Hello everyone, and welcome to the PH&N Investment Perspectives podcast, where we discuss interesting and relevant topics for institutional investors. My name is Haley Hopwood. I'm a portfolio manager on the PH&N institutional team, and it is my pleasure to introduce my guests today, Kristian Sawkins and Matt Dubras. Kristian is a senior portfolio manager and also co-head of the PH&N Fixed Income team, and Matt is a senior portfolio manager on the team. And both are responsible for the management of our active universe and short bond mandates. Thank you, Matt and Kristian for being here today for what is our first ever institutional podcast.

Hi, Haley, great to be here and excited to be a part of institutional podcast history.

Hi Haley, also excited to be here.

Perfect. Alright, so we're going to be diving into the exciting topic of interest rates today. And I know it sounds like I'm being a little sarcastic when I say that, but it truly has been an exciting area over the past couple of years and it's drawn a lot of attention recently. And one of the reasons for that is the volatility that we've seen in interest rates.

So volatility picked up pretty substantially back in 2022. We started seeing some big upward and downward moves in yields. And just an increase to the sheer magnitude of daily yield movements for government bonds. When we looked at quantifying this, what we actually found was that for the ten-year Government of Canada bond, for 2022 and 2023, the yield volatility was two times higher than the years prior to that. So maybe we can start here. And Kristian perhaps you can share some thoughts on why yields have been so volatile.

Sure. Thanks, Haley. You know, lots of things jump to mind, when we're talking about the recent volatility in interest rates. Maybe I'll try and lay them out in a hopefully somewhat coherent and chronological order but let me start back with, COVID in 2020. That I think is the jump-off point for a lot of this volatility.

Inflation really took off after some of the initial shocks that we saw in the COVID time. This was originally caused by people's demand for goods, so we had increased demand. We had a breakdown of supply chains, and we had, on top of that, a lot of governments, writing cheques to individuals not only in Canada but in the U.S. So, you know, there was a real confluence of events here that were both demand-driven and supply-driven that caused inflation to sort of get off the ground and much more inflation than we saw prior to the COVID period. If you think about inflation, this was also compounded by the fact that we had higher commodity prices.

This was commodity prices also driven by this demand impulse, driven by some other geopolitical event. So if we think about what happened in the Ukraine and Russia. We've had a great deal of supply and demand imbalances, not only on the goods front but also on the commodity side.

That was the first step in sort of what laid the groundwork for interest rate volatility. If we think beyond 2020 and then starting into 2021, inflation really started to move higher. After we got through that initial shock, and central banks being very much inflation-targeting entities, started to take notice and target low, stable inflation. And when they started to see this move higher, they jumped into action, and in, I guess this was in early 2022, they started to raise rates, but we have to keep in mind that there is a long time period here where, inflation was deemed to be what the central bankers like to call transitory and so that was a key word that was used for a lot of the time in, in early 2021, and all the way into to the beginning of 2022. So, you know, we had inflation rising. We had central banks that were, clearly, behind the eight ball here, hoping that inflation would just go away on its own.

But when they realized that wasn't going to happen, they had to really jump into action here and there. So they started hiking rates and the rates started to go up and had to go up in a quick and, relatively large fashion. So, they started late. They had to make up for lost time and sort of, those underlying central bank rates started to really go higher.

The third thing I would talk to you about, so after we had supply and demand imbalances, then we had rates go higher because the central banks were trying to fight this inflation. And we got into later in 2022 and inflation, as we all know, rapidly increased and then it sort of peaked out there.

The market took notice of this and realized inflation had stopped rising. That is, it was still increased. We still had it going at a decent clip, but the rate of change had slowed down and now the market was starting to sort of reassess what was going on and how much hiking was ultimately going to be needed.

So you had this market trying to take notice of how much more hiking would actually be needed given that inflation was starting to slow down. And so this dynamic of the market reassessing sort of on the fly, how much more hiking would be needed, maybe when cuts might start?

That caused a lot of gyrations in interest rates just because expectations were, moving around quite a bit. Sorry, this is really a lot of chronological order, but it's quite important.

No, don't worry. Keep going. I like the word gyration. That was good.

