Authored by Kevin Muir via The Macro Tourist blog,
It seems like the only time Canada makes the news is when America elects some right wing President the Hollywood elite don’t like, and they all threaten to move to Canada.
We are usually too polite to say something, as it is often clear the Americans are in the midst of quite the family squabble, but what makes these Hollywood shmoes think we want them? Leah Dunham? Alec Baldwin? Whoopi Goldberg? It’s not like we have an open door policy for Hollywood complainers. But while we are on the subject, we would like Seth Rogen back (tell him our pot laws are about to loosen up, that should get him), and my daughters have asked to put in word for the two Canadian Ryan’s to return home (Gosling and Reynolds). America, you can keep Justin Bieber, Howie Mandel and William Shatner.
But that’s often the most news coverage that Canada receives. And in terms of economic news, Canada has trouble making the B segment on even the most boring day of financial network TV.
That’s a real shame because there are some interesting economic experiments happening in Canada.
There are two major differences occurring with Canadian economic policy, and many experts are watching with great interest how they play out.
The first is on the fiscal side. Canada was at the forefront of electing a leader who promised more infrastructure spending. Before Justin Trudeau, most politicians were running on platforms of promising to balance the budget and cut spending. But Trudeau’s win ushered in a new worldwide wave of politicians advocating the opposite.
The second interesting development is Canada’s monetary policy. Bank of Canada Governor Poloz has taken a much different approach than most Central Bankers. Whereas it has been typical for Central Bankers to guide markets and remove short term policy uncertainty, Poloz believes this unproductive, and has instead recently surprised the market with a rate hike that was not telegraphed in advance.
Are Canadian politicians and Central Bankers on the cusp of new trends that will sweep financial markets? Or will this be like maple syrup on bacon - purely a Canadian thing? Easier fiscal policy with less reliance on monetary stimulus is the opposite of policy trends of the past decade. Canada’s success or failure might set the tone for the rest of the developed world for years to come.
Recapping Canada’s recent economic past
Much to the surprise of the legions of Canada bears (yes, hedgies, I am talking about you), the Great White North has been the best performing G7 economy over the past year.
This growth occurred despite warnings about the unsustainability of the Canadian housing bubble and the prediction of doom from the energy market’s collapse. By most measures, Canada should have been nowhere near the top of the G7 growth list. Usually, Canada’s performance follows its main trading partner, the United States, with a little bit of a commodity kicker/drag. But US GDP is not as robust, with GDP growth declining, and is now, in fact, sitting below Canada’s.
So what’s going on in the land of frozen ponds and hockey sticks?
For the next part, I am going to rely on the terrific work of Bloomberg reporter Luke Kawa for a bunch of charts, starting with this one. Justin Trudeau was elected on a platform of increasing infrastructure spending. It took a little time for Trudeau to get the fiscal stimulus flowing, but since mid-2016, infrastructure spending has spiked higher.
Many of my free-market / libertarian readers will view this sort of government spending as wasteful, inefficient and ultimately counter productive for the economy. To which I reply, that is your prerogative and you should pull out a stack of pink tickets because there is even more infrastructure spending scheduled. This infrastructure spending pulse is not about to roll over, but instead, accelerate from here.
I am a huge fan of Richard Koo’s work. Koo coined the term “Balance Sheet Recession” and believes monetary policy is ineffective after the bursting of a credit bubble. Here is his explanation from a 2015 Maclean’s article:
A balance sheet recession typically happens after the bursting of a debt-financed bubble. In the bubble days, people leverage themselves up, and once the bubble bursts, liabilities remain, asset prices collapse and people realize their balance sheets are underwater. When that happens, people start repairing balance sheets by paying down debt or increasing savings, which is basically the same thing. That’s the right thing to do at the micro level: everyone in that situation has to get their financial house in order. But when everybody does it all at the same time, then we enter a massive fallacy of composition problem [in other words, while individuals are correct to save and pay down debt, if everyone does this at the same time it hurts the economy by lowering consumption]. If someone is saving or paying down debt, you’ve got to have someone on the other side borrowing and spending money. But when a debt-financed asset bubble collapses, everybody could be paying down debt and no one is borrowing money, even at zero per cent interest rates. In that case, all the savings that are generated and all the debt that’s repaid comes into the financial sector but won’t be able to leave the financial sector. That becomes the leakage to the income stream. And this can happen even with zero interest rates.
