BOC: Easing bias before a rate cut

Nice table here from Pension Partners (via @MktOutperform )

The Race to Negative Yields (%)

And here is the Canada 10 year Government Bond (from Trading Economics)

Canada10 Year Bond (2009-2015 YTD)

On January 21, 2014 I argued that the Bank of Canada’s policy rate would continue to flat-line for the year despite market optimism to the contrary. I also disclosed that I had added long bond exposure to my personal portfolio with the view that 2014 would be a bounce back year for sovereign long bonds, specifically Canadian. Little has changed to deter the portfolio choice as the global landscape worsens.

At home, in an era of what I believe are low rates for a very long time, financial repression is killing the spending capacity of retirees. A not so small point is that the front end of Canada’s baby boom generation began retiring last year. That is a trickle; a flood of retirees will follow. Central banks are relying on reduced interest rates to spark credit creation (and in turn a greater stock of private debt) to spark consumption. The price of real estate remains at a high in nominal terms in major cities like Toronto and Vancouver and household debt to income ratios remain high as well. To keep the not so virtuous cycle of consumption going will require the central bank to more encourage credit creation and asset price inflation to spur the industry that is growing –real estate development– however with the federal government attempting to balance its budget the output gap that the BOC calculates as a guide (but necessarily a final decision making metric for policy) is likely to expand rather than contract. With slack only increasing and knock on effects from oil’s price decline yet to be felt in the numbers that drive markets, 2015 will be another year of easy monetary policy. Absent increases in real wages of working and middle class workers there will be no spike in effective demand within the Canadian economy that will be sustainable. If anything, the case is now being made by Ted Carmichael and others for a policy rate cut. I agree with this view. While a rate cut on January 21 is unlikely the language leaning toward an easing bias may occur in the coming months. Reading the tea leaves of monetary policy statements is more art than science. If the BOC’s dovish language is enough then it will stand pat as long as it can but as the data flow increases and core inflation falls we will see a rate cut this year.

The scheduled announcement dates for BOC policy rates in 2015 are:

Wednesday 21 January
Wednesday 4 March
Wednesday 15 April
Wednesday 27 May
Wednesday 15 July
Wednesday 9 September
Wednesday 21 October
Wednesday 2 December


Is banking ready for the digital revolution?

When asked “What technology skills (programming or other) do you see becoming obsolete by 2020?” Josh Schubkegel, ex-head of global equities technology at UBS, answered:

 “After Facebook bought Instagram a few years ago, they seamlessly moved petabytes of data on a live application via configuration automation tools like Chef, and their end users didn’t notice at all. All of us in the financial industry rely far too heavily on humans doing things in a certain sequence or legacy systems that have been patched together, but to be able to effectively handle the complexities of today’s world we have to be able to remove those types of steps from critical processes. Folks in roles where they’re managing legacy systems or processes with bailing wire and duct tape should probably begin actively looking to augment their skill set, since it feels like we’re rapidly moving to a point where new technologies will significantly reduce those types of jobs.” (emphasis added)

You can read the rest of his interview with e-financial careers here but suffice to say that his view scratches the surface.

Taking the evolution in the area of mobile payments and the payments landscape as an example

Mobile Commerce Ecosystem (Source: Perficient blog)

Understanding the payments landscape

there will be a rush of capital going to the “FinTech

How to influence FinTech buyers

A good report by Thomas F. Dapp of Deutsche Bank research title “Fintech – The digital (r)evolution in the financial sector” came out in November, 2014. Download it here: Fintech-The digital (r)evolution in the financial sector

It’s main takeaways are;

The significance of digital structural change in many business segments is, however, frequently underestimated. Digitisation is impacting not only on certain elements of value-added processes and business models but on them as a whole, and they must also be adapted as a whole to the architecture of the digital age.