Yeah. I'm trying to not to be your regular, boring, fixed income manager here. I do have a little bit of vocabulary. So the next spot after we had inflation, sort of peak is, you know, in 2023. So just over a year ago, then we started to see some downward movement in inflation and it really began to decline, and sustainably, in 2023.

So the debate was no longer really about, you know, how much more hiking and the uncertainty around that. But now there was a lot of discussion about, okay, if inflation has come under control, how much further, or how quickly we can start, the central banks start cutting. And so now there's a lot of questions that that began to arise, not only about when would cutting start, but how much cutting would ultimately be needed and how fast that cutting would happen.

So again, those are three pretty big unknowns. Again, more gyrations, in the market because expectations were moving around. Now for, you know, ultimately how low interest rates will ultimately go. And then we started talking about another word out there in the investment world, which was neutral interest rates or what people have coined, “r-star.”

And so that's a term that came up quite a bit in 2023. And basically it's a theoretical interest rate where, the economy can grow at capacity, without igniting inflation. So it's basically this utopian level of interest rates that causes no inflation. But, you know, basically allows the economy to still be growing.

So no recession, but no inflation. And so the market was basically in a dark room, trying to look for the exit here and feeling around on the floor to see where, where neutral interest rates will go. And, and so again, this, this path of interest rates, expectations caused a lot of volatility, along the way. And so finally, I guess “finally,” but in the last part of this chronological story of interest rate volatility, the last item really came to bear, I'd say summer of 2023, all the way into the fall, where the market started to get concerned, off and on.

They'd been concerned, but really concern ramped up late 2023 about how much fiscal spending was happening. And so fiscal spending, by governments around the world, causes two problems or two concerns, for interest rate markets and the volatility out there. And so the first element of it is, you know, to the extent governments are spending money, that's boosting growth and that's going to cause more upward pressure on growth and potentially inflation because you're using up capacity of the economy on that front.

But also, how are governments going to actually finance this? And so, a big concern that happened last year was, what is the extra amount of interest, or term premia – another one of those fun finance terms – how much term premia is going to be required for governments like the U.S. Treasury and the Department of Finance in Canada to issue debt. So, you know, that caused some volatility in the market.

And so this sort of confluence of events that took us from 2020 and COVID supply-demand all the way to today, and this pro-cyclical compounding of fiscal spending has really caused interest rate volatility to increase and to be sort of sustainable over this four-year period.

And I should point out – I've just highlighted some of the main points here about what I think has caused inflation or has caused interest rate volatility. But, you know, clearly there are other geopolitical events I haven't referenced. There was a regional bank crisis that happened in the blink of an eye in early 2023. And right now we're headed into some political election issues, both in North America and in Europe. And so, I think there's no shortage of events right now for the markets to worry about. And, you know, these are events that are ultimately have economic, and inflation and interest rate repercussions.

So hopefully, Haley, that that gives you a bit of a sense for volatility and interest rates over the last few years.

Yes. definitely. Thank you so much for that thorough overview, Kristian, as you were speaking earlier on there, I couldn't help but wonder where we would be now if central banks had actually responded quicker to inflation. Perhaps policy rates wouldn't have needed to get as high as they are currently. But, that's not a question, we can save that for another time.

But I do want to pivot over to the topic of central banks, because you did mention that their actions have been one of the big drivers of volatility. And we did just see an action from the Bank of Canada, which cut its policy rate by 25 basis points earlier in June after holding it steady at 5% for almost a year.

So maybe you guys can share some views on that decision. Do you think it was appropriate?

In terms of whether it was appropriate? I don't want to be, dismissive of the question, but really, you know, as fund managers, it's not our job to opine whether a policy decision is right or wrong. Of course, we do have some opinions. But in terms of how that works in the way that we manage our portfolios, really, our job is to have a view on what policymakers will do, what the implications of those moves are going to be, and how the market ultimately will react to them.

And so, you know, in other words, that's basically a question of, is the information that we see priced into the market right now or is it not? So in terms of the bank’s decision that they made in early June? You know, if we reflect on some of the trends that the bank has been seeing over the last, let's say, 6 to 12 months, on the inflation side, which is their sole mandate, their sole mandate is to manage inflation at or around 2%.

