Category: Economics

The Bank of Canada yesterday had a more interesting than usual rate announcement:

The Bank is ending quantitative easing (QE) and moving into the reinvestment phase, during which it will purchase Government of Canada bonds solely to replace maturing bonds.

The headline is “ends quantitative easing”, but in reality, this is a reduction from $2 billion per week to $1.3 billion per week, which is enough to keep its $425 billion load of government treasury bonds level (the average duration of the Bank of Canada’s portfolio is 6.2 years, with most of it front-loaded in the first five years).

The picture painted (in the Monetary Policy Report) is projecting a restoration in the next couple years, but I believe such forecasts are going to prove misguided in that they are too optimistic. I do not want to provide much evidence to this claim here, however.

The Bank of Canada is trying to slow down the liquidity party without crashing the asset markets. This is going to be very interesting. In Canada, the big number to watch out for are the reserve levels of the banks that the BoC has bought the government debt from – this is the feedstock for the creation of currency, and there is still a lot left in there.

If history is true to form, things will appear to proceed until monetary conditions start choking and that’s when you’ll see the onset of further monetary policy induced volatility (which will then trigger another round of QE). We’re a bit of a ways from this point, however. The BAX futures are predicting quite a few interest rate hikes by the end of 2022.

A word of caution – any of your investments relying on this excess liquidity, be very careful.

There appears to be a win-win situation coming for Canadian oil and gas companies.

I normally avoid politics on this site except when it intersects the financial markets, and this is one of those cases.

While publicly pooh-poohing the construction of hydrocarbon pipelines to placate their environmentalist voter base, the current federal government took actions to effectively kill the “northern gateway” pipeline and “energy east”, both of which were to provide egress from the Alberta/Saskatchewan production areas. In particular, Energy East would have solved the problem of how Ontario and Quebec could source an energy supply strictly through Canadian territory (something they are not doing presently!). Bill C-69 of the previous parliament (the enactment of the “Impact Assessment Act”) was the spike into the heart of further development, which allows the federal government to drag any development through light-years of muskeg bureaucracy for approval – unless if such a project receives its royal blessing. Indeed, it had exactly this effect.

However, our current government has also displayed some very glaring inconsistencies in their approaches to many things. I’ll leave most of it for the opposition parties to pounce on, but one of them has been the acquisition and subsequent ongoing construction of the TMX pipeline from Kinder Morgan – an opportunity for graft that even the Liberals couldn’t give up. Most people associate the TMX purchase with the expansion of the pipeline, but many less are aware there is a fully functional pipeline already in place (which, if you read Kinder Morgan Canada’s prior financial statements, generated a ton of cash flow).

To the present day, the biggest piece of hypocrisy has been the reaction to the governor of Michigan threatening to shut down Enbridge Line 5. Instead of cheering on the Michigan governor for her bold stance on reducing evil carbon emissions associated with the transportation of fossil fuels, especially in a potentially destructive manner that would spill oil inside the Great Lakes, the current government has shown grave concern for the shutdown of Line 5. Since Line 5 supplies over half of the raw fossil fuel product for Ontario and Quebec, a shutdown of this pipeline would have catastrophic economic consequences for the region.

Because of the regional effects (Alberta and Saskatchewan are a political wasteland for the Liberals and hence they will never lift a pinky finger to do anything beneficial for the region that won’t also benefit their power base of Ontario or Quebec), this is why the Liberals are screaming foul and suddenly the continued operation of an oil pipeline becomes paramount.

Enbridge said it won’t stop the pipeline unless if ordered to by a judge.

However, on the backs of everybody’s minds (especially those in Alberta and even those in Enbridge itself), I think there is a significant segment that actually want the pipeline to be shut down, at least for a month or two when it will become glaringly obvious that there is indeed a connection between the smooth functioning of hydrocarbons and people’s everyday lives.

It is an interesting political calculation – while Enbridge would lose short-term cash flow if they shut down Line 5, the pain dished on everybody (on both sides of the border – Line 5 also services a good deal of the American side’s fossil fuel needs in that region) would be quite the marketing lesson. Canadian producers as well would have to scramble to deal with the storage and transport situation (and oil-on-rail would get a temporary kick).

