro’s Chief U.S. Bond Strategist. Prior to joining Alpine Macro, Mark was a Senior VP and held numerous key positions during his 23-year career at BCA Research, including Chief Global Fixed Income Strategist. He was instrumental in developing and directing several fixed income publications, including the BCA Global Fixed Income Strategy and the U.S. Bond Strategy services. Mark also covered U.S. asset allocation when he headed the U.S. Investment Strategy service, as well as BCA’s centerpiece publication, the monthly Bank Credit Analyst. Mark began his career as an economist and macro forecaster at the Bank of Canada, and holds a M.A. (Economics) from Western University and a B.A. (Economics) from McMaster University.
Mark McClellan, Arthur Salzer, Joseph Abramson
Arthur Salzer 00:03
So welcome to Northland's The ARTISAN Podcast, where we share insights into investing by hosting some of the world's top investors and their advisors. So this morning we'll be exploring the topic. Will the Fed or the Bank of Canada ever be able to raise interest rates with our special guest speaker Alpine macros chief us bond strategist Mark McClellan. Now, Mark is Alpine Macro's Chief US Bond Strategist and prior to joining Alpine Macro, he was the senior vice president and held numerous key positions. At his 23 year career at Bank Credit Analyst Research, including Chief Global Fixed Income Strategist. He was instrumental in developing and directing several fixed income publications, including the BCA global fixed income strategy, and the US bond strategy services. Mark also covered the US asset allocation, where he headed the US investment strategy service, as well as BCA centerpiece publication, the Monthly Bank Credit Analyst, Mark began his career as an economist and as a macro forecaster at the Bank of Canada, and holds an MA in Economics from Western University, and a BA in Economics from McMaster University. So, good morning Mark. Right out of the hopper. So you worked at the Bank of Canada, with Stephen Poloz, who was the former Chief of the Bank of Canada. How do you make sense of the current monetary policy with negative interest rates, and massive money printing for the average Canadian?
Mark McClellan 01:36
Alright, well, good morning, Arthur. And his pleasure. Thanks for having me, as part of your podcast today. So this question that we're going way back to the 19, early 1980s, when I was doing my bachelor's degree taking economics 101. In that textbook, they told you that monetary financing of government deficits, it's bad because it's inflationary, full stop. Nobody, nobody debated or countered that point, you know, it's just a fact of life. So there's, there's, there's going to be consequences down the road for this kind of, of action. But But today, we seem to be stuck in what's called a secular stagnation, a term that's been made popularized recently by Larry Summers, a famous famous economist. And it's a world characterized by low economic growth, poor demographics, poor low productivity growth, and, and also weak capital spending, by the by the business sector. And on top of all that, you've also got a real desire to save on in many countries in the household sector. So we call it the excess saving story. And this has made life difficult for central banks in a couple of different ways. First, the flip side of that excess savings story is deficient private sector demand. And so that has led to pockets of deflation. And in low inflation, overall, central banks around the world have had a hard time getting inflation up toward their targets of 2%. So that's the first problem. The second problem, and it's related to the first is this idea that the neutral level of the central bank rate is very, very depressed, I won't get too technical, but basically, the neutral level is the of the state of the Bank of Canada rate is the level at which, you know, above, if the actual Bank of Canada rate is above that level, it's restrictive for the economy. And if it's below that neutral level, it's stimulating the economy. And so it's a theoretical theoretical concept, bought one. That's, that's, that's, that's quite useful. And the problem is that the excess savings glut and this inflation being being so low and below target is that is pushed down that neutral rate down towards zero. So it's made it more difficult for central banks to stimulate the economy because they have less room below that level. Because they have to push the interest rate below that neutral level to stimulate the economy and getting it going. But when it's down close to zero, while they have the zero Bound Problem, or, you know, they're limited as to how much they can cut rates, rates below that level. So you get into the they're worried about getting into sort of like a catch 22 where low inflation reduces that neutral rate, making it difficult for central banks to stimulate the economy to get inflation up until inflation and, you know, fall short of 2% target even more, and you get into this kind of vicious circle. So that's why central banks are really, in recent years pulled out all the stops. In order to try to get inflation up toward toward their target, including what we call a quantitative easing just the massive purchases of government debt, to try to stimulate the economy that way by pushing down the long end of the yield curve, making it cheaper, cheaper to borrow. So that's the that kind of brings us to where we are now. That's why they've been so aggressive. And but the thing is, we're running a grand macro experiment that we've never really done before. And nobody knows how this is all, you know, going to play out in the coming years. So it's very, very foggy, sir. Long, long run outlook.