They've seen inflation , as Kristian described, coming down fairly steadily over the last 12 months or so in particular. And for them, the most important measure of inflation is actually the core measure of inflation, which strips out some of the volatile categories like food and energy. So what they're trying to do is really focus on what's the trend of inflation that we're seeing.

And what they've seen is that inflation has actually on the core side, steadily moved back down towards where they want it to be, which is, you know, roughly around 2%. They have a band around, 1% either side of it. So 1-3% is their target band on the growth side of the ledger. We've also seen growth in in Canada slow over the last 18 months or so.

And you know, this has been probably most notable because we haven't really seen the same thing, with the U.S. And so we've seen an economic divergence, which kind of suggests, to us, to the market and ultimately, I think to the bank that, you know, policy rates are probably restrictive and they are doing the job that the central bank is expecting them to do, which is to slow things down to slow inflation.

So I think when you overlay those two things, along with the fact that the bank has previously articulated its view that they believe that rates at 5% are restrictive from a policy standpoint, that I don't think anyone should really be surprised, that they chose to lower their policy rate in June.

Perfect. That makes a lot of sense. And maybe just to continue on that theme, can you share what your expectations are for the remainder of this year?

Yeah, sure. So I think it's fair to say and characterize the rates at 4.75% – so, 25 basis points off the peak – certainly still in restrictive territory, and probably will need to come down over time. I think how this happens, how it evolves, will really depend on how the data moves in response to how restrictive rates are right now.

You know, I think that the bank is probably going to be focused given the state of the Canadian economy, given the leverage that we have on the household sector, given, you know, businesses and things like that, they're going to be looking for signs that borrowers are under some kind of stress.

As things stand right now, the last that we heard from the bank, they seemed quite relaxed, quite sanguine on the state of borrowers, in the last financial stability review. But I think that's going to be something that they'll probably be paying close attention to as we go forward.

As it relates to the rest of the year, I think, if we look at the recent history of cutting cycles, what we see is that the bank doesn't usually just cut rates once and then stop. But oftentimes in the past, the bank cutting cycle has been in reaction to specific market or economic disruption, things like the great financial crisis, obviously would be a big one.

In 2015, it was falling oil prices, which had an idiosyncratic effect on the Canadian economy, of course, and forced them to cut rates. And then, of course, during COVID, which was obviously more of a global phenomenon. But these are specific market events or economic events that have led them down that path. You know, in the current situation that we're living in, Kristian did a good job explaining the path that we've walked down and how we got here, but I think it's fair to say that the BOC and policymakers in general will probably be a bit more judicious about how they approach cutting, this cycle, given our experience the last couple of years. I think it's probably therefore reasonable to think that this cutting cycle might be a bit slower, and a bit more spaced out than what we've become accustomed to recently.

So I guess this is really just a long-winded way of me saying that it's going to be quite, I think, hard to predict. How many moves happen in the next, say, six months? It's going to be really about, you know, how does the data come in? Does it justify them continuing to move in the direction that they've chosen to move in?

But one thing I think I can be confident about is saying that I think that rates, in Canada specifically, will need to be lower in the years ahead than they are now. I think the final thing that I would want to say on the rate decision tree or the distribution of outcomes that I would expect in the future, is that I think that the bar for them to hike rates again at this point is extremely high.

I think that there was a period of time in early 2023, the Bank of Canada felt that the job was done. On the inflation side, I think at the beginning of 2023, they characterized it as a pause or a conditional pause, I believe, is how they characterized it, their hold at about 4.5%.

But then inflation started to move higher again, and they were forced to hike rates again, another 50 basis points, bringing the rate to 5%, I think at that point. And if you look at how other central banks around the world have kind of approached their policy rate from that point onwards, I think most central banks around the world, in fact, all central banks really, felt that the job was kind of done, from their side and that they just needed to hold rates there in order to achieve the desired results.

And so I think really from here the bar to hike rates is high. At worst they hold. But I think really the debate is going to be around how many cuts are going to be needed, as we go forward.

