Category: Economics

Derek asked:

Do you think negative interest rates would ever be implemented in Canada?

My opinion (and realize that the error bars are huge with this response):

Not yet.

For instance, there would be a pretty good legal case to be made that Sections 18(l), (l.1) and (l.2) of the Bank of Canada Act would have to be amended since, for example, it only authorizes the Bank of Canada to pay interest on deposits, not charge banks for such deposits. Changing the legislation requires parliamentary approval, and such a decision would likely not obtain unanimous consent. This would mean there would be at least a week of debate on the matter, assuming a majority government forced time allocation on such legislation, coupled with senate approval. Let’s just say with the current political environment in Canada, co-operation in Parliament is not too likely at the moment.

I am not a lawyer. I could be wrong. However, I have not seen this particular clause in the Bank of Canada Act mentioned by any commentators on hypothetical negative interest rates in Canada – i.e. whether the Bank of Canada actually has the authority to doing this. It is assumed by all of the media and publications they can do so, but in my eyes such an assumption should not be granted.

This is not to say that the yield curve can’t go negative – indeed, the markets can push bond yields to negative rates, or push BAX futures above 100. This is completely allowed. The question is whether the Bank of Canada can set the overnight target rate to below 0%.

The Bank of Canada has examined the matter and written about it in a small amount of detail regarding the impact of international banks when they implemented negative rates (Framework for Conducting Monetary Policy at Low Interest Rates), a November 2015 paper on The International Experience with Negative Policy Rates).

If somebody out there has a legal background and would like to chime in on this matter, it would be appreciated.

Putting it mildly, things are not going to end well. Whatever party ends up in power after the (guessing there is a good chance of this happening) November election is going to face one hell of a mess to clean up. The accumulation of debt and government entitlements will be sucking up private sector capital like a vacuum and this will result in a lowered standard of living for most in the country. It is going to be very difficult to unwind the existing entitlements, including the emergency programs, without a lot of pain. Perhaps this was the intention – to accelerate the economic collapse of the real economy (note: this is not the financial economy, which is an entirely different beast).

For instance, ask yourself why anybody at or under the $15/hour pay bracket would bother working under CERB? Working is effectively taxed at 100% of marginal income for these people. This affects the real economy, specifically the availability of low cost labour. Even middle-class labour (e.g. the $25-$30/hour bracket) has a significant marginal tax (financially, the after-tax amount one gains for spending the time is a minimal wage). The only solace is that the elements of the real economy that have been affected (restaurants, retail, tourism) are not apparently critical to the functioning of the economy.

However, this will be a “canary in the coal mine” type environment. Have any of you gone to the west coast of Newfoundland and looked at the near-ghost towns that are along the coast, most of which had their glory years decades ago when there was a thriving cod fishing industry? The first types of businesses that leave these towns are the ones that thrive on disposable surplus income. After that, other pillars go. Eventually what remains is government – hospitals, schools and city hall, but as the tax base shrinks and people emigrate, this goes as well.

The core industries that produce wealth, farming, forestry, mining (mineral and petroleum), and now to a much lesser degree, fishing, ultimately sustain the rest of it. Another major industry, the export of land titles, is also popular, but there are limitations.

The Bank of Canada confirmed on September 9 that they will be keeping rates low for a very long time, and their version of quantitative easing, $5 billion a week, which works out to a cool $260 billion/year.

QE is a conversion of long-dated maturities (held by the central bank) for short-term liquidity (held by the financial sector or whoever was the counter-party to the bond purchases). It inflates the financial economy, but it is at the expense of earning a return on investment. It also has the consequence of widening the wealth gap and this creates political problems.

Fiscally, the Government of Canada is blowing out gigantic amounts of money out the door and hoping it will reignite a flurry of economic activity and keeping away food riots and other political issues that come with economic upheaval while they figure out what the heck to do. The government can afford to do this because the Bank of Canada is supporting the activity (interest rates are being held very low), in addition to the perception that Canada still has real economic output (which buoys the Canadian dollar – relative to America, we are doing quite well). Despite the Liberal government trying to destroy one of our major industries (energy), we still produce a lot of it. And hypocritically, Trans-Mountain is being constructed by the same government and Coastal Gaslink is progressing.

The short-term effect of this fiscal stimulus will be to keep things afloat. Indeed, you can see evidence of this in the vehicle market, where people are using their new-found wealth to purchase vehicles. There is evidence of other such buying elsewhere.

The issue is that this is going to be transitory. There will certainly be a “feel good” effect to injecting $300 billion into the economy, but it will not be able to last – it will break when capital allocators cannot obtain a proper return on their investments. There are a few economic scenarios that may play out, but two likely ones are we end up in a debt-ridden deflation coupled with economic stagnation for a long period of time (the only escape is significantly long periods of austerity to restore the balance sheet), or we get governments that will fund government spending directly from central banks, which in that case we get serious amounts of inflation (in addition to interest rates skyrocketing). There are other scenarios that may come out of this, but most routes are going to involve pain.

Finally, every province in the country is incurring a massive deficit. Unlike the federal government, provincial governments cannot print their own currency. Taking the inflation route is not an option – they have to go along with whatever the federal government decides.

The Liberals full well know the withdrawal pains from the binge of QE and deficit spending will be coming soon, which is why they are trying to buy themselves another year with an election. Even if the result is status-quo (plurality of seats; minority) they have bought themselves time.