Over the long term an all-encompassing digitisation strategy should be accorded a high priority (not only) by traditional banks. Despite the massive squeeze on some margins, the fallout from the financial crisis which has still not been cleared up, the changing consumption behaviour of clients and increasingly strict regulatory requirements the banks need to undergo a radical course of innovation therapy during the transformation process. This will tie up considerable resources over the medium term.

The financial sector has a lot to offer. Valuable comparative advantages that a traditional bank has to offer include specific financial expertise (risk assessment, evaluation and management), discretion in handling client-specific (digital) data, as well as many years of experience of providing clients with regulatory-driven high levels of operational security. The latter is of less importance (as yet) to the new players in particular.

This is how modern banking will look. Modern data analysis methods will be used just as routinely as a seamlessly integrated web of all distribution channels. Flexible digitised infrastructures will in future enable banks to implement modern technologies and appropriate finance-specific internet services efficiently and above all in a timely manner with the aid of (open) programming interfaces. Strengthening one’s own brand and identity as well as the obligation to handle client data confidentially will also help to deliver a sustained increase in customer satisfaction and loyalty.

I am less sanguine about the ability of the banking industry to come to terms with this. Banking in some nations is a protected oligopoly and a technological laggard in employing capital to improve infrastructure. Bank executives have been swift to cut costs and outsource thus employing cheaper (from the reserve army of labour globally) at the expense of capital at home but that gig cannot continue indefinitely. Is banking ready for the digital revolution?

George Magnus on Boom and Bust

Fast forward to 4:00

George Magnus, former chief economist at UBS, in conversation with RT’s Erin Ade on the emerging markets sell off, the concern with China, the demographic challenges facing advanced economies as well as Russia and China, and an assessment of Ben Bernanke’s tenure as FED chairman.

More thoughts on real estate and the nature of Canadian banking

(Disclaimer:  Opinons are my own and don’t reflect in any way those of my employer)

There is a very good post (“Real Estate: Are High Prices a Bubble or New Normal“) from December 2013 by my colleague David Wishart that I had overlooked. It concentrates on banking and the nature of why banks lend, why they prefer to lend a certain way and how they hedge their risks. Read the whole thing here

Here is an excerpt:

As the banking industry has consolidated over time after periodic recession induced bank failures, management decision making has become more centralized. The era of the small independent savings and loan institution depicted in the movie It’s A Wonderful Life is largely over. The average branch manager has far less autonomy to make loans to local businessmen than in the past and must defer the credit approval process to formal adjudication centers. These centers rely mostly on standardized credit policies rather than personal relationship management (the character C of credit). As a result of regulatory pressure, competitive pressure to manage costs, and additional compliance to handle increased operational risk in a larger organization, differentiated small business loans with their own unique features become less feasible. What banks need for lending purposes is consistent, homogeneous collateral like real estate or an automobile. When collateral is similar and subject to a more straightforward legal framework than a small business loan, it means that these mortgages and auto loans can be securitized more easily in to Mortgage Backed Securities (MBS), Asset Backed Securities (ABS) and then further tranched in to Collateralized Mortgage or Loan Obligations (CMO or CLO). This kind of securitization at least at present isn’t available for small business lending. A combination of a bank’s own ability to shoulder risk and BASEL regulatory requirements like the liquidity coverage ratio (LCR) or the capital ratio’s risk weighted assets treatment (RWA) means that the modern global bank isn’t able to make numerous dissimilar small business loans and is naturally steered towards lending for real estate purchases. This is further exacerbated by government guarantees on high ratio mortgage loans that protect banks from losses in the higher risk portions of the housing market.