Okay. Well, thanks, Matt. I think that that's certainly comforting to know that we're not going higher from here. And just maybe adding another variable to this topic – you kind of hinted at this theme of divergence with the U.S., but is the Bank of Canada limited by what the U.S. Federal Reserve is doing in how much they can cut?

And what would the implications be if they cut more quickly than the Fed?

Thanks, Haley. I think this is a really excellent and topical question. You know, given that the Bank of Canada has just started cutting, and that the Fed has yet to signal when they are going to start cutting. So, we are at the beginning of some divergence and it's a very – there's no straightforward answer.

It's one of those topics where, it really depends. And it's hard to predict given there are a lot of moving parts. I guess ultimately, just to answer your question directly, ultimately, we do believe that the answer is yes, there is some amount of difference that will cause the Bank of Canada to say, hold on here.

And Canada will be limited in what it can ultimately do. But I think the more important question here is, and the more difficult thing to really assesses, is at what point does this differential matter. And so, how does this relationship really manifest itself? And the answer there is the divergence really will manifest itself, we believe, in the foreign exchange rate.

So the Canadian dollar, versus U.S. dollar, currency exchange rate. And just to get into a quick bit of background and I'll try to be a lot more succinct about this than the first question that I answered, but, you know, generally speaking, currencies that have lower policy rates, such as the Bank of Canada, relative to ones like the Federal Reserve that have higher rates, the Canadian currency in this example will weaken or will likely weaken just because it's less advantageous or less desirable to own Canadian assets given that they pay a lower rate of interest.

So as we see the Bank of Canada, we expect it to continue to lower the overnight rate in the future, timing to be determined. But as Canada and the Bank of Canada does that, we expect our currency to depreciate. And as that happens, that makes anything Canadians buy from foreign entities or namely, anything we buy in U.S. dollars, it makes it more expensive. So, if you think about fun stuff like going on a nice sunny foreign vacation, that will cost more. As long as we're assuming that's priced in U.S. dollars.

But maybe even more importantly, from a day-to-day point of view is a lot of the stuff that we import as a country, or a lot of the stuff that we consume as a country is actually imported. And so, if you think about food, that's a major, major element of stuff that Canadians consume that's imported.

You're thinking about fresh fruits and vegetables in the middle of January. We're not getting a lot of those from our domestic sources. So, stuff like that is really going to weigh on inflation. And so we're going to be importing stuff that's going to cost more in Canadian dollars because our currency is likely worth less.

The other element of inflation that we'll start to see play out from a weaker Canadian dollar, is any commodities that are priced in U.S. dollars. So again, a lot of global commodities like oil, for example, copper, any of those major inputs to things that we consume or build, are priced in U.S. dollars.

And so again, to the extent the Canadian dollar is weakening, those are going to cost more. So if you bring it back to the Bank of Canada and their decision making, it's really going to be a balancing act for them. On the one hand, if they're seeing a slowing domestic economy because interest rates are high and starting to choke off some of that growth, then they're going to want to lower rates just to stimulate growth and to get the domestic economy going again.

But they're going to really have to balance that off with the fact that by lowering rates, if the U.S. is standing pat, or just not cutting as much as Canada, they're going to have to offset that with how much our currency is depreciating and causing the inflation impulse, from all the goods that we import.

So it's really going to be a tough balancing act for, for the Bank of Canada. And, you know, I'm somewhat sympathetic to, to the tough decisions that they likely have, coming down the pipe. you know, the the big question is, and the million dollar question is always, you know, what amount of divergence is going to cause, problems are going to cause, problems or issues for the Bank of Canada's mandate, this inflation versus, growth trade off that they're going to be facing.

And that's really, really hard to know, where that's going to be. As I mentioned, there's going to be a lot of moving parts here. If we look at history, well, currently the divergence after the most recent cut by the Bank of Canada is three quarters of 1% differential between Canada and the U.S. policy rate. Over the last 25 years, so, a good chunk of time, the maximum difference that's ever been was 1%. So we're three quarters of the way to the max. And admittedly, in the 1990s when growth was maybe a little more suspect for Canada or tougher to come by, we had a bigger interest rate differential, at that point.