Koo believes that governments need to step up and take over the spending so that the economy doesn’t enter into a deflationary self-reinforcing loop (ala Japan in the 1990’s.) I can already hear the guffaws from all my hard money readers. The last thing the government needs to do is spend more money is what they will say. We need to save more, spend less, and tighten our belts. Well, that has been tried. Germany gave that prescription to Greece and it nearly took down the European Union. You cannot save your way out of a balance sheet recession. There are only two ways out. You either have a vicious 1929 style depression, or you inflate your way out. And say what you want about the morality of inflation, but it doesn’t appear the public has the stomach for an Austrian style reset. So, regardless of what you think correct or moral, it seems clear that that the eventual end game is inflation.
You can have governments spending money on non-productive stuff like giving away lavish benefits to government employees, or even worse, wars. Or you can have governments spending money on infrastructure that will improve society’s productivity. I choose the latter.
Canada’s experiment with infrastructure spending seems to be working, at least so far. Now maybe this is a disaster in the making. Maybe this will end in tears. If you are in that camp, then grab some sell tickets and hit the bid. But I think it is actually one of the reasons for Canada’s economic outperformance. And unlike the short term stimulus from a war, or a tax cut for the rich, I suspect this spending will pay dividends many decades in the future.
How much spending is too much spending is the real question. I don’t think this works at extremes. Yet when the bond market is begging someone to spend, it certainly makes sense for governments to step up. When evidence government spending is crowding out productive private investment comes to the fore, then I will be sympathetic to the idea that government is spending too much. But if anything, we have the exact opposite situation. Private corporations have nothing to invest in, so they buy back their equity in a stupid levering up of the corporate sector balance sheet.
In April of 2014, Canada sold 50-year paper at a yield slightly under 3%. If the government can’t invest that money in infrastructure to earn a return better than 3%, then they are a lot more incompetent than even my most extreme libertarian friends believe.
I am not sure if the hard money advocates in America and Germany will allow these two economic zones to loosen the purse strings and invest in their countries. But I want to point something out. Have a look at the US budget over the half century.
After the 2008 Great Financial Crisis discretionary spending has not increased, and in fact, declined and then leveled out. This was the Tea Party’s influence with the sequestration mumbo jumbo. And in Europe it looks similar due to German’s insistence on austerity.
So how did cutting discretionary spending work out over the past decade? Did it fix the debt problem? Nope. In fact, overall debt is much worse because the economy is growing so slowly. By creating a pro-cyclical fiscal drag, it forced monetary policy to do all the heavy lifting. Now you may blame the Central Banks for the stupidly stimulative policies, but it’s easy to forget how close we were to the whole economic system imploding in 2008. I will concede that the Central Bankers should have tossed the ball back into the government’s court and told them, “we have done all that we can do, the rest is up to you.” But don’t forget that Bernanke tried that, and the Tea Party just demanded more budget cuts.
To some extent, this is a philosophical debate. Either you believe Richard Koo, or you are an advocate for the Libertarian Austrian style reset. You can disagree with my analysis all you want, but if Canada’s recipe proves successful, then I suspect governments throughout the world will follow that model. As I often say - it doesn’t matter what should be done, as traders, all that matters is what will be done. So for my hard money friends who are insulted with this government response, put away your outrage and watch closely for signs of success or failure. Would you rather be right, or make money?
Monetary policy divergences
Talk, talk, talk. It seems that’s all the Federal Reserve does. Speech after speech. Dot plot after dot plot. Opinion after opinion. FOMC board members express their views on monetary policy, and in the process, attempt to mold markets to their views.