From a risk management perspective, private banks have to do the best they can to line up their liability cash flows with their asset cash flows. What this means is that if the bank has a lot of long dated loans on its books and many short dated deposits, it can either securitize the loans and sell them for short dated bank reserves (cash) or it can sell long dated bonds to the market and stretch out the term structure of its liabilities. Mortgage and auto loans more easily facilitate this process on either side of the balance sheet, especially as covered bonds (a debt of a bank that is typically collateralized by mortgages) become more popular as a bank funding instrument. (bold emphasis added)

Related to this I have made the point in some previous posts that for the macroeconomy to grow better in the long run it may require that banks become ‘less’ profitable in the short run. Now, as a bank employee, this may sound counterintuitive and against my interests and those of the many banking employees that make a living working in the Canadian financial sector –I am not referring to investment banking “Master of the Universe” or prop trading types, I am referring to the legion of middle class employees that have benefits, a pension and work diligently day in and day out– but upon closer examination it isn’t.

Currently, everything is structured towards pushing the banks toward areas such as residential mortgage lending as the David Wishart’s passage illustrates. This cannot continue indefinitely as the Canadian economy becomes less diversified and more concentrated in its reliance on resource extraction and real estate, there comes a time when the expanding balances sheets of Canadian households (driven by bigger liabilites of ever larger residential mortgages) meets the reality of stagnant incomes. To reprise the business analogy, it isn’t a great sign to have an ever larger balance sheet with no concomitant rise in income. Greater levearge entails less resilience.  This is what has been happening in Canada. Rather than a housing crash, which is in no one’s interest, we will arguably see slower growth as discretionary consumption by many is curtailed to support debt obligations. The low growth thesis also  relates to the cost of raising a child to adulthood which is reaching astonishing new heights according to Maclean’s magazine and means that the consumer, the driver of growth and the bastion of consumption, can only spend so much witout further access to credit in the absence of wage increases.

Back to the issue to bank lending and the supply of credit: clearly on the supply side we do need to refocus an emphasis on not only getting more lending to SMEs but also have policies that encourage those SMEs to become bigger and more productive. In financial parlance, this is termed credit for investment purposes rather then credit for speculative purposes (i.e. buyin a house, making cosmetic changes and then flipping it for substantially more after a few months). None of these problems have ready made solutions but we aren’t going to get there with speculative finance and hoping that real estate prices continue to skyrocket. Trees don’t grow to the sky and ultimatley the price of a place to call home has a limit.

BOC’s benchmark policy rate to continue flatlining

The Bank of Canada is set to release its interest rate announcement and Monetary Policy Report tomorrow morning at 10 AM (ET). There is an expectation of no policy rate change and the possibility of an easing bias by market participants. The former appears a good bet given the flow of economic data recently, from employment falling by 46,000 in December to  inflation remaining below the BOC’s 2% target yet remaining just within the central bank’s (1% to 3%) operating band.

 The chart below illustrates three metrics, 2 observable the other an estimate, that BOC watchers pay close attention to: core inflation (in dark blue), the BOC target (i.e. policy) rate (in teal), and the output gap (in brown measured against the right Y-axis). It is the latter that should be reason enough to believe that the BOC policy rate will continue to flatline for the short term (2 years) as the slack in Canada’s economy continues to widen despite a low nominal central bank policy rate, credit extension by the banking sector, and federal and provincial governments that are running budget deficits.  


My personal view is that there is no reason for the BOC policy rate to move up before the 2015 Federal elections. The Conservative government of Stephen Harper will be running, according to its Executive Director Dimitri Soudas,  on a platform of supposedly ‘strong, stable leadership’ (below).dimitri.soudas
Moreover, there is the determined effort on the part of the current Conservative Federal government to ‘balance the books’ and return Canada to the promised land of budget surpluses. For a graphic on how federal governments from the time of Lester B. Pearson’s Liberals to Stephen Harper’s Conservatives have fared in this endeavour, see this graphic from the CBC.

The idea of conflating the budget of a federal government with that of a household is attractive but it doesn’t work for Canada; it can for other nations, such as those under the monetary straitjacket of European Monetary Union, but it doesn’t make sense in the Canadian context. Every nation has a particular political economy to deal with that is the legacy of history and goepolitical relations. Moreover, the nature of a nation’s currency –is it sovereign or is it shared or pegged to global reserve currency– is worth considering as is the composition of that nation’s debt ownership.