The S&P has more or less been on an uphill trend for the past 3 months. The last major incursion to the prevailing market trend was in June, which shook out the people with low amounts of conviction. Since then, the people that have cashed up during Covid (“let’s wait for a vaccine”, “let’s wait for case rates to go to zero”, “let’s wait for the presidential election to conclude”), etc. have been staring at stock charts of companies like Tesla, Microsoft, Zoom, etc., all rising in price. During the three month process, the temptation to buy becomes too much (“let’s board the train”), and that also starts attracting unsophisticated retail investors (Robinhood traders) into the mix.

There is still a lot of cash on the sidelines, and there is still a lot of pessimism out there in regards to Covid and the general state of the economy, so this cash will be the ultimate backstop to the markets.

However, once in awhile, the markets need to exhibit a “shake-out”, where confidence is obviously lost, and the sentiment turns short-term negative, such as the moment we got yesterday and today – what’s happening is that equity holders with less conviction are taking gains and this creates its own stampede of people that have decided that taking gains on the past three months of performance is “good enough”.

Note I haven’t mentioned a thing about valuation in this post. Of course companies like Apple, Microsoft, etc., are trading at elevated ratios. Where else are you going to stick your capital, 30-year US treasury bonds yielding 1.4%? Of course companies like Zoom and Tesla are over-valued, but over-valuation alone is not a sufficient condition for going all negative on the S&P 500. Indeed, if the entire S&P 500 index were to collapse 25% in the next week (without a corresponding change in interest rates), you’d have the media shouting about how everything is going to hell, but privately within the halls of pension funds and institutions, would be a pretty good chance to deploy cash into equities.

The underbelly of the high profile, high-PE, high capitalization stocks still shows a market that is relatively stable and doesn’t appear excessive.

I’m guessing this hiccup will be a two week ordeal, especially when combined with presidential election antics. Panicked hands will bail, and when they’re finished, we’ll begin the slow march up against the wall of worry.

Indeed, the implied volatility of the S&P 500 has spiked, where the short term contract (mid-September expiry) is hovering around the 35% mark, while the October contract is at 40%. This massive diversion is due to the anticipated effects of the US presidential election on equity markets.

In general, I would be a seller of volatility going into the election.

Finally, this is not to say there will be economic headwinds that will cause issues in the marketplace. But this is going to be a 2021 story, not 2020. All of this nearly free money provided through quantitative easing, central bank asset purchases, and the provision of massive government fiscal deficits will have consequences. The analogy is that the shot of meth has been given to the patient and the patient has been feeling really good. But this high only lasts for so long before you either have to pump up the patient again, or let the patient sober up.

The federal reserve’s balance sheet is telling of where monetary policy is going:

(You can view the longer term chart here)

It peaked on June 10th and the next week’s update (June 17th) showed a minor contraction.

From the last interest rate announcement, we had the following implementation note:

* Increase the System Open Market Account holdings of Treasury securities, agency mortgage-backed securities (MBS), and agency commercial mortgage-backed securities (CMBS) at least at the current pace to sustain smooth functioning of markets for these securities, thereby fostering effective transmission of monetary policy to broader financial conditions.
* Conduct term and overnight repurchase agreement operations to support effective policy implementation and the smooth functioning of short-term U.S. dollar funding markets.
* Conduct overnight reverse repurchase agreement operations at an offering rate of 0.00 percent and with a per-counterparty limit of $30 billion per day; the per-counterparty limit can be temporarily increased at the discretion of the Chair.
* Roll over at auction all principal payments from the Federal Reserve’s holdings of Treasury securities and reinvest all principal payments from the Federal Reserve’s holdings of agency debt and agency MBS in agency MBS and all principal payments from holdings of agency CMBS in agency CMBS.

Things are continuing, but monetary injection is not going to be the rocket ship that it was. The 3 trillion dollars of liquidity thrown into the system will have to take its time to transmit into the real economy (if indeed, it does at all).

I will point out that during the 2008-2009 economic crisis, essentially the same response was there – the primary liquidity injection was done in the 4th quarter of 2008, but it took some time from 2009 onwards in order for stock prices to really jump up. All analogies have different variables at play, and this is most certainly not the 2008-2009 economic crisis (nor the great depression) so again, the playbook here is going to be quite different.

I’ll also point out that the Bank of Canada is getting into the business of inflating its own balance sheet, albeit not nearly at the pace that the Federal Reserve has (even adjusting for the relative sizes of the countries).

The post-COVID-19 world is going to incur a material extra cost to doing street level business, at least if they want to do things “by the book”, which includes abiding by yet another layer of regulatory burden from health and worker’s compensation board agencies, lest the authorities pull your business license. Individuals can flaunt the unwritten laws of social distancing with little consequence, but businesses have much more to risk if they do not toe the line.

Getting plexiglass installed, and distributing masks and faceshields to employees, isn’t free. The labour to disinfect everything and to maintain it, isn’t free. Having your square footage utilization ratio decrease by a factor of 2 or 2.5, most definitely is not free, especially in urban centres where retail leasing prices are (or were) sky-high.

Good example of an article: Shops are reopening after COVID-19, and some are adding a new line to your bill to pay for it.

Psychologically speaking, a surcharge is ill-advised in competitive businesses. Customers will feel like they’re getting ripped off. Smarter businesses will embed it into the sticker price.

But the underlying point is that within businesses that have to deal with other human beings close and up-front, fixed and variable costs are going to increase. This is a cost burden that all such businesses will have to face, so it will give a natural competitive advantage to those that don’t have to put up with such costs, or those that can amortize fixed costs over a wider base.

These costs are not going to materially add value to the customer, but because they will be spread amongst all in-person business participants, the customer will have to pay for them.

If it isn’t obvious already, businesses that do not have much in the way of a physical presence will gain one more competitive advantage, relative to those businesses that serve customers in-person.