Arthur Salzer 05:47
Now, now, you're firmus has come up with a very thought provoking piece that it's unlikely that the Fed will be unable to raise interest rates. What happens if the Fed did raise interest rates? And what do you think happens? If they don't? It's, it seems that there's a lot of fog around this. Because the last time I mean, I was around rising interest rates was the late late 80s. And it seemed to really cool off the economy.
Mark McClellan 06:23
Right? Well, the the pandemic, you know, as you know, it's changed the economy in many ways. But better at Alpine Macro, we think that the the excess savings story, the deficient demand story, that backdrop has not really been fundamentally changed by the pandemic, we still, there's no real, probably no real change in underlying productivity growth, the demographics are the same. It doesn't look like there's any huge spurt in business capital spending. So we're still in that, that that world that secular stagnation world is kind of being masked right now by massive fiscal stimulus coming in, and then the bounce back from from the pandemic recession, smashed by that but underlying it are still is still this, these macro fundamentals that are still operating in the background, inflation, that we're seeing higher inflation readings in Canada, in the US and around the world, because of these supply bottlenecks. Mostly, and we don't think that's going to last, that's not the new normal those, for example, as semiconductors are shortages there, and that not everybody's well aware of. But those supplied structures are going to work themselves out over time. And so inflation is probably going to come right back down pretty soon and drop back below that 2% target that a lot of central banks have at the moment. And in the US, those stimulus checks that they've been bailing out, some states have already stopped them. I think for almost all states by September, they're, they're done. So those industries that have been having a hard time hiring people and have had to boost wages, too, because they just can't get workers in the door, like in leisure, especially in the leisure sector, like restaurant hotels and things like that. There's been some upward pressure on wages, inflation, but those people in the fall are going to have to go back to work one still stimulus checks. And, and so we'll see that little spurt and wage inflation come come back down. So the bottom line is that we think that the neutral interest rate I talked about earlier, is still very low, that hasn't gone up, hasn't really been changed by by the pandemic. And central banks will try to raise rates here and there. But they're probably be forced before long to reverse course. So we've seen this time and time again, since the great financial crisis. Whenever central banks try to take their foot off the accelerator, you tend to get a negative reaction in equity, in risky assets and and in the economy. And enough of our negative reaction in both of those of the central banks have to back away, and in some cases reverse. So if they have raised rates, they have to back off and cut cut rates again. Now we've got in the US, the Biden administration is trying to push through some very large spending programs, trillions and trillions of dollars. But the thing is, you got to remember that those are stretched over 10 years, and they're not starting right away. And so they're not going to offset to any great extent that fiscal drag that's coming. So those when those stimulus checks and the you know, the fiscal stimulus then turns into fiscal drag and it becomes a drag on the economy for a while. And that's not going to be offset by the infrastructure spending, even if the Biden administration Moses to get it through. In recent weeks, we've seen commodity correction, we've seen some volatility in stocks. They are the meat is blaming it on COVID related concerns the Delta virus and all that. But I think that, and that's I'm sure playing a role. But I think also the market is beginning to sniff out this, this the story that I've been telling you that that the backdrop really hasn't changed, in terms of, you know, we still have too much savings, not enough private sector demand. And that we're returning to that we're on our way to returning to that world. And that's being reflected in financial markets, we've seen, you know, the Treasury curve, both flatten quite a bit over the last last month or so. So returning again, like I said, return into that pre pandemics kind of secular stagnation world where interest rates have to stay on. So that's, that's the main reason why we think the central banks are going to have a difficult time raising interest rates over the next few years.