Currently, the Canadian context is one where the household sector has taken on an increasing amount of debt –both residential mortgage and consumer– that will be serviced for the coming decades and at the same time the federal government has gone into deficit spending mode since the 2008 financial crisis.

Debt to income ratio in Canada

Debt to income ratio in Canada


The Bank of Canada understands this and has made the explicit assumption in previous Monetary Policy Reports that the business sector would drive growth in the economy through capital investment. That hasn’t happened.

Arguably, businesses require signals from the consumer in order to have the confidence to enact capex. Say’s Law need not apply for most companies: supply does not create its own demand. The decision in favour of capex is demand driven. Absent that effective demand, businesses can propel growth via a combination of increasing efficieny or financial engineering. The former prescription has meant offshoring, outsourcing, and hiring more workers as temporary and, increasingly, the autommation of work that requires fewer and more specialized workers (if any as the graphic below concerning the decoupling of productiviy and employment illustrates).


The latter prescription has meant, at best, bringing leverage onto a company’s balance sheet as a catalyst to translate modest top line sales growth into robust bottom line profitability and, at worst, aggressive revenue recognition to make a balance sheet and income statement look better than it really is.

Fundamentally, the deficits of one sector emerge as the surpluses of another. If we consider the debt burden of most Canadian households in terms of the stock of liabilities divided by the flow of income, we recognize that the moribund income growth entails curtailing future discretionary consumption. Canadians have brought forth a lot of future consumption by taking on mortgage and consumer debt. This requires debt servicing. Furthermore, the demographic factors facing Canadian society are a challenge that this country’s policy makers are inadequately prepared for. As the dependency ratio increases, the growth trajectory decreases: older Canadians, many of whom have saved inadequately for retirement, won’t consume as they did during their working years.

The Bank of Canada will continue to cling to the hope that the sagging loonie will spur greater demand for Canadian exports and thus make their heretofore forecasts appear more credible. This is more faith and hope then scietific reasoning as the flipside to this is that it will make capital expenditures more expensive as that is invoiced in USD. The Canadian dollar remains a petrocurrency:

CAD remains a petrocurrency

CAD remains a petrocurrency

Head winds to growth:

  • Household deleveraging
  • Government deficit reduction
  • Aging demographics

Tail winds to growth

  • A depreciating currency
  • Credit expansion
  • Easy monetary policy

Market rates will continue to ebb and flow on the steady trickle of economic and financial data. Mortgage rates, in turn, will go up and down as a result based on the risk appetitite of the major banks. What won’t change is the policy rate: the Bank of Canada will be circumspect in articulating an easing bias as it won’t want to further inflame a housing market that is becoming expensive for most Canadians yet, in the face of the head winds facing the economy it is unlikely how the slack out of the economy will disappear over the coming years.

(Full disclosure: the author’s views are his own and he added allocation to XLB iShares in anticipation that 2014 would be a bounceback year for Canadian Long Bonds)

Dark side of housing-price appreciation

Figure 1. Housing prices and real estate loans

From a vox piece by Indraneel Chakraborty, Itay Goldstein, Andrew MacKinlay:

Are housing price appreciations always desirable for the real economy? Unfortunately, the answer to this question is negative. As discussed in the theory of rational bubbles, an increase in housing market activity may crowd out commercial and industrial lending through increased interest rates. As a result, one sector of the economy that is receiving liquidity and experiencing bubbles may overheat, and crowd out other sectors of the economy….The normative implications for the economy are significant – if monetary policymakers are actively supporting one sector of the economy, such as the housing market, they are causing a detrimental effect for other productive sectors.

