Recorded on January 7, 2020

Bryden Teich and Paul Gardner discuss Avenue’s outlook for interest rates and Federal Reserve policy as we enter 2020. The past year saw a significant change in policy from the U.S. Federal Reserve with three interest rate cuts and a significant re-expansion of their balance sheet starting in September. The conversation touches on the economic outlook for both the United States and Canada and the impact on interest rates and stock prices.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

*Listen to the audio for the full conversation

Bryden Teich (BT) | Paul Gardner (PG)

BT: One of the things, obviously last year was such an incredible year for interest rates, where you had 2018 peaking at three-and-a-quarter on the 10-year in the US and the bias that has been felt for a couple years of saying, “Oh, we’re going into a higher rate world” finally felt like it was happening. And then 2019 just came back and more, and sort of the volatility of rates that are now collapsing and if you look at the long-term history of interest rates where we are historically you’re in this unprecedented low-level, and so what’s your view of that volatility last year, and what do you think the bond market is reflecting?

PG: Last year was a really interesting microcosm of the bond market because it was like a two-headed investment – it was two-headed snake in a way – because you had rates going up aggressively and everyone, everyone was saying, “The US is about to see three-and-a-half yield treasury or 4% treasury.” They always do this at beginning of the year. They always overestimate the yields, and they’re always mistaken, and then yields drop. Well, we saw what happened with the trade war; we saw what happened with the weakening global economy; and it just completely -on a dime- reversed itself; very nasty and very aggressively. And we were always kind of in that defensive mode for bonds just because the risk-return of being very aggressive wasn’t in our favor but at that time you still have to be invested and it’s still a relevant asset class too. So, in the end, there was a thought that the best you’re going to get is a coupon yield. You actually got capital gains. Whether it was our bond fund or the index, you’re talking roughly around 6-7% rates of return from the bond market where everyone hated it in the first quarter of 2019.

BT: It felt like there was a couple years of rates being low and inching up, and from a capital gain perspective there wasn’t much. There was just the yield; but it feels like that excess return for 3-years’ worth of it, all came in the last year on a capital gains side. I think the one that you said that was also is important is this importance of fixed income as an asset allocation tool, where you had a tougher stock market in 2018, but then having fixed income alleviated that sort of overall rate of return even in a tougher year.

PG: Even internally we had this discussion about how relevant are bonds for clients? Now we know that capital preservation is foremost important, but also you want to rate a return so we’re struggling with clients who kept pushing back on saying “Why do I got to be in the bond market if not going to make any money” or “It’s low-yield environment” but at the same time you have to balance two bonds just for that rainy day or that capital preservation. But what they what did change – and we had this internal discussion at Avenue – was that we always talked about theoretically everyone needs, at retirement, at least 6-7 years’ worth of bonds to cover the volatility from the equity market. So, everyone’s invested in the equity market. What you can’t do is pull money out of your investments if the equity markets down. So that’s why there’s a need for the bond market. So, the debate that went on internally was “Maybe that’s too conservative. Maybe we don’t need 6-7 years of bonds. Maybe it’s more like 4 or 5” and that’s how we left it, and that’s why we had thought over the last year there was a chance for lower exposure to fixed income even though it’s still a very relevant asset class. Of course, that depends on individual circumstances. But going into 2020, there’s been a lot of interesting stuff that you have looked through as well. I saw some charts that you showed me, and I’ll throw it back to you on 2020, but then I’ll give you my cut.

BT: So I think the most interesting thing – if you go back and really dial in on some of the things that the federal reserve has said the last couple meetings – is that you had this really aggressive about-turn by the Fed in early 2019, after they hiked in 2018, into a tough market, and then you had the three cuts this year and at each meeting it was very well-priced in that the Fed was going to cut. Then the last two meetings, they’ve now been on hold but the language around the Fed of finally realizing the difficulty in creating inflation and they have this aggressive view that they have to get inflation higher, and so this idea that they’re not going to cut unless you see sustained and persistent inflation. I mean to hear a Federal Reserve Chairman say that, that is extreme, and it didn’t really get as much [broad] play.