Arthur Salzer 11:08
Do you think it's going to be forever, though? Is this something where this is maybe a two to three year outlook? Or what happens? Five, seven, you know, 10, or even 15? years out? I mean, all of us, we've been in the markets now probably three decades or longer? We've we've seen, you know, declining interest rates, more or less year over a year, during during those periods? Is this an apex moment? Could this be a slow increase over time? What do you think, Joe? Like, I don't know, like, disagree, or maybe agree with Mark on this.
Joseph Abramson 11:48
I mean, it's a little bit unusual, but I think on this issue, are more in line with the consensus. Um, what you tend to see is, after long periods of a certain trend, policymakers will fight the last war. I think that's exactly what's happening right now. So if you compare the reaction to the pandemic, versus the great financial crisis, the monetary response was the same, just as big. The fiscal response was as big or bigger, and there's more to come. But if you look at the underlying economic structural issue, the pandemic, as Alpine has argued correctly, is much less than the great financial crisis, I don't think we're looking at 10 years of deleveraging. In response to this, it's an economic shock that gets done actually rather quickly. Um, and then if we look at the underlying, it seems like policymakers are a lot more aligned with labor than capital as they have been over the previous 30 years, we look at minimum wage increase. And if we look at the underlying world, it's at least somewhat more inflationary. Globalization peaked over a decade ago. So these these real deflationary forces are weaker. Now, since there's less competition, it's unclear how the labor market is going to play out in reaction to the pandemic, how long lasting, you know, either the power of labor is or the the power of capital in response to work from home, you know, etc. But what we're seeing right now is, you know, one of Greenspan's favorite measures, job Levers as a percentage of employment is at a multi decade high. So it appears that at least in the near term, labor has the power, we're all seeing this anecdotal, I show restaurant can't find workers because they're in construction or what have you. And that's also very true, you know, of white collar. So, I, I'm more along with consensus that I do think the Fed will be able to raise rates, and that will allow the Bank of Canada to follow suit. But it's going to take a really long time, because the Fed has a dual mandate, both inflation and employment, I think inflation will come off. I think growth is slowing marks, absolutely right here. But on the employment side, it's gonna take quite some time until we're at full employment. So I think there are some structural changes at the margin. But I think we both agree it will be quite some time until the Fed can raise rates.
Arthur Salzer 14:45
That's that that's, that's great on that aspect. What do you think you want to counter on that mark?
Mark McClellan 14:50
Oh, yeah, I mean, the the inflationary backdrop in the next six months to a year is highly up in the air. I wouldn't argue vehemently. Would you on that? Looking further out? You know, this? The if you look at the what's what's driving the secular stagnation story that Larry Summers talked about? And what has changed? What what what could change that in the future. I mean, the demographics aren't going to improve much unless, you know, Canada and the US election a lot more, you know, immigrants, let's say labor force growth is probably going to stay quite low. On the productivity side, you could tell a story where climate change forces, a lot of investment by the private sector. And, and he added on top of that extra government spending to fight climate change as well, you could see, you know, investment spending as a share of GDP rise quite a bit. Now, this is a long, long term story, it's not going to happen next year or anything like that. And and typically more private sector investment leads to a faster rate of productivity growth in the overall economy. So these two things would help to mitigate the secular stagnation stagnation story that Larry Summers summers talked about. So there's the silver lining, if there is one for climate change, is that it? Like I said, it might force a lot more innovation and investment in new technologies.
