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Shaun Osborne: Welcome back to the Market Points podcast. I’m Shaun Osborne, Managing Director and Chief Currency Strategist at Scotiabank. I’m joined by Brendan Stark, Managing Director and Head of Institutional Short Term Interest Rate and FX Sales at Scotiabank. We’re recording this episode on September the 5th. We’ll be discussing yesterday’s Bank of Canada rate announcement, the Federal Reserve’s impact on global markets with its upcoming interest rate decision, and how the upcoming U.S. election could impact the dollar, interest rates, and other markets over the course of the next few months.
Brendan, great to have you back on the podcast.
Brendan Stark: Yeah, thank you very much, Shaun. It’s great to be here. Very exciting time in markets.
SO: It is very exciting, a lot going on. Let’s kick off with the Bank of Canada rate decision that we had this week. So, 25 basis point cut. Pretty much fully priced in and expected. No great surprises. There was a very limited reaction to that decision. We have 25 basis points priced in sequentially for the next few meetings. I think the Bank is responding to the weakening in the growth situation here. They’re less concerned about inflation now that we’ve got CPI, headlined CPI, moving back towards 2%. Still a little above that. Do you think that we’re going to see steady rate cuts roll-out over the next few months?
BS: It feels to me like we’ve actually, you know, this is the first time in a couple years where the rate policy path looks like it’s pretty much in line with market expectations. How far they go from here is harder to say, but I think certainly in the next two or three meetings, we should expect another 25 basis points per meeting.
That being said I think the relief that we’re getting from an economic perspective and the transmission in this economy is harder to really get a feel for. Most of the messaging is related to the data. And I think the data that really starts to matter for us is the data South of the border.
And obviously tomorrow as much as Bank of Canada and we’re Canadian and we want to be, we want to highlight its importance, I think the Nonfarm population payroll number tomorrow is significant, and I think the policy reaction could be beyond what’s priced in markets at the Fed meeting on the 18th.
SO: I guess, with so much volatility and uncertainty in markets, we do have this, this big data point tomorrow that’s probably going to determine, to a very large extent, what we see from the Fed on September the 18th.
BS: Yeah, I think the revision that we got this year in payrolls is pretty unprecedented.
I think the general market feels a little bit more confused than, than normal. And I think that it’s put a lot of extra attention and focus on this number. We had a big payroll number at the end of July and I think that kind of probably cross-footed the Fed a little bit going into Jackson Hole.
A weak number tomorrow should elicit a strong response, both in the FX markets where carry was important, and I think in the U.S. obviously in the rates complex.
SO: Yeah. You mentioned Jackson Hole there and I think the thing that maybe caught the markets out a little bit was we were expecting some sort of guidance from Fed Chairman Powell at Jackson Hole. I think the anticipation typically for this meeting over the years has been overhyped and often it under delivers.
But this year we did seem to get something fairly significant from Powell in the sense that it was a pretty clear signal that the Fed was finally starting to signal readiness to cut rates. But there was also, I think, a degree of abandon there that we weren’t expecting. If we were to get a signal that rate cuts were going to come, I was expecting something that would be couched in more cautious language than we got.
So, we seem to be sitting in a situation here where the bar to an aggressive rate cut is pretty low at this point, and we’ve already priced in a fair degree of risk that we could get a 50 basis point cut later this month, but it seems not unreasonable to think that these rate cuts with the Fed perhaps being a little behind the curve now are probably going to roll out pretty aggressively over the next few months as well.
BS: Yeah, I think there’s some gameplay around when they actually go and how much they do. A weak number tomorrow I think allows for that 50 in September and get to 100 by the end of the year. The market’s pricing somewhere around 220 basis points between now and this time next year. Which feels maybe like this is where the markets start to overstep their bounds a little bit. They get a little bit too, I hate to say optimistic, because it’s not a good situation if we have bad growth. But I think they get a little bit over their skis.
SO: Yeah. Let’s go back to your point that you made about rates, maybe getting to the point where we’re perhaps a little overambitious. I mean, we can look at the curve and see what the swaps curve are pricing.
