A 50/50 Proposition - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Adam Whitlam from BMO's fixed-income sales team. This episode is titled A 50/50 Proposition.

I'm Ben Reitzes, and you're listening to Views from the North. Each episode, I'll be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes.bmo.com. That's benjamin.reitzes@bmo.com. Your input is valued and greatly appreciated.

Hi, Adam. Welcome back.

Adam Whitlam:

Thank you so much, Ben. It is great to be back.

Ben Reitzes:

We get the Bank of Canada next week, and so this is our Bank of Canada preview show. Like the last meeting, we have no clue what they're going to do. Pretty much going in 50/50. It really does still hinge on Friday's employment report. That could change everything. No clues. A little bit extreme, obviously. But it really could go either way, depending on which way jobs go. Why don't we start with your thoughts on the bank? Because I know they're a little different than mine.

Adam Whitlam:

In terms of the Bank Canada... I mean, if you want the best trade, just take the street consensus, and they'll do the opposite because that seems to be the trend that we've had with the Bank of Canada this go around. I don't know if it's that they want to keep the street on their toes. Expect the unexpected. But that seems to be the most reliable trade in terms of trading meeting gaps.

When I looked a little earlier, we were around 72% priced for a hike next week in terms of OIS. Consensus on the street is a little divided. I think it's a little better than 50/50. It's probably 60/40 in terms of a hike, favor for a hike. Part of those reasons are the bank... They went in June, while the data has showed some slowing trends, particularly when it comes to inflation or inflation expectations as were outlined in the BOS. It's not enough. The slowing has been moderate. The outright levels remain too high or higher than the bank should be comfortable with. There's been questions about... At some point, will the bank expand the comfort band around inflation expectations? Will they lean toward favoring a higher ongoing inflation rate rather than a lower one?

The bank seems to be pushing back on that. 2% is still the inflation target for the bank. That makes me lean toward them looking to hike again next week another 25 basis points when they can also update their forecast. I think it's worth noting the GDP flash estimates came in a little bit higher than expected. We're looking for Q2 growth to come in above what the bank is expecting. That's a bit of a lever. It highlights that consumer demand isn't really waning despite the higher interest rates that they've seen.

Now, they've acknowledged it takes more time for these costs to flow through the economy, but they've also been big proponents about the psychology of inflation expectations and having to nip that in the bud early. I think if the market's going to give them the cover to go 25 more basis points, that they'll take it.

Ben Reitzes:

Two things you mentioned there I'm going to key on: one, levels, and the other is time. With respect to levels, so the level of inflation, the level of inflation expectations... still most definitely too high. However, they have come down. I'll give the flip side of this in a second also. But inflation expectations, in particular, have continued to trend lower. I think that that's unambiguous from both the consumer survey and the business outlook survey, that both of those which came out last week pointed in the same direction, which is encouraging.

That being said, again, levels of both are still too high. Is the trajectory enough to get the bank to maybe pause here again? Because things are going in the right direction, and rate hikes take time to have an effect. That's what brings us to the time factor. How patient is the bank going to be? I think that that's really the question for all of this and for all central banks. It's like do they raise rates more immediately to force inflation down as quickly as possible, or are they willing to be patient and let prior rate hikes fully flow through the system, knowing full well that there is an impact coming? You can see very well that on the mortgage side of things, there is going to be a bite over the next six months/12 months/24 months. It is coming. There's no question there. It's just a question of how bad it gets. That'll be determined by how far they push rates higher.

Are they going to be patient enough to wait? Are they willing to tolerate inflation expectations sticking at 3% for maybe a little bit longer? I also lean toward no on that, as Adam noted, but there's a question of how much pain they really want to inflict on households. I think that's a reasonable question to ask. There have been some signs of a few cracks here and there: insolvencies, which had gone up a lot in March, came down to April, went right back up in May, and business insolvencies even higher on a historical basis than consumer insolvencies, which are back into a normal range.