Arthur Salzer 16:20
Now, no, previously on one of your, your answers, Mark, you were talking about quantitative easing, and and the Federal Reserve buying bonds that are issued to the market? Is this something that can can be reduced over time or tapered? And if so, in or maybe they stopped buying bonds? What what happens to the bond market if the Fed steps out of the way?
Mark McClellan 16:47
Yeah, we do think that the Fed is going to announce, you know, before year end, a tapering program that will probably start early, early next year. They see the economy is probably strong enough to handle, you know, a pullback in that area. And they're going to proceed quite slowly with this. They're nervous about repeat of 2013 the last time they announced a tapering because you know, the bond market sold off, there's there's you know, heavy risk off in financial markets at that time, the Fed is going to try very hard to convince us that look this time, tight, tapering does not mean tightening. So rate hikes are not right around the corner, just because we're stopping, you know, asset purchases now. You know, and maybe markets will believe at this time, because, you know, we've been through this now, once before, and 2013, actually, the taper tantrum came because I think because it was a surprise, the Fed didn't really give us much heads up that this was coming out. And then Ben Bernanke, he at the time the Fed chairman, kind of shocked the market with this announcement at this time, it's well discounted, I think, but nobody knows for sure. Investors still to take take it the announcement poorly. If it happens in the context of, let's say, the US economy, growth disappointing to the downside, not a recession, but just slower than expected growth. China has been slowing as well, markets might see it as a bit of a policy mistake that the feds tightening just at the wrong time. And then you get a risk off phase. And that negative reaction and probably a rise in the US dollar associated with that would probably cause the Fed to then back away or at least, you know, calm down its rhetoric in terms of tightening policy, talk a bit more dovish Lee. And then that might be enough to get risk assets moving up again, but there, but you won't see that until unless unless you have reaction financial markets in the first place. This is one of the reasons why we're Alpine macros become more cautious for the for the near term, or at least between now and the end of the year because of this potential for sort of a mini taper tantrum.
Arthur Salzer 19:14
And taper tantrums basically mean that the pricing or the value of publicly traded that tends to tends to decline as it's re priced into the higher interest rates. Now now, Joe, is there a way to deal with that either publicly or privately to either hedge that risk or to take it off the table somewhat?
Joseph Abramson 19:41
Well, I mean, first of all, to begin, I would concur. With Mark statement in terms of tapering, I think that there'll be very slow, they'll try and telegraph things as much as possible. And I think a lot of that transition, you know has been discounted. I mean, You know, given risky asset yields and public markets of, you know, two or 3%, I think that there's asymmetric risk in those sorts of bonds. The same is not true. You know, on on the private side, where you're beginning yield is 1011 12%. And to be honest, the default rates historically have been less than the public debt, which is currently yielding two or 3%. And you're getting much better collateral value. In addition, there are certain specialty hedge funds that can limit your downside risk through, you know, either trading the option curve, or having things like knockout options. So we will tend to put a small percentage of assets in these sorts of specialty funds, because what we want to do as a total portfolio is limit downside risks. So if 95% of the portfolio does well, in good times, and bad times, we'll try and have 235 percent that can go up quite substantially and offset any risk.
Arthur Salzer 21:16
No, that's that's great, Joe. So Mark, I mean, we've been talking about the Fed, but the Bank of Canada is not the Fed Canada's not the United States. Is our Bank of Canada independent? Like, can it can it look and see what's going on south of the border and say, we're going to come to our own conclusion? And how would the Bank of Canada respond to the Fed tapering?