PG: No, that was a really big thing for me; a transformational kind of moment. It’s always very boring – this fed [speech] – you don’t get much from them, everything’s more or less obvious, but I thought it didn’t even really resonate with any of the investment community. I thought that speech where they basically said, they’re going to not raise rates until they see inflation sustainably above 2%, and then you overlay that with the Trump administration’s obsession with lower rates, and then you look at the global landscape where I think there’s a real possibility that not only the Fed doesn’t raise rates and they try to get inflation hotter – and the ingredients are there for it to get hotter – it’s just I’m a little suspect on if we ever can see high inflation because Japan has been running this model for 20 years to ramp up inflation. They had negative rates they’ve done everything possible. The problem with Japan [is that] it’s a society that doesn’t allow immigration. Its aging population is probably around 65, so there’s a natural structural deflation embedded into Japan. So that’s really not the greatest test case, so then we move over to Europe, and they’re more or less trying to do the same thing. The trouble is they’re policies are so archaic, and so behind, and they’re so structurally fixed; so with that, it’s also a hard example to kind of flow through so the US is finally probably going to enter into this zone of “How do we create more inflation?” because they have so much debt that they have to try to inflate their way out.

BT: Yeah, I think that’s the psychological thing that’s happened. I think they haven’t expressed it directly but I think they realize that you have to be at a point where you’re real yields or real interest rates are at or close to zero because that’s the only way that you’re slowly defacing the value of the currency. I think the view a couple years ago is that you’re in this better growth environment, you’re going to go to positive real yields. And it seems like the economy couldn’t take it for more than a couple quarters of actual positive real yields. Then all of a sudden, we come back down to what is basically a zero real yield but that’s a way that they can debase the massive amount of debt that they have

PG: If you look at the ingredients of inflation – like I said those couple of prior examples weren’t the best case scenarios because they had they had individual or they had country specific issues, but if you look at the US – we have full employment; we have easy monetary policy; and we have capital spending, our investment infrastructure spending; and most importantly the consumer is incredibly healthy. So generally, what happens in recessions is you’re trying to save the consumer because the consumer has high unemployment rate, the consumer is restructuring, they’re bankrupt, or they’re over-levered. Well that’s not happening in the US. We have savings rates of now 6-7% which is huge in the US; the consumer’s 70 percent of the economy, and now you’re juicing up the system. So, I have conviction on this idea but I’m not going to go all in and what I mean by that is I still don’t know if we can see structural inflation again. But this will be an interesting time because with the Fed on hold, you’re going to have this enhanced fire pushing onto the consumer because they’re already hot, so this might be the chance. Another thing is, this is the first year – I can remember that all the strategists and the economists – they’ve always said higher treasury rates every year at the beginning of the year – three percent, four percent, five percent – they’ve always talked about this and they always been wrong other than maybe one year in 2017. But what’s interesting is now everyone’s so used to that, they all think rates are going down, so that’s anecdotal proof to that, but you’re also given something on a contrarian view that this might be the year that they get it wrong, and then rates do climb higher. And when I say rates climbing higher, I don’t think it’ll be substantial but then at the same time, it might be big because if we do see inflation then what do you think the bond market is going to do? It’s going to react violently to that because the bond market has never believed in the equity markets inflation story. The bond market has always thought that there’s massive disinflation in the global economy, but if we did see a whiff of inflation then you actually might get the bond market to really adjust. And what does that mean? You see the yield curve go up and you also see the yield curve steepen. So, one of the biggest positives of the bond market of the last ten years have been is the long-term bond rates, you know, ten years and higher. Well that might reverse itself because you’re going to get a steepened yield curve and you’re going to suffer price losses. So, where do we end it? The question is then, what do we do with 2020? So, we go into it no different than last year; always trying to get duration up because we’re always struggling with duration. We tend to be short-term buyers of corporate credit -and we can kind of go into the credit markets after this because there’s a dynamic there that’s really strange that you’ve talked about a little bit- but the fact is that we’re going to be slightly conservative and slightly negative to duration in getting ready for that possibility of higher rates. I’m not going to like I said put all my money on black on this idea, but I just need a little more proof because the ingredients are there for this to play out. That being said, my forecast is this year, you’ll probably just get a coupon return of maybe 3%. I don’t think much more.