So what is this win-win I’m talking about?

After this debacle, it will be really difficult for the Liberal government to talk trash oil pipelines. Only the NDP and Bloc can remain ‘ideologically pure’ on the matter and maintain an opposition to it.

If there is a disruption in Line 5, Canadian oil producers will take a short-term hit, but this would be transitory. If there is no disruption on Line 5, the message is still intact – even southern Ontario and Quebec need oil to function – it’s just a question of where they’re going to get it from.

The completion of the construction of Enbridge Line 3 in Minnesota (estimated Q4-2021) and TMX (est. Q4-2022), will bode well on this front for Canadian oil. There’s still a US$13 or so differential between West Texas Intermediate and Western Canadian Select, and Canadian producers (which are already very profitable at current WTIC levels) will be able to make even more – and so will the Albertan government, which makes a pretty penny out of the royalties coming out of the oil sands.

How much spare change should you keep behind the couch? You need a little bit in case if you want to head out to the grocery store to pick up some beer and popcorn, but too much of it and it will be wasting away earning a zero yield, which can be more efficiently thrown into the short term treasury bill market where you can skim off a rich 25 basis points. Depending on how much you actually have in the couch, that could translate into an extra beer!

Sarcasm aside, in the case of the US government, they raised a ton of money during the COVID-19 crisis as illustrated by the following chart:

In recent history, the US treasury normally keeps $200-$400 billion in cash available for day-to-day operations (noting that the annual US deficit in recent years typically hovers around the trillion dollar range), but they raised about 5 times this much during Covid-19.

However, now that the worst of things presumably are over, they have begun to bleed away this excess cash balance, approximately half of it. This can be attributed to some factors, but I would estimate the stimulus spending bill has accelerated the distribution of this cash, coupled with the necessity of keeping a high float due to the even further elevated deficit the government is incurring (estimated $3.3 trillion in 2020).

I don’t know what to make of the implication of the US government bleeding off the cash balances, but I will also note that the Government of Canada appears to have a similar trajectory:

Balances held by auction participants have presumably been zeroed because participants could get higher yields on their capital from other areas.

My understanding is that with the BoC still engaging in a very healthy amount of quantitative easing (‘at least’ $4 billion a week) interest rates will continue to be suppressed. I will note that the 10-year yield has almost reached to the range of the pre-Covid yields and the financial overlords are probably trying to manage some fine balance between the level of QE vs. what is truly going on in the economy. However, the current course of action (accumulation of massive amounts of debt and monetary suppression of interest rates) will come at a cost of economic growth being lower than what it could be – it is sort of like strapping additional weights on the ankles of a marathon runner.

Michael Burry linked to the following paper – Dying of Money: Lessons of the Great German and American Inflations. He is trying to make an analogy to present times with past times and some of it is reasonably convincing:

Stock market speculation, which adds nothing to the wealth of any nation, is the inflationary activity preeminent, and it was the craze of America in the 1960’s as it had been of Germany in 1921. A buoyantly rising stock market marks the opening stages of every monetary inflation. A sharply rising stock market proves to be an unfailing indicator of monetary inflation happening now, price inflation coming later, and a cheap boom probably occurring in the meantime. The stock market boom like the prosperity is founded on nothing but the inflation, and it collapses whenever the inflation stops either temporarily or permanently. American investment in the 1960’s, with its instant fortunes, its swamping volumes of turnover, and its absurdly high prices for incredibly useless ventures, underwent a species of insanity that was quite typical of inflationary booms. In 1968, the last year of full bloom of the inflationary prosperity, the volume of trading on registered stock exchanges alone was $200 billion, or more than four times what it had been in 1960. The income of the securities industry increased from $1.2 billion to $4 billion. The exchanges were compelled by the overwhelming volume of trading to close for part of the week, as the German Bourse had done in 1921. Capital gains of individuals reached $36 billion, more than three times the levels prior to 1962, and more than the income generated by the entire American gas and electric utility industry and agricultural industry combined.

There are many other damning paragraphs in this book worthy of note, but I will leave it at this.