But, suffice it to say, we're near the wider end of the range of divergence already. And so I think this is something policymakers, and market participants are really going to be starting to pay close attention to, if and as we get more diverging cuts.

Okay. Perfect. Thanks for that, Kristian. And Tiff Macklem certainly agrees with you. I think he mentioned the other day that he does indeed see that there is a limit to how much divergence there can be, and indicated that we're nowhere near to that point. So that's good. So, overall expecting more cuts from what it sounds like, but there are limitations on how far and how fast.

So, very likely that we could be in a higher-for-longer rate environment. Could this potentially be a policy error that sends Canada into recession? 

I'll take this one. So, yes, thanks, Haley. So I think, maybe I'll start with the first part of the question, which is, could these higher-for-longer rates be – is this an environment that we expect to stay living in? So I would say if we look at what the Bank of Canada is seeing right now, you know, recent communications from them, the recent message that they seem to be sending to Canadians is that they think, that we are likely going to be in a higher rate environment than what prevailed in the past, Great Financial Crisis to pre-COVID era. I think they would characterize and it seems that they are characterizing that time period is sort of abnormal or unusual. And the levels of interest rates that we are at right now are restrictive, but the levels of interest rates that they expect us to sort of move to over time are going to be higher than the 1% overnight rate that we saw for a long period of time after the Great Financial Crisis.

And in fact, as recently as April – Kristian spoke before about the neutral rate – this is something that the Bank of Canada updates, on a periodic basis. But they recently updated their estimate, so for this neutral rate, they increased it relative to the last estimate by 25 basis points.

So their estimate is kind of the midpoint of a band of interest rates. But let's say right now that's around 2.75%. It used to be 2.5%. And that would be a nominal rate of interest. Also, I think in the press conference following June's rate cut, Governor Macklem actually stated that it would be prudent to assume that rates will not go back to pre-COVID levels.

So he's on the tape, effectively saying the same thing. This is backed up by some of the analysis and some of the work that the Bank of Canada has done itself. So in terms of the increase in the neutral rate, why does the Bank of Canada think that the neutral rate should be higher now than it used to be? Or why do they think that rates ultimately should be higher than they used to be?

They had two big factors in their work. The first was that they’d just upwardly revised the neutral rate for the U.S. Now, this is interesting because the last question that Kristian was talking about was why should there be a limit to a rate differential between the Bank of Canada and the U.S.?

Well, you can see, inside the Bank of Canada's models for the neutral rate, it's actually explicitly using its estimate of the U.S. neutral rate as a building block for the Canadian neutral rate. So clearly, the Bank of Canada understands that there's some very strong ties and linkages between our two economies and therefore our two policy rates.

But its reasons for raising the U.S. neutral rate was that a higher level of government debt is what's assumed going forward in the U.S. Of course, that's assumed probably going forward here too, in Canada, but in the U.S., obviously that's a very, very big factor in their model. And also they cite higher investment demands in the future from climate change, which I think just dovetails into the idea that there's just going to be a higher level of government debt that's needed to pay for this type of investment with respect to the domestic economy.

They cited that aside from the debt thing, higher population growth in Canada is a factor. And that's actually being offset by weaker productivity growth in their model, which obviously is going to result in a slightly more inflationary environment and therefore raises the neutral rate. So overall, I would say based on those things, our own view is that we're sympathetic, I think, to the idea that that rates may ultimately need to settle a bit higher than what we'd become accustomed to in the pre-COVID period. And this is certainly what the market's pricing in right now.

But we're also of the view that current rate levels, like the bank thinks, are restrictive. And we think that there's also a possibility, to be determined, that the so-called terminal rate for this cycle, i.e. the rate that we are going to end up at once all of the cutting is done, is going to turn out to be a restrictive rate for Canada as well.

So, you know, inflation has come back down towards target, but it may be stubborn to come all the way back down to the bank's 2% target, and that may just take some more time to play out. But the fact that inflation might just take a bit longer to get back down to 2% doesn't change the fact that, governments and businesses in Canada and probably most importantly of all, households are sitting on a much higher debt load today than they were pre-COVID.