BT: I think it’s interesting -having worked with you for a number of years and always trying to see and feel what you’re thinking- the one thing you touched on which was for years everyone said rates were going higher. Every year it was at same drum beat in January, and I totally agree with you. To see it have reversed, of now everyone saying rates are going to be here or lower, it shows you the shift in market sentiment. I have not seen a year mis-positioned like this, where you do have the view that rates going higher as a contrarian call and/or slightly contrarian. It just shows you that if you do have -to your point- inflation expectations change a little bit, or you get oil higher, or you have this cyclical growth recovery, there’s no reason why in the long end [of the yield curve] you can’t steepen 50 basis points or 1%. At that point, a lot of the views that are being expressed now that are offside about, “you know rates are going to collapse lower” because the other thing we didn’t really touch on yet is this idea that not only is the Fed easing and keeping rates low, you’re still pumping a trillion dollars of new deficit spending into the economy in the US this year. You’ve got the consumer that’s in good shape; you have the Fed that’s easing; and you’re still massively expanding on the fiscal side by 5% of GDP again; this year is going to be in deficit. This idea of, you’re running incredibly stimulative policy when you have inflation or you have unemployment at 3.5% and a basically full economy, you’d have to go back 50 years to see this kind of an aggressive policy and a lot of that speaks to also the sort of political, divide where everyone wants to take credit for all the good things, and the bad stuff is everyone else’s fault. But the Fed, this year, had to start re-expanding the balance sheet because all this excess issuance from the treasury was basically bloating the balance sheets of all the broker dealers and now the Fed has had to step into the T-bill market and repo market.

PG: So, can you talk to the audience about explaining that dynamic, what happened in September?

BT: So what happened in September 17th was that in the overnight rate market …

PG: Which is the funding market for all these US banks of the world…

BT: So basically, it’s the cash market for overnight lending and you had rates very quickly spike up to, I think they topped out around, 10% overnight; which means for one-day money, interest rates were 10%, which just shows you the Fed had been on this program of decreasing the size of their balance sheet, pulling liquidity from the system, quantitative tightening is what they call it, and you hit this mini crisis point in September where all of a sudden there wasn’t enough cash in the system, and so you had short rates spike because of that. The Fed was very quick on the case with regards to that, and a week later started doing a repo, started expanding their balance sheet with T-bill purchases. But the amount of liquidity that the Fed supplied, if you wanted to pick the day the S&P bottomed in October and was on a hockey stick into the end of the year, it was on the day that the Fed basically came out and said we’re going to be expanding our balance sheet again, and taking this liquidity…

PG: Yeah and that’s really telling because in regard to that overnight issue, it’s a technical issue, basically there’s just too many bonds chasing, and not enough dollar bills. I’ve seen this historically where, of course during the Fall of every year, there is liquidity issues but this only lasts for a week, for three days, for four days. This seems to be permanent and that leads me, once again another piece of the ingredient, is you have systemic debt issuance in the US that’s not turning around, and it’s probably going to get worse because if you do have a recession, the deficit is going to 2 trillion – which isn’t sustainable. It’s only sustainable until it isn’t, and we’ve always said that you can never pick the day that you don’t buy another US treasury bond but there will be a day if it keeps going like this -I don’t know if that’s two years, I don’t know if that’s five years or ten years- but there will be a day where you just go, “I’m bidding out.”

BT: I think the other thing that’s interesting that ties into this is that if you look at how the current administration has weaponized the US dollar in tariffs and globally, they’re running economic sanctions against the world and using the dollar’s strength to do that, but the one thing that’s really changed the last couple years [is] if you look at the issuance of T-bills or treasury bills that are being bought by foreigners -so foreign governments, foreign central banks- that’s now collapsed to really low levels. So, you have these massive deficits: foreign governments and foreign central banks aren’t buying your paper anymore and so that’s where the Fed has had to come step in and be buyers of T-bills. They said originally it was a year-end tax problem and it was going to be a week; they’ve been buying five billion of T-bills every day for three months. They’ve been caught in a situation.