Beyond that, you could argue that maybe you're seeing some softening on the job front. We'll get that on Friday. We'll see. I'm not really convinced there. Overall, I think the balance still tilts toward a rate hike. But it's not as clear-cut as it seems. There's enough uncertainty there that you could make a really good argument for them to wait.

The business outlook survey highlighted that excess demand is fading, inflation expectations are slowing, wage growth is pulling back as well, and corporate pricing behavior is normalizing. None of those things are where they need to be, again, but they're all going in the right direction. Those are the things the bank highlighted in their statement that they want to see. They're getting exactly what they want. They're just not at the endpoint yet.

Is that enough? I don't have an answer. Jobs probably determine whether they go or not. You get a decent enough job print with decent enough wage growth: they probably hike 25. You get a softer report, like last month, even if the details weren't quite as bad. Then, they probably hold off. But then, if they pause, that begs a different question. Well, why do they even go 25 last month? Is 25 BPS enough to make any difference at all if things are already cracking? It's because of what they had done previously. I would argue that 25 BPS they did in June would be a mistake.

It's a tough question. The bank is faced with a pretty meaningful dilemma here. Hiking 25 buys them insurance. They can pause after that for probably six months. That seems like the most reasonable path. But as you said, they like to go opposite of consensus. They did that last month. It wouldn't shock me if they did it again this month, I guess. Who knows?

Adam Whitlam:

Yeah, I think the psychology behind taking a pause at this meeting would probably be a mistake. I mean, you're in a situation where you're seeing trends go your direction. You've talked on this podcast lots of times about 25 basis points. What does it really matter? In this case, the impact to the psychology behind spending might be more beneficial than the actual negative impact of 25 more basis points.

Ben Reitzes:

I think on the housing front, that's probably a key point in that. In January, when they paused and they made it clear that they were pausing, housing came roaring back pretty quick. If they send a similar signal this time, that would be a mistake, pretty much, either way. I think no matter what they do, whether they go or not, the door will be open to more hikes either way. If they hike, it'll still be open to more. I don't think they can send the signal that they're done pretty much at all until it's very clear that they cannot go any further and things are going the wrong way. Either way, expect them to be hawkish. Expect the very front meetings to consistently price some odds of rate hikes depending on whether they go or not. But it will be positively sloped for probably at least one to three meetings at minimum and then maybe flatten out thereafter.

But again, it looks like rate cuts are a long way off at this point. Adam mentioned that: the 1 to 3% band and 2% target. I think they've made it pretty clear that 2% is the target. The band is not good enough. 3%'s not good enough. Just being in the band is not sufficient. It's 2% or bust. If that really is the way forward and core inflation... And I think this is very much overlooked by almost everybody I speak to that the core inflation measures... Yeah, there was some improvement in the May figures. But the three-month annualized rates are still in the three and a half to 4% range. That's exactly what they highlighted in the statement as being too high.

There's some improvement. But you're still in the range, and you've been there for nine months. That is just not good enough. There's no clear sign there that you're headed for 2%. Another reason to go... And maybe I'm convincing myself that they should be hiking as we work our way through this podcast even though I was doubting that. But it looks as though that's the way I'm leading. We'll see what jobs do on Friday, though, and go from there.

The interesting data flow over the past month... I mean, we've seen some softness in specific sectors. Manufacturing's been soft globally. You can see it in all the PMI. Services PMI as well have backed off somewhat, at least in Europe, for sure. We'll get the US services PMI on Thursday. We're recording this on Wednesday afternoon, just to be clear. The services side... I mean, we've seen some softness there as well globally. But most of the softening, I mean, that I've seen is more on the manufacturing side. That shouldn't be a shock with the shift from goods spending to services spending. There shouldn't be much of a surprise there.

What I guess has been interesting over the past month is the backup in US rates more than anything despite some more mixed data. I mean, things don't look great, I don't think. But any sign of good news on the economy, I think rates are quick to back up fear of more Fed rate hikes.