And we know that monetary policy works with a lag. So, you know, the Bank of Canada hikes rates, to try to quell inflation and try to quell demand that's perhaps driving inflation. But we know that that doesn't come through immediately. You know, there are certain loans that people have that are on fixed terms, and those will reset at points in the future. So it's going to take time for the transmission of those rates to flow through to the borrowers whose behaviors they're trying to influence effectively. And we know that that hits with a lag. So it's also plausible to us that these higher rates are still in the process of working their way through to borrowers and that we may not have actually even felt the worst of it yet.

I mean, we know in Canada that obviously the mortgage market is one area where – based on the fact that mortgages reset over relatively short periods of time, but given the move in rates has been so quick and so fast – many, many mortgage holders, many borrowers have not actually even felt an increase in mortgage payment yet. That's still to come. So things like that give us some pause around, you know, whether or not rate levels right now, are too high to be sustained in the long run. And I think finally, on the recession question, you know, of course, to be determined; I think ultimately, we always have to remain attentive to the risk that a recession looms.

But there have been some offsets that have supported demand throughout this period where rates have been rising. Fiscal stimulus, that Kristian talked about would be a very, very big one and one that's obviously helped to kind of buttress growth, during this time period and things like that could be an example amongst maybe many, as to why a recession we may have expected to come, given where rates have gone and given where they've been held for a long period of time…but these layers of support that have been added and maybe these lags in monetary policy, being changed to it actually impacting borrowers is perhaps the reason why it's taking a bit longer to arrive than maybe we originally assumed. 

Perfect, thanks, Matt. I know I'm definitely in the camp with a mortgage renewal coming up next November, so fingers crossed that policymakers – 

Don't think you're the only one, Haley. 

No, no. Definitely not. Okay, so just going full circle now, based on all the comments that you guys have made here today, still lots of uncertainty out there. What does this mean for the volatility of bond yields going forward? 

Yeah I'll jump in and take that one, Haley. I think, if you think about everything Matt and I have spoken about here, the factors that have led us to where we are now, we've had certainly a higher degree of inflation, volatility and uncertainty, relative to what we had from, call it 2009 to 2020, the post-GFC or so.

So inflation has definitely picked up. And the volatility around inflation has picked up. Geopolitical events just, you know, keep coming one after another. It seems to be that is another area that's going to continue to be, you know, causing market assessments insofar as how geopolitical events flow through to inflation and growth.

And so, we don't foresee any slowdown in geopolitical events going forward. The fiscal stimulus and the fiscal beliefs out there, certainly seem to be heavily embedded globally about borrowing and spending, and that does not seem to be slowing down. And you take all those factors together, and you have central banks that are, you know, interpreting and reacting to all these different elements, and you put that all in the blender and you're definitely going to see, gyrating interest rates, for the future as far as we can see now.

Now, you know, what does this all mean? And I want to bring it back to the philosophy, you know, at PH&N and on the fixed income side, how we manage money and you know, it's something we talk about, time and time again. Our philosophy involves using multiple strategies, across our mandates to, to achieve all of our value-add targets. For each of our different mandates that we have, interest rate anticipation, is one of those levers. And we're very upfront on, this is not the easiest lever to pull in order to generate value-add, and, you know, that's the reason Matt and I both don't sleep very well at night, but, nevertheless, that's still a lever we have.

And so as an active manager, high volatility or just any volatility, that creates opportunities for us to capitalize on. And so ultimately, this volatility increased volatility around interest rates. That's ultimately going to be beneficial for our clients. And so I'm going to steal a Tiff Macklem line that he used in the last press conference.

So, I imagine there's clients that are out there that are probably worried about volatility. And, you know, Matt and I worry about volatility all the time, too. But, I think, to steal Tiff's words, we should enjoy the moment. Because it really is going to create opportunities, for all of our clients.

And so, at the end of the day, if anyone was hoping for interest rates to get low and boring again, I don't think that's in the cards for any time in the near future. 

Excellent conclusion, Kristian. Strap yourself in, folks, we're in for some more excitement when it comes to bond yields. Okay, so big thank you, to both of you for providing your insights on this topic. And thank you to all our listeners out there for tuning in to our inaugural PH&N Investment Perspectives podcast. We hope you can join us again next time.

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