PG: Yeah, I think we can talk about the dollar a bit right now because it flows through into the dollar conversation. That you have a Trump administration, you have the federal reserve, and you have the dynamic of the global economy which is: good growth, not great growth gives you the ingredients that the sundry currencies or the emerging markets or the non-US led currency such as Canada or Australia or Europe, all slightly doing better in December and they’re breaking technical levels that we haven’t seen for a while. It’s set up for a very bullish run in non-US currencies -well anything against the US seems to be doing better. Of course gold is another ingredient on why we think that -and we’ve talked about this over the last several weeks- that the US dollar is really vulnerable over the next two years.

BT: I think that for the last couple years it kind of felt like you were entering this period on the policy level, where things were setting up for a weaker US dollar but then you had this period where it was still a better growth environment in the US versus globally, you had the US stock market ripping, buybacks, all this stuff. So all of that forced dollars into the US system so you were strengthened with the US dollar because of that, but it feels like all of those things now are going back the other way: you’re having better global growth, Europe looks a little bit better, emerging markets look better, Asia looks better, you have at least a trade truce, whether this phase one deal is anything at all. But this risk on sentiment that’s changed -and at the same time the deficits exploding- the sustainability of the strength of the US dollar, I think is really starting to crack. And I think that all you need is the Fed to continue easing, or there to be more expansion of the balance sheet, things that aren’t priced in for that to change. I think the other thing that I think would be interesting to talk about is, you’ve now had 5 years of negative interest rates in Europe, so you had to change in the ECB recently with Christine Lagarde, and this negative Europe view and the negative Euro view for so long, that have really allowed the US dollar to maintain its strength. But the one thing that’s interesting is that, the Swedish central bank which was the first to go negative in 2014, now basically said “This isn’t working anymore. We’re going to take our rates back to zero and be done with it.” And you’ve had for the first time a really significant strengthening in the Swedish currency Krona against the US dollar and all of that is just saying, “We’re no longer negative, we’re going back to zero, but it shows you how much pessimism was built these other currencies. So what is your view now and what the euro looks like and this shifting winds of central banking in Europe? Do you think that there’s a chance that even if the ECB says “We’re going back to zero. Things aren’t great but we’re going back to zero because negative interest rates don’t work.” That you could have this kind of whiplash in a bond market maybe in Europe about where you have still all this debt that’s trading at negative yields.

PG: I have less conviction on the euro because the euro would generally go stronger and it probably will, but there’s so many structural issues in so many political issues in Europe; but if we take the same thought process and put it upon Canada -let’s use Canada because of course, we are way more exposed to Canada because that’s our portfolio and how we manage money but let’s talk Canada- and you could make the case that Canada could be really strong over the next two years, let’s go through this: oil prices have gone up recently, and they haven’t gone up as much as you would think they’ve gone up considering all the geopolitical events that’s happened over the last two years or sorry two weeks, so that that’s positive. Relative budget deficits as much as we can cry about the liberal deficits that are happening and that are about to happen, they’re still within the spectrum of normalcy or spectrum relative to other countries. You’re talking 1% deficit to GDP on Canada, you’re talking in the US at least 4%, if not 6%. Two, the economy’s generally decent here and never forget that immigration in Canada, which we generally like, adds about 1% of GDP growth just by all the immigrants coming in here so it’s a net positive to the economy because demographically we’re in the same situation as Japan or most other countries. We’re not having enough babies, so by that default, we need to have immigration come in because we have almost full employment.

BT: You know what’s funny? I think Canada is seen as a country in a world where a lot of people want to come to, if you’re coming from other countries, and it’s really been of a huge boost to growth the last number especially the GTA, in Ontario, and in Quebec.

PG: Right let’s now look at foreign investment which is stagnated for years because of the perception that we’re not business friendly and that hasn’t really changed too much. But the fact is when you go through the global investing world, if you’re not interested in investing in the US well, do you want to invest in Europe? There are so many problems there. Do you want to invest in Asia? You wouldn’t want to invest in China or even Japan. You start whittling down, you could say, “Canada’s not a bad spot and they have the gold, the oil, the pipelines” as much as we’re yelling about it, they’re still, I would assume, Trans Mountain and Enbridge Line Three is going to be completed in 2022. Then most importantly, no one’s really talking about this, the fracking revolution in the US is either slowing down because of bankruptcies and capital destruction, or the depletion rates of these wells which are inherently very quick unlike in the oilsands which are more manufacturing, the decline rates are much lower, where decline rates in fracking are in 40-60%, and we haven’t seen that roll over. So for the moment we see 13 million barrels a day -up from 8 from five years ago- crazy. so if you start seeing it just slow down, stop, or reverse, then you start seeing a premium into Canadian oil.

