Category: Canada

Almost two months ago (December 7, 2022) we had the key paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target.

Now, the forward guidance has been shaded to:

If economic developments evolve broadly in line with the MPR [monetary policy report] outlook, Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases.

This is being interpreted as a “If things are in expectations, interest rates will hold steady.”

That said, this quarter point raise is relatively a consensus decision and one that I was expecting myself.

However, the yield curve says otherwise:

The bond market, and also the short-term interest rate futures market, are projecting a rate drop – March 2024 futures have a 3-month bankers’ acceptance rate of 3.65% (right now that 3 month rate is 4.86%).

When reading the MPR, we have the following projection of inflation:

Pay attention to the dual y-axis on the chart, specifically where the 2% inflation target lies in relation to various inflation components.

The other item is the huge amount of the yellow component “Other factors”, which is a huge fudge factor that is given little bearing in forward inflation forecasting.

My reading of the tea leaves is that the future is not going to be nearly as easy as presented. My crystal ball is starting to clear up somewhat.

I’m expecting, due to the mathematical quirk of how headline inflation is calculated (year-over-year) that comparisons between March and July will be very favourable. The reason is due to this chart:

Due to the Russia-Ukraine conflict and all of the spillover effects thereof, the baseline energy inputs (which drive a good chunk of industry) will be dissipating.

The change in natural gas pricing is even more drastic. (It is too depressing to post here).

Inflation will obviously be seen as tapering. The markets will declare victory, and there will be a massive push of capital into the equity markets since clearly central banks are done – why get 4-5% on long-term investment grade corporate debt when clearly there’s more opportunity with equities? All of that cash that is on the sidelines will plough in, Gamestop and AMC will have another hurrah, and everybody will have this sense of comfort that Covid is behind us, the damage done in 2021-2022 is over and we can look forward to living happily ever after?

Between now and around the month of May, I would say “risk on”. Recession? What recession? Rising interest rates? No more! Inflation? Dropping!

Where things are going to get really dicey is the time period after September, where it will become really clear what’s going to happen in terms of the conflict and the global trade situation, especially with India and China. The import of materials from China historically was deflationary but things are changing with on-shoring.

We look at the various components of Canadian CPI (Table 1 on this link – scroll to the bottom):

Food (16%) – whether from a store (transportation, F/X, labour) or especially a restaurant (labour, municipal land taxes, and retail REITs passing on higher interest costs to customers), this will increase and I do not see supply conditions improving to mitigate this
Shelter (30%) – especially rents in urban centers (7%), mortgage costs (3%), or raw construction (6%), there is not enough supply, and when you keep cramming in half a million people into the country each year, with no real expansion of supply, the net result here is obvious
Household operations, furnishings and equipment (15%) – This should actually be roughly level.
Clothing and footwear (4.5%) – Steady
Transportation (16%) – A function of energy prices. The car market should stabilize somewhat, you are already seeing used car indexes in the USA begin to flatten, and one-time windfalls on used vehicles are no longer to be had
Health and personal care (5%) – This is a service sector and rates will continue to rise with labour costs
Recreation, education and reading (10%) – Post-covid, there is much continued demand for this and limited supply (e.g. take a look at international flight pricing, and hotel pricing) – this is heading up. There is a huge labour cost component here.
Alcoholic beverages, tobacco products and recreational cannabis (5%) – Up, namely due to taxes and raw input costs.

In general, I see the supply side continuing to have a great impact on pricing – not enough supply is being thrown into the economy.

Think of it this way – when you have central banks saying “We are trying to kill demand by raising interest rates until people feel pain”, are you, as a business owner, going to be putting in long term capital investments into anything consumer-related? No way, unless if you have some sort of secured demand (e.g. government funding – look at how much money the Government of Canada is blowing on EV subsidies at the moment).

Right now, the crystal ball says that inflation will appear to flatten for the first half of the year, but the assumption of the downward trajectory is going to be mistaken.

I suspect the short-term interest rate will remain steady for longer than people expect. Right now the Bankers’ Acceptance futures for September 2023 give a 4.69% expectation – roughly half-pricing in that the Bank of Canada will start to drop rates on their September 6th interest rate announcement.

In the meantime, the true deflationary headwind is still ever present – in the form of quantitative tightening.

These balancing factors (suppressed demand due to high interest rates, limitation of supply from both material and labour and decreased productivity, and monetary compression due to QT) will continue to cause confusion. The strategy of the Bank of Canada is that these factors will balance out. I don’t think they have much choice.