We’re getting very close to what many people consider to be, I guess, the neutral rate of interest, no one knows what it is. We won’t know until we get there. It’s one of those known unknowns, I guess. But we’re getting to the point now where we’re pricing in rates somewhere in the region of 3%, 3.5% for the U.S. When we look out the curve, we’re down to about 3.5% maybe in Canada. So is that the point where we think we can put a pin in and perhaps say that rates probably aren’t going to fall that much more than that.
I think from my point of view, it’s starting to get a little bit interesting just because interest rates have been such a huge driver of FX over the last two or three months.
I’m just starting to try and work out what the next big move in FX might be, given that we have priced in quite a bit of easing around the globe. We have priced in quite a significant degree of narrowing in interest rate differentials between Canada and the U.S. We have a policy spread now, after yesterday’s move, that’s 125 basis points wide, which we haven’t been that wide in 20 plus years. But we have a spread down the curve, looking two years out which rather implies that that differential is going to narrow to 50 basis points, which would probably be a little more normal.
And, and therefore, you know, one of the reasons why the Canadian dollar was able to shrug off this rate cut yesterday was the fact that the swaps curve is suggesting this, this policy spread is going to narrow quite considerably going forward as the Fed catches up to the Bank of Canada and other central banks.
But now that we’re getting close to the terminal rates in terms of where the swap curve is two years out, I do kind of wonder if we’re going to need some sort of new development in terms of either much, much better economic news or much, much worse economic news that starts to change the market’s reaction function to where we are now, given that we’ve priced very close to what would be considered the terminal rate or neutral rate for a lot of central banks.
The question I’m getting from clients, and actually from a lot of media, is where is the next big carry trade? So, just very briefly, for anyone unfamiliar with the term carry trade, we’re talking about shorting or selling a low yielding currency.
So maybe we can kick that idea around for a little bit and, and...
BS: I can’t tell you what it is. No, I can’t share that secret. I mean, people make a big deal of the carry trade. I think the, and the overextension and, and I think when I look at it and I look at what the basis moves have done, like yen basis to the dollar, it’s not, it was never that big. I think the asset and the yen moves were connected but there’s something else going on beyond just the carry.
And they sort of talked, they started talking that market down. They’re continuing to talk it down, even at these levels. I’ve been watching markets long enough to, you know… I remember dollar yen on a seven handle, like in high six handle. So, it can move a lot from here, particularly if the Bank of Japan is serious about raising rates. And so that becomes a carry trade.
SO: Well, I guess one currency that keeps getting mentioned is the yuan, being a relatively low yielder, weak economy. Talking about potential for maybe some interest rate cuts there. So that has been suggested as a potential vehicle for carry trades.
I’m not, myself, especially convinced about either that or the return of the carry trade at this point, because I think we’ve got market volatility that’s still, generally the carry trade works well in low volatility calm environments, and that’s just not where we are right now. We’ve still got the VIX in excess of 20, volatility of the VIX is still relatively elevated, so when you look at risk adjusted returns the carry is not, there’s not an obvious return to carry at this point in my opinion.
BS: I agree. I think it’s, we’re probably into a period of adjustment as we have this sort of snap back and forth.
We have a lot of different exposures that need to probably still be washed out of the market. And as that’s happening a lot of carry trades will probably look more challenging. And carry trades kind of sneak up on you. People have it. I mean, if you think about the yen move and the move in, say, Nvidia, I mean, I don’t know what you’d be doing right now, but you probably wouldn’t care about much if you were long Nvidia and short yen. During that sort of last sort of gasp move in, in that, that pair.
With, with China, I think it’s very interesting because they’ve got a, you know, and again, I’m not a China expert, but it does feel like when you look at electric, you know, the EV tariffs we have, where in the battle now with Canola being sort of, like there’s a lot of, those are things that are disruptive.
Those are supply chain. Those are actions that create volatility, I think, because it’s, because those are arbitrary. They just happen one, one day to the next. For people who are generally in markets, they’re not anticipating these kinds of tariffs. But I think anecdotally it feels like China’s kind of in a bit of a spot right now.