BT: And then if you have the pipeline capacity coming on at the same time, and then all of that just changes the sentiment. I think the difference is that there’s an arguments to be made where Canada’s improving, but I think the current moves in the US dollar or the strength in the Canadian dollar which has been one of the better currencies of the G10. The other thing that’s interesting is if you look now at central banks around the world, so if you look at the Fed, ECB, the Bank of Japan, all of them are expanding their balance sheet, or basically manipulating overnight interest rates or the currency through their balance sheet. Canada is the only G10 central bank that actually isn’t manipulating its balance sheet – there is no balance sheet. You’ve got this almost tightening and one thing I thought that would be interesting to talk about is: in 2015, you had an opinion piece that you wrote for The Globe and Mail about those first few central bank cuts that Stephen Poloz has had. If you remember back [then], the oil prices had cratered, and Canada was very quick to come out and cut rates twice. I think it really hurt the currency at the time. The view was that, things aren’t that bad, that was maybe too aggressive, but I think the interesting thing is that the Bank of Canada was actually the only G10 bank last year to not cut rates and so to see how sort of the view of Stephen Poloz was that he was the former Head of Export for Canada. [He] was a very weak-dollar-person and pro-export and the way the central bankers can lower the currency you get more exports, that was a growth way. To see how sort of steadfast he was of saying “We’re not cutting rates, the economy’s okay, it’s improving,” I think did a really strong job stewarding.

PG: We had the free trade agreement signed in Europe, the CETA.

BT: Yeah and then the USMCA. But I think he did a really good job this last year, steadfast in the face of all these other cuts from central banks. What would be -evaluating the Bank of Canada, now that he’s retiring in the next month- what would be your view of central bank policy in Canada?

PG: It’s kind of alone globally, it’s really in a situation where they don’t need to lower rates. If you’re going to lower rates, you are going to spark the housing market which the Bank of Canada has been obsessed with -keeping consumer indebtedness at high level. I have issues with that stat but I don’t have time to go into that, but things are lining up where the Canadian economy is doing quite well. Quebec is doing amazing, we have the infrastructure, we have the immigration, and we have it seems like the tone in place for increase employment from the tech sectors, whether it’s Vancouver, [and] Calgary. We have really high value immigrants that are coming in whereas the US is basically shutting it down. So just as an aside, we have a building going up across from us and it’s going to be completed next year but I think Google’s taking the whole building, so it’s kind of crazy.

BT: I think a lot of the technology companies you have now that have moved to Toronto, or Vancouver, or this kind of Waterloo-Toronto corridor have a pool of talent. You have a highly educated workforce, you’re paying people less than you would in Boston or San Francisco, because obviously currency is lower, cost of your wages for employment high quality employees is lower, so there’s this huge attraction to Canada.

PG: Plus, we have the same rules of law, I would now make the case that we have higher rules of law than the US since they always seem to put tariffs on. One of the things that that’s really important is -because we have to get back to the investment side- is that global money managers mark Canada as a 2% weighting globally because that’s actually what it is, it’s 2% of the global GDP and so all you need is a global manager, a bunch of them, and they’ll have the same thought process. Coming into a new year, you look at rebalancing all your global weightings and go “You know what? Canada should probably go to 3% or 4%.” What’s crazy is going from 2-4%. Let’s say they do that, that is so massive towards this small economy that it’ll be so much money coming in that it could move the Canadian dollar, maybe five cents over a course of six months.

BT: I think if you look at where the dollar is, it’s really interesting because sentiment has been super negative for a number of years, positioning has been negative for a number of years, but really, I mean, if you look at a longer term chart of the US dollar and the CAD it really peaked out in January 2016 at just under 70 cents. That was kind of the capitulation moment where the view was that the Bank of Canada was going to cut again, and they didn’t, and that kind of put in the floor for the time being but Canadian dollars actually been in a pretty nice uptrend since then but because it’s still at a low relative level people look at it like “Oh…” but if you look at rate of change and the directional move you’ve actually been strengthening now for a couple of years.