I have long believed that all this communication counterproductive. It often confuses markets as one moment markets will hear an argument for raising rates at the next meeting, and then hours later, a different FOMC board member will make the case for no rate hikes for a considerable time.
But the real problem is with the Fed’s unwillingness to surprise markets. They are convinced that moves should be telegraphed well in advance. In fact, in modern times, the the Fed has never changed policy without markets pricing in at least a 65% chance for a move.
This unwillingness to go against markets means that to some extent, the Fed is a slave to market expectations.
Bernanke and the other academics believe this makes for better monetary policy. I know they have all their fancy papers saying why this is the case, but in my gut, I have never felt this wise.
Well, Bank of Canada Governor Poloz is willing to take the other side of this view. Arguing that in normal times, there is no need for such guidance;
“Offering instead full transparency on the risks that the central bank is weighing causes the market to assess new information more or less as the central bank does; and because every data point can give rise to a debate between economists, the market remains two-way and less vulnerable to unusual leveraging and volatile shifts in sentiment,”
Bingo! Knowing monetary policy in advance encourages excessive leveraging. The system needs risk, and Poloz understands this.
Bloomberg reporter Luke Kawa wrote a terrific article that summarized the debate surrounding Poloz recent surprise rate hike. Instead of just repeating his arguments, I am including it in this post:
The Bank of Canada has gone back to the future.
For the past decade, traders have been conditioned to expect central banks to both telegraph policy tweaks ahead of time and offer a thorough rationalization of those shifts at the time of implementation.
Canada’s central bank provided neither when hiking its benchmark rate to 1 percent on Sept. 6. Monetary policy makers hadn’t spoken publicly since July 12, when they delivered their first increase in almost seven years, nor was the latest decision followed by a press conference.
The data – which showed the Canadian economy expanded at a torrid pace of 4.5 percent in the second quarter, with core inflation measures beginning to edge higher – spoke loudly enough.
It’s a throwback to the way central bankers used to operate in the 1980s and 1990s, when policy shifts could be made on any business day, without warning. The Bank of Canada didn’t adopt fixed announcement dates until the new millennium.
“It’s bringing monetary policy back to what it was 20 years ago – no bells and whistles, just a decision and a statement,” said Christopher Ragan, associate professor of economics at McGill University and former special adviser at the bank.
Nicholas Rowe, associate professor of economics at Carleton University, agrees. “If it weren’t for the fact that interest rates are quite a bit lower than they were 15 years ago, everything about this does look quite normal,” said Rowe, who’s also a member of the C.D. Howe Monetary Policy Shadow Council.
Even as central bankers across advanced economies tiptoe toward tightening policy, only Governor Stephen Poloz, who joined the Bank of Canada in 1981 before moving to the private sector 14 years later, seems to be willing to let the data speak for itself. By way of contrast, ahead of its Thursday meeting, the European Central Bank chose to pre-announce a decision not to clarify plans for the future path of its quantitative easing program until its following decision in October.
“This is a reminder that Stephen Poloz is not Mark Carney, and this is not the financial crisis,” said Brian DePratto, senior economist at Toronto-Dominion Bank, referring to Poloz’s predecessor and now Bank of England governor. “It’s safe to say that the absence of a forward guidance, hand-holding type of approach stands out relative to its peers in other advanced economies.”
During the last Canadian tightening cycle in 2010, a combination of communications and data prompted the majority of economists to anticipate each of the three rate hikes delivered that year by the Carney-led central bank. By contrast, only six of 29 economists surveyed by Bloomberg expected Wednesday’s move.
Poloz’s preference to avoid steering market participants to predetermined outcomes ahead of meetings has been evident throughout his tenure atop the central bank.
“He genuinely prefers central banks to not provide forward guidance and for markets not to expect moves only at Monetary Policy Reports,” said Frances Donald, senior economist at Manulife Asset Management Ltd.