Mark McClellan 21:42
Um, you know, well, the Fed tapering, if it leads to a risk off could truncate or at least delay Bank of Canada rate hikes, but kind of sort of starting at the beginning for Canada, that some of the same things I macro things in the macro backdrop I talked about, for the for the US in terms of the secular stagnation and the excess savings story. A lot of those apply to Canada as well. And a lot of people, including ourselves think that the neutral Bank of Canada rate is also very low. And so they're in kind of the same boat as the US and the ECB. Most most central banks have this zero Bound Problem. And, but I think there are some key differences between Canada and the US. The first one is that I think there's less slack in the labor market. So right now, I think that the number of payrolls in Canada's is about 300,000, short of the pre pandemic high. So as a ratio to the size of the economy, there's, there's a bit more, there's less slack in Canada than there is in, for example, in the United States. Secondly, the Bank of Canada is has expressed concern many times about the housing market, those runaway prices to the upside, and all that debt associated with those high high prices, they certainly like to see that cool off. And the other thing is that the Bank of Canada has not changed its policy framework, unlike the Fed, so the Fed has this new framework where instead of just targeting 2%, inflation, it's targeting above 2%, for a while to offset the fact that they've been been below 2% for so long, so sort of a makeup policy. So if you undershoot your target for a long time, then you want to overshoot it for a while in order to make up for lost ground. The Bank of Canada does not have that is not targeting that I mean, the Elfi, the Bank of Ghana would mind a little overshoot of inflation, but it's not definitely not targeting that. So it's in Bank of Canada's is in his position to begin hiking rates before the Fed, I think, and they've already begun to taper, as you know, and they probably be done buying assets by the end of this year, and then or early next year. And then the first rate hike coming perhaps in the second half of next year in Canada, which we think would be before the Fed because we think the Fed is more a year later in in 2023, before they'll be in any position to to hike interest rates. Now, is it is there a constraint? Well, if the Bank of Canada moves ahead of the Fed, then there you get this interest rate gap opening up that's makes Canadian fixed income assets look a little bit more attractive and so it puts upward pressure on the on the Canadian dollar. So, to that extent, you know, that the Bank of Canada is is is a little bit restricted in the sense that it can't raise rates extremely If the Fed is on hold, and the thing is raising rates and the Canadian dollar shooting through the roof, then that kind of limits how the extent to which they can raise rates because it might be really undermining the Canadian export sector. So to answer your question, yeah, what it means for Canada is that if rates are going to stay low in the US, then limited upside for Canada as well. And then you layer on top of that the fact that our need for rate is probably also very low. So that's, again, another limiting factor for how much the Bank of Canada can can raise rates. But anyway, it's a bullish story for the Canadian dollar. But the problem is this this risk that I talked about earlier that that the Fed starts, the tapering, is interpreted as a policy mistake, there's a risk off phase and in a risk off phase, then the US dollar would normally go up came dollar would normally go down. So we're not even though we have this view on the Bank of Canada, we're not recommending long positions in the C dollar just yet, you know, we want to because of this risk, once we get through that, then you know, and especially if China Chinese growth is ramping up, you know, because they've had a bit of a slowdown, if they start to really accelerate, commodity prices start to go up. And that's a very bullish backdrop for for the Canadian dollar. But we just have to wait, I think into next year for that to play out.
Arthur Salzer 26:27
Now Mark, you mentioned something that everybody wants to talk about, pretty much all the time is, is home prices, interest rates on people's mortgages, you know, should they be variable or fixed? And and we've seen huge price appreciation in real estate in Canada the last decade. Really record amounts. Stock market here, not so much. But but definitely real estate. So how does how does an increasing interest rate in Canada affect real estate prices? Is it something that we can overcome with with with demographics with with people moving to Canada? Or can we can we see a replay of the 80s?