PG: And it’s gone up by stealth because it’s a weak US dollar story, it’s not a strong Canadian dollar story, but in inherently the reverse is true. The Canadian dollar is strong as you mentioned, it was the strongest in 2019, and did you see any headlines on that? Very little. There’s this thing going on that I think the sentiment is so terrible for Canada globally from investing, that we know it’s turned around and it’s just a matter of time until they recognize it because the global investors are very scared about buying S&P at these levels, so it’s all relative when you have four stocks comprise of 80% of the gain last year. FAANG stocks created -just so you know- what, 80% of the NASDAQ return which is crazy. So that tells you that there’s real elevated levels and then when you look at Canada, there’s so many value stocks here whether it’s Enbridges or…

BT: Yeah, it’s kind of a cyclical, energy, materials, financials…

PG: We’re still noted as that, but I would say we’re less so but anyway, maybe we can tangent into the credit…

BT: The one thing I was going to ask about was the amazing thing that happened last year as rates were really collapsing in the US, and so bond prices going up, you had BB or BBB credit spreads at historically tight levels, but one of the views that’s been expressed by a few people -it’s kind of a contrarian view and I’ve seen a couple good articles about it recently- but it feels like the same issues are creeping in with the rating agencies where a lot of bonds on the credit side -both in the US and Canada- it feels like it’s being mis-traded again and you have this demand for more lucrative credit ratings, than the companies probably actually deserve, and some Moody’s, DBRS, S&P, Fitch, all of those that are now back being complicit in the huge blowout if you look at debt issuance on the corporate side in the US. Based on your historical experience and views, what are you sensing with regards to credit ratings, and do you see that kind of manifesting?

PG: Well first of all, it’s expensive. The credit market bonds with ratings, with corporate credit -not only was there a record issuance last year- but it’s an expensive category. So unlike what we just talked about on the bond side, interest rates side, and on the currency side where it’s a relative gain, I look at the credit market in the bond market as an absolute gain meaning that it’s hard for me on a BB or on a B+ or CCC whatever you want to use as high yield, to get excited about something that’s trading at Government of Canada’s plus 400 basis points over, when that used to be 700 basis points over. So an absolute level, the risk-reward is not in our favor in the bond portfolio, so for the last year -and it hasn’t helped or hurt us that much- we were very cautious on getting invested in the high-yield space because you’re just not being compensated to be in that high yield space even though we do have some exposure, where I consider us very defensive now. I’ve been waiting for yield spreads to back up, they have not. They have in the worst credits, the CCC’s but we don’t generally invest that. The BB’s that’s still not investment-grade has done quite well. I think the best sector, which we invested in, why we weren’t hurt by our conservative stance, was the BBB market had a great year and we generally invest 30-40% of our portfolio in BBB’s so that did quite well. Going forward, even though the investment side -just as an aside- the investment grade market did incredibly well last year, the high yield market had mixed results to the point where the last quarter I think there was a big sell-off in the high yield market. So, you take that and go, “Even though we’re invested in it, I’m not excited about that sector, you got to be invested in something…

BT: You try to find the highest qualities stuff you can…

PG: And the lowest duration as well. So, we’re still waiting for that moment where there’s a buyer strike in the credit market and the trouble is you need a down equity market which hasn’t happened for 18 months, so you’re waiting for that even though I don’t even know if that’s my view but that’s why from an absolute return basis, I don’t want to buy stuff that yields me 4-5% in the high yields spot and even in the investment-grade spot which only yields you 3-3.5, we do it because we got to buy something, but it’s not making me excited about it. So that’s why we have a lower exposure to it, even though we are exposed to it. I would say, I’m still waiting for this moment where credit markets deteriorate, and then at that point when you have the flexibility, and the money to spend on those markets, that’s where you really add value because in a crisis market or in a down market in the credit markets, if you have a dollar to spend, it’s price discovery when it gets really bad, so you can buy ridiculous yielded bonds at 7-10% sometimes or just because there’s no liquidity. I want that liquidity. I think the value is liquidity in the credit markets. There is not as much value in the high yield markets or credit market.