Figure 2. Housing prices and commercial and industrial loans

Authors’ Conclusions:

While prior research has investigated the effects of a contraction of bank balance sheets on firm activity, our paper is the first to investigate the role of banks in capital allocation when asset prices are rising in a specific sector of the economy. We find that it is incorrect to assume that an expanding balance sheet leads to positive spillover effects across all sectors of the economy. There is a crowding out effect in which banks divert resources across sectors – in the case studied in our paper, rising real-estate prices lead banks to cut commercial loans and increase real-estate loans.

If the change in relative prices is market-driven, then banks can be seen as reallocating resources across sectors to support the growing sector. However, if the price change is policy-driven, then the channelling of assets to one overheated sector of the economy at the expense of other (potentially more productive) sectors may not be the consequence policymakers have in mind.

Read the full vox piece here.


Chakraborty, Indraneel, Itay Goldstein, and Andrew MacKinlay. Vox, “Dark side of housing-price appreciation.” Last modified November 25, 2013. Accessed November 25, 2013.

Banking isn’t baking but it should be, laments Tim Harford

Tim Harford writes in the FT about banking not being baking (but wishing it were): 

There is something different – something sinister – about the financial services industry these days. So what is the difference between the baker and the banker?

The first difference is competition. This is partly about pluralism: there are lots of places to buy bread, but not so many to get a mortgage, or for that matter to underwrite an initial public offering. It is a devil of a job to set up a bank – and even harder to attract stuck-in-the-mud customers.

More fundamentally, many consumers of financial services cannot tell a good product from a bad one. The spectrum runs from payday loan customers unable to grasp quite what the loan is going to cost them, to people saving for a pension amid a fog of confusing charges, to clients of Goldman Sachs who bought into a subprime mortgage deal called Abacus 2007-AC1. (They did not realise that Abacus had been constructed with input from the Paulson & Co hedge fund, which was betting that the entire thing would implode.) It seems nobody is safe.

In a speech about the UK’s asset management industry this week, Clive Adamson of the Financial Conduct Authority quoted economist and Nobel laureate George Akerlof: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will come to be dominated by crooked sellers and gullible or desperate buyers.” Mr Adamson added that he did not mean to apply this description to UK asset managers; however it is hard to see why else he said it.

At the same event, Mr Adamson’s boss, Martin Wheatley, fired a shot across the UK asset management industry’s bows – although even trying to understand quite what Mr Wheatley is worried about will have the ordinary punter’s brain bleeding out of his ears. In a nutshell, some of the people who buy, sell and analyse shares are paying some of the people who run companies to meet up with some of the people who pick the stocks that go into the investment funds that your pension fund is buying. Mr Wheatley thinks that is OK, but the price tag for all this needs to be more transparent. (No, I don’t understand either.)

It is a safe bet that when the regulator cannot even clearly explain the commercial activities that are worrying him, the market has become too complex and opaque to deliver happy results.

If all that was wrong with finance was that customers at every level were repeatedly being ripped off, that would be one thing. But it gets worse. Income from banking is highly concentrated. When an economy – such as the UK’s – becomes highly dependent on financial services the effect can be a little like the phenomenon of “Dutch disease”, which afflicts oil-producing countries.

If a nation exports a lot of hydrocarbons, their exchange rates may appreciate, which means that it is difficult for those petro-states to compete doing anything except selling oil. As a result their manufacturing and industries decline. Similarly, it is difficult for bank-led economies to compete doing anything except selling financial services. And this matters if the employment in these sectors is slim. It would be going too far to suggest that either the City of London or Britain’s North Sea oilfields are a curse – but they are not an unadulterated economic blessing, either.

Then there is the fact that banking has a tendency to blow up, causing tremendous collateral damage. The last time a baker laid waste to the City was 1666, when one accidentally triggered the Great Fire of London; bankers seem to be able to perform the trick more frequently. (emphasis added)

Read the whole thing here.


Harford, Tim. “Why can’t banking be more like baking?.” Financial Times, Online edition, sec. Comment, November 1, 2013.