However, later this year, if for whatever reason you see inflation refusing to taper below the 4% point, this really puts the central bank into a quandry. Just beware of future guidance.

More media headline scares:

Notice the word “Kraken”. Sounds much more scary than XBB.1.5!

December 21, 2020 post: Mutant SARS-CoV-2 Viruses, Perceived Risk, Actual Risk

Here’s your Kraken virus! Run for the hills!

Many, many times in history people believe that they can control what is inherently the uncontrollable – whether it be conditions conducive to agriculture, or the spread of disease. Things have not changed, except now the ways of transmitting such information has reached a near-universal scale instead of localized sects.

Headline: Ottawa says no to Glencore’s Sukunka open-pit coal mine project in B.C.

I don’t think anybody should be shocked these days that opening up a new coal mine in British Columbia is next to impossible. It will be killed at the environmental regulatory process.

Glencore has been at it since 2013 and halted in 2016 and 2018 to obtain more data on cariboo and water quality and perform further consultations with various First Nations bands. Interestingly enough, one of the identified impacted First Nations bands, McLeod Lake Indian Band, issued a letter in support of the project. The various reports made for fascinating reading.

On this post, I am not making judgement on the environment assessment process or to determine its efficacy or whether it was a good decision made or not; however, I will point out the obvious that this is not the only project to be bludgeoned on the entrails of the environmental ministry and it will not be the last. What this does, however, is provide a huge layer of incumbency protection on the existing projects (especially looking at Teck).

Practically speaking, there are two coal miners in British Columbia – Teck and privately-held Conuma Resources. Looking at their transparency reports (Teck, Conuma) it is like the proverbial elephant and mouse in terms of their contributions to the government.

The last (to my knowledge) issued environmental assessment certificate given to a coal miner in BC was to HD Mining in 2017 for their proposed 6 million ton a year metallurgical coal mine project near Tumbler Ridge, BC. While there was a very colourful story to this company almost a decade ago, today it is pretty obvious that the project is still dormant.

Considering that Teck got rid of its interest in its Quintette coal mine (for a not insubstantial $120 million) to Conuma very recently, there is still obvious economic value in these residual interests even if they are dormant.

However, developing a new mine from scratch in BC is going to be very difficult to clear through the government regulation. Incumbency protection is very significant.

Bank of Canada link.

I was expecting a 25bps raise, but they did 50bps instead, which wasn’t entirely out of the realm of possibilities. The short-term bank rate is now 4.25%, while 10-year government debt yields 2.78% – extreme inversion.

The second to last paragraph of the relatively terse Bank of Canada announcement says (with my bold-font emphasis):

CPI inflation remained at 6.9% in October, with many of the goods and services Canadians regularly buy showing large price increases. Measures of core inflation remain around 5%. Three-month rates of change in core inflation have come down, an early indicator that price pressures may be losing momentum. However, inflation is still too high and short-term inflation expectations remain elevated. The longer that consumers and businesses expect inflation to be above the target, the greater the risk that elevated inflation becomes entrenched.

This “entrenchment” of inflation expectations is the key variable. As long as people believe in inflation, demand will continue to be high. Run through this thought experiment – if you think the purchasing power of your money is going into the toilet, what do you do? Buy more stuff while you can.

Also, we’re in the tail-end of what I will call the “covid effect”, namely after suffering from two years of lockdowns and general malaise, people are spending money because they haven’t been spending for the previous two years. This Christmas is probably going to be the end of it. In early 2023, I’m expecting a sobering-up period and this will probably be sharper than most expectations.

The last paragraph:

Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target. Governing Council continues to assess how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to achieving the 2% inflation target and restoring price stability for Canadians.

The “will be considering” is a very different change of language than “will need to rise” to describe the next interest rate action.

Finally, quantitative tightening is a slightly misleading term at the moment simply because there is only a billion dollars of Canada Mortgage Bonds due to mature on December 15, and then the next tranches of maturities is not until February 1st (with a $17 billion slab of near zero-coupon debt due for maturity). Reserves at the Bank of Canada continue to be around the $200 billion level and have not moved for the past 6 months or so:

Those banks are very happy to keep their money at the Bank of Canada and earning 4.25% – you’re certainly not going to give a sketchy customer a leveraged unsecured loan at 6%! The reserves will get bled out as QT resumes in February and concurrent with the Federal government doing what it does best – deficit spending.

My prediction for the January 25, 2023 announcement is a 0.25% rate increase to 4.5%. The expectations for retail sales during Christmas season might be even better than expected – especially given that we still aren’t very good at mentally adjusting the “same-store-sales” numbers down 10% to account for inflation!