Mark McClellan 27:17
Yeah, I mean, with the, you know, the data that I've seen, and how, you know, loaded up Canadians are with debt, and a lot of them have taken out short term, you know, floating rate loans, you know, even 100 basis points, it's going to be very painful for for a lot of homeowners. So I think that's another limiting factor for the Bank of Canada, they're going to have to go very, very slowly on hiking rates and just hold that the bubble. If it is a bubble doesn't, there's a burst and take the rest of the economy, whether they have a very delicate balancing act. So I mean, for me, I would, I would say, I mean, they're hoping for a soft landing and housing, that's where house prices stop going up. And they just kind of go sideways. And you don't have the big decline. But we know historically, that bubbles, if it is a bubble bubbles do not normally go out with a win for the go out with a bang. It's been tried in many countries to get a soft landing, it's very hard to engineer. Usually when a bubble pops, it just it just goes down hard. So I don't want to stop start, I don't want to sound like Mr. Doom today or anything like that. But you know, history is not on our side, the only thing they can do, I think besides if raising interest rates is going to be too painful for housing, then the only the only thing really you can do out there. And that is the macro prudential adjustments that just make it harder for people to qualify for a loan. It just keeps snugging the requirements a little bit at a time. And then perhaps maybe the government will make it harder for foreign investors to come in and buy Canadian housing. And and then also, what what would really help to attain a soft landing is if municipalities would just ease up on the red tape and allow builders to build like crazy. We need supply right now. Right. And I don't think there's enough and far as I can tell, there's been enough discussion about that it's not enough pressure on municipalities to get you know, to get to ramp up house building. And try to engineer this the soft landing if it has to be if it's not going to be macro prudential or supply then you know, it's going to be interest rates that ends it and and there I think, you know, it could be in in for some real trouble in Canada.
Arthur Salzer 29:44
Now I want to I want to sort of end end today's podcast with a real political hot potato, modern monetary theory MMT. You know, everybody seems to have a position on it, but But in general MMT allows the government to borrow indefinitely, almost to any extent, as long as there's faith in that government, you know, what are your own thoughts on MMT? Is it Can we can we borrow our way to prosperity?
Mark McClellan 30:23
Well, that's, that's the other thing they teach you in economics 101 is that there's no free lunch. Now, it seems like there has been a bit of a free lunch because central banks have monetized a lot of debt. I mean, after the the great financial crisis, and they started the QE program, they started buying all these government bonds. But at that time, the idea was, Well, don't worry, it's not gonna be inflationary, because this is all just showing up on the banking systems balance sheet has excess reserves, we can still control interest rates. And once we get back to normal, we're going to sell those bonds back to the market. So we're not going to increase the central banks are saying we're not going to increase our balance sheets on a permanent basis is temporary, we're going to reduce it back again. So no long term inflation consequences from that, right. I don't hear them saying that, now that we've had the pandemic, you know, cranked up government spending, government, central banks have pretty much bought all of this new debt that's been issued, Canada, in the US and Europe as well. And but central banks aren't really talking about their balance sheet about shrinking anymore. So it's like a permanent monetization this time. And I don't believe they'll ever be able to sell it back into the market, this is no way as too much of it now. So central bank balance sheets are huge, and they're going to stay that way. So that means that they have really monetize this debt. So we've spent money that has been created by a central bank. So this is a little bit different from what happened after the after the GFC. So the you know, the risks are higher, you know, going forward that eventually we will see higher inflation, and that would be the limiting factor for quantitative easing, and it would prove MMT wrong. So at the crux of MMT. I'm not an expert in that area, but it seems it seems to be that there there is a free lunch here that central banks can just create money at will and we can spend it and no problem. So you're creating wealth kind of out of thin air. And, and there's no there are no negative consequences for that. Oh, call me old fashioned, but I just I can't see it. There has to be consequences down down the road. So we've gone through both so far. They've monetized it. who've done the experiment. Let's just hope that they never have to do it again.
Arthur Salzer 32:55
So Joe, I'll let you add the last words for for today's podcast.
Joseph Abramson 32:59
I know nothing, nothing to add on MMT.
Arthur Salzer 33:03
So it's free lunch for a while until you have to leave the table, go to the cash register and pay it sounds like but thank you. Thank you so much. Mark McClellan, Joseph Abramson. We look forward to everybody again next month. Take care.
Joseph Abramson 33:18
We'll see later.
Mark McClellan 33:19
Good talking to you gentlemen.
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