In a 2014 discussion paper announcing the end of formal forward guidance by the Bank, Poloz outlined the benefits of moving away from such an approach “in normal times,” echoing a 2010 argument advanced by former Deputy Governor David Longworth.
“Offering instead full transparency on the risks that the central bank is weighing causes the market to assess new information more or less as the central bank does; and because every data point can give rise to a debate between economists, the market remains two-way and less vulnerable to unusual leveraging and volatile shifts in sentiment,” he wrote.
The jury’s still out on whether the era of enhanced transparency and increased communication on the part of central bankers since the financial crisis has sufficiently improved economic outcomes or reduced uncertainty.
“I’m not sure that telegraphing everything to the nth degree is appropriate when the data’s changing all the time,” said James Price, director of capital markets products at Richardson GMP Ltd., who recalls cutting his teeth in the industry during the late 1990s when the Bank of Canada delivered a surprise 100 basis point hike amid the Russian financial crisis.
In stark contrast to Canadian monetary officials – who speak with one voice – members of the Federal Reserve Open Market Committee often chart courses that do more to confound than inform market-watchers.
“In one day, Bill Dudley and Esther George are telling us they’re happy to raise rates again, then Lael Brainard’s out the next saying no – and you’re telling me that the Fed communication strategy should be a model for everyone else?” said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. “Give me a break!”
In any case, too much certainty about the future of monetary policy may sow the seeds for financial instability. Tobias Adrian and Hyun Song Shin, in a paper presented at the 2008 Jackson Hole Symposium, made the case forward guidance could prove counterproductive for a central bank that’s looking to smooth the business cycle.
“If central bank communication compresses the uncertainty around the path of future short rates, the risk of taking on long-lived assets financed by short-term debt is compressed,” they wrote, warning that this could potentially increase the odds of a “disorderly unwinding” at the end of the cycle.
To be sure, Poloz’s team simply doesn’t have as much to talk about as their counterparts in the U.S. or Europe, who made extensive use of asset purchases as well as rate cuts to provide monetary stimulus in the wake of the financial and sovereign debt crises. And in this case, the complete lack of communication between hikes may have been a product of the fact that the central bank was in a blackout period when the blockbuster growth numbers landed.
“All central bankers would like to get back to a time when monetary policy was normal,” said Ragan. “And monetary policy is normal when it’s boring.”
The recent Bank of Canada rate hike was nowhere near priced into the market. Have a look at the chart of the Canadian short term interest rate future for December 2017, along with the USDCAD rate.
In the US, on Fed rate move days, futures barely budge because it is all priced in. The recent Bank of Canada rate rise caught the market completely off-guard. BA futures and the USDCAD rate got absolutely smushed.
Having a Central Banker that is willing to surprise the market completely changes the game. All of a sudden there is some uncertainty. And what is one of the consequences of this unpredictability? A steeper yield curve.
In this day and age of global flattening yield curves, countries might well have a look at Canada’s monetary policy and realize this policy makes more sense than telegraphing each and every move.
Canada - the exact opposite remedy than the rest of the world
So whereas the rest of the world is trying to cut fiscal stimulus (in order to keep budgets balanced) and reducing monetary policy uncertainty through forward guidance, Canada is doing the exact opposite.
This will be one of the great economic experiments of the 21st century. Will it prove a disaster? Will it blow up in our faces? The good news is that there is no need to argue about it. There are plenty of deep liquid markets for you to place your bets.
Although I am short term bearish on Canada’s economic prospects (to me, it was a little too much, too quickly), I am actually a believer that the rest of the world will adopt Canada’s policies. Global government spending is headed higher and monetary policy will be less one-sided. This will result in higher long rates and steeper yield curves. I realize this flies in the face of all deflationistas who are advocating buying long bonds up the yazoo. Yup, sold to them.
So far Canada’s greatest exports have been comedians and hockey players, but this might be one time where we branch out to include economic policies. And for all my US hard money pals who shudder at that idea, don’t worry, it won’t include universal healthcare.