SO: Right.
BS: I think they, again, broadly speaking, it went from a very manufacturing you know, factory for the world type economy and then tried to shift to a more consumption based. And that’s not such an easy transition.
I think that’s gonna take more time. There’s endless stories of the demographics. There’s endless stories of misallocation of capital. They’ve got, they’ve already built all the roads, they’ve already built all the, you know, well they’ve got the high-speed rail, high-speed train is beside the other high-speed train.
SO: And they’re building too many houses.
BS: And they have a lot of houses.
I think what’s interesting is their yield curve, if you watch what’s happening in terms of Chinese bonds, we’ve seen them actively selling bonds to try and keep yields at higher levels. So it’s again, it’s a very complicated, there’s a lot of stuff to consider and that doesn’t feel like an environment where carry is necessarily like the trade that you’re chasing after.
SO: Yeah, I think this is just a question of people just casting around looking for, or hoping for a revival in the carry trade to get the equity market going again.
So, let’s talk about the kind of elephant in the room, I guess, which is the U.S. election. That was looking like pretty much a foregone conclusion a few weeks ago. What are your thoughts on the election and how that may impact markets in the next few months?
BS: I think it’s going to be a very interesting handover. I mean, you can speculate all you want about what that looks like if it’s a, it's likely going to be a very close election.
Again, I don’t have, I’m not a pollster. You can read a poll that’ll tell you kind of whatever side of the story you want to hear. But my sense is it’s going to be a very close election. They typically are close, and we’re not battling on actual issues right now. It’s become sort of a cult of personality.
And I think that that means that the period between the election and the actual administration taking over can be quite volatile. It goes through some very difficult times of the year for markets typically too, which is we’re going over a, we’ll go over a calendar year end.
SO: Markets aren’t going to want to discount something though.
I mean, we won’t just sit here twiddling our thumbs for the next three or four months waiting for something to happen. Back in June or July, we were talking about Trump presidency, the focus is on potential for tariffs to come back, as a big feature of what his economic policy would be.
A more kind of mercantilist approach to his global outlook, make America great again, encouraging onshoring, reshoring of manufacturing jobs has been a kind of an undercurrent thought to this. And all those kind of things were assumed to be potentially dollar positive, reflationary, higher interest rates potentially down the road, tax cuts, pro growth.
The dollar was catching a bit of a bid in the early part of the year on the back of those assumptions. But then I guess the needle scratch to that narrative was the fact that he did actually come out and start talking about the currency, which is kind of unusual. He did suggest that the US dollar was potentially a little bit too strong against likes of the yen and the yuan.
With two currencies that he mentioned, but it’s very difficult knowing or, thinking how they could engineer a weaker dollar against two currencies in isolation. So the very fact that he’s talking about the currency did help push the US dollar a little bit lower. And also, you now, you’ve got essentially a two horse race as opposed to a foregone conclusion that is making the outlook for currencies here a little bit more challenging.
And I guess the point you’re making is that we won’t know a lot until much, much later on in this process. And in the meantime, there’ll be uncertainty and more volatility.
BS: The immediate impact on Trump and having that sort of a lift to the dollar, I think that is the natural first reaction.
I don’t know that anybody can predict or, you know, the full appreciation of how the FX markets work globally and what all the different powers that can be at play. But I think if any administration or globally needed to manufacture a lower exchange rate, I think the U.S. is capable of doing that. If Trump was in, I would think that you’d maybe get a lift, probably pro growth lift because equity markets do well, but I think you’d likely shift on that to a, I would probably want to, I don't necessarily think it would be a follow, like a slam dunk with the Canadian dollar. I’d probably be looking at yen and I think I would not look at China, but maybe Euro and maybe some other pro Asia currencies like Aussie dollar and Kiwi potentially.
SO: So let’s just steer it back to rates very briefly before we maybe round up here a little bit.
You know, we were assuming that, in the developed world at least, we were going to continue to see rates decline over the next few months. But there are one or two banks where, central banks where the policy outlook is a little bit less clear. So, sterling the Bank of England is one. I guess the Reserve Bank of Australia is another area where inflation is still too high and the central bank is clearly uncomfortable at this point, signaling they’re ready to even think about lower rates. And the Bank of Japan is the only bank in splendid isolation amongst the majors that are actually raising interest rates at the moment and that looks to be a process that will be very gradual, but continuing. We had some data out just last night showing that wage growth in Japan is picking up in the way that the Bank of Japan wants to see, so it makes it I think more than likely that we’ll see another very minor but still quite significant interest rate increase in Japan before the end of the year.
SO: So, from that perspective, I guess, you know, currencies that I still see as potential outperformers this year, the yen being one. I think sterling is another. We had since I think our last conversation, certainly change of government in the UK. One of the big things that’s associated with the change in government in the UK is this attempt to get a closer relationship or a stronger relationship between the UK and the European Union. We’re not talking about a return to the European Union even though the polls are showing that there’s a clear majority of back into the European Union, ironically.
But the potential for the UK to forge a stronger relationship with the European Union is, I think, going to be an important piece of the economic story for the UK economy in the medium term. We know there’s been a lot of friction in an economic sense between the UK and the European Union as a consequence of Brexit. I think this government is going to try to ease some of that friction, get the economy going again, so that is another factor for me that suggests the pound sterling could be from a medium term point of view one of the stronger outperformers over the next little while. It’s also still pretty cheap in really effective terms, when we look at how depressed the UK economy has been, how depressed the UK exchange rate has been.
It wasn’t that long ago that sterling was trading very close to parity with the dollar. Got back to, I think 104, maybe a little below that. We’re back to the 130s at this point. And there’s probably, from my point of view another decent potential bump in sterling to come as the economy continues to improve and perhaps the Bank of England in the relative near term is less eager on the interest rate trigger than some other central banks. So, the yen, the sterling, and maybe the Australian dollar are a couple of standout potential candidates for me. If we’re talking about an environment where the US dollar, we think, is likely to underperform somewhat, these are currencies, I think, that could do a little bit better.
And to your point about the Canadian dollar, unfortunately, there’s just nothing compelling in terms of a narrative here that I think will draw international investors in at the moment, so we’re probably going to be condemned to a continuation of this range trade. We may see the CAD improve a little bit in the next few quarters, but it’s difficult seeing it trade much below 130 at this point from my point of view.
BS: Yeah, I don’t disagree. I try to find relative strength for Canada. So looking at Euro/Canada, Sterling/Canada, Aussie/Canada, the main crosses that are not necessarily economic crosses like dollar Canada is, but they’re an important sort of barometer for CAD strength. And it doesn’t, it’s not really compelling. Doesn’t pull you that direction.
When I’m listening to you and I hear you talk about the sterling and Euro, what’s interesting is that you’re actually saying growth and you’re talking about like economic strength and, you know, for a long time now that hasn’t really been the case. And the global economy moves in long cycles and we’ve had a pretty long period here where global economic strength has really been driven by the U.S. economy. China’s sort of stepped out, it has very anemic growth.
If you look at the, the sort of three big blocks, I think that Europe is rarely capable of grabbing global growth higher. I think that the Chinese economy is capable of exporting growth and obviously the U.S. economy is expected. But if you can get sort of just regular sort of, lukewarm growth and some repair to China and Europe and the UK economies actually do well, that could be very interesting for global growth, which should feed into… the Japanese do well in global growth, and I think commodities do very well in global growth. And that might be, if we’re grasping for something to get excited about the Canadian dollar, that’s actually specific to us, would be the potential for a commodity led rally in the Canadian dollar.
SO: Yeah.
BS: Still a little bit far fetched, but the error bands around that forecast are quite wide, but they’re still…
SO: It’s not outlandish.
BS: It’s not crazy.
SO: No.
BS: Yeah.
SO: All right, thanks very much, Brendan. I think that brings us to an end of the discussion for this time. Thanks very much everyone for tuning in, we look forward to the next one.
BS: Thanks a lot, Shaun.
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