In Canada, the story's been a bit different. Canada's rich on a relative basis. US 10s nearing 4%, whereas Canada 10s have been pretty range bound, to say the least. Can you walk us through why you think that's been the case over the past month or so?

Adam Whitlam:

Yeah. It's been interesting because we've been testing range extremes, but they've been on opposite ends. US: that 387 level held for a long time as a local yield peak. That was the range to trade and US Treasuries. It was 10 years, anyway. It was 387 down to... call it 362. That range finally started to get tested and broke at the same time as the Canadian range in 10s, which was 350 at 330, was breaking to the downside. It's been a really interesting market because as yields have backed up, total all-in yields, over the last month, we have seen a phenomenal amount of buying. We've seen buying from all kinds of account bases. The front end has been heavily international/real-money-focused, buying in twos and threes. We've seen significant domestic demand for 10s, 20s... In particular, the 20-year sector has done particularly well. A lot of that's been LDI duration type buying; and thirties as well.

There's been a phenomenal amount of cash buying, which obviously has contributed to some of the massive Canada outperformance we've seen. I think there's also a bit of a street-positioning trade going through the month of June. We had a lot of extensions going on June 1, June 2, June 15, June 18, month end, quarter end, which all was net bond bullish. The street knows this. The street prepares for this. We saw that cash buying come through. The market squeezes Canada to outperform. You get a drastic outperformance of Canada versus the US. I mean, you could actually argue that earlier in the month of June, we were too cheap. You saw a lot of that get taken back throughout the month of June.

On the other side of the coin, anytime that you've seen a made-in-Canada sell-off, as I've told all of my clients, it hasn't been a result of cash selling. It's been futures led. It's been regular CTA selling. You can see that in things like... We talk about this CTD 10-year role. That role has continued to invert deeper and deeper and deeper and deeper. It really highlights the tug of war that you're getting from CTA algos selling 10-year futures against the cash buying that we're actually seeing, which is really serving to flatten that role.

We've seen this story before. One notable takeaway, I would say, from it is that the CTA algos are one bad data print away from completely flipping around. Typically, the cash buyers end up winning this tug-of-war. But right now, that would also favor steepening style trades in 10s/30s, and none of that stuff has worked out. It's continued to flatten and flatten and flatten. I think the cash side is losing a little bit of patience if they have curve trades on, but typically just adding duration because it hasn't just been curved. It's been net buying at 10, net buying of longs, net buying at 20s. I do believe that over the long term, the cash buyers are going to win that tug-of-war.

Ben Reitzes:

But today, we saw the worst five-year auction in a quarter. There is something to be said for lots of supply having an impact: that the auction was 5 billion in size. I mean, it's the third one of that size. It's not like we haven't done this before. But the last auction that was weaker than this was a 10-year and then before that was the other five-year. Obviously, bigger auction sizes are not helping here. Plans to maybe grow those further... not a great idea. The cash buying obviously isn't overwhelming across the curve. I think it... a little more focused further out the curve. That's helping drive that flattening as well, generally, and kept us extremely flat and still on curve.

I see no catalyst, at least not immediate catalysts to steepen the curve meaningfully like 2s/10s. I just don't see what can move that. 10s/30s: same. I mean, what you mentioned. I mean, that probably has room to steepen a bit given we're at the absolute extremes. But even on that, I still probably wouldn't be overly keen there. Against the US, it has moved a fair amount. That box has gone from... The 10s/30s box, it's gone from minus 30 and it's now, at minus 20 today.

We're through minus 20. That has moved a decent amount and something we'll continue to highlight at the extremes. But just Canada on its own... It's hard to think of a near-term catalyst given the way the data have performed/given the momentum. On top of things, if you thought that Canadian consumers might run out of money, well, they're going to get another couple of billion from the government this week, pretty much over the next five to 10 days, due to a grocery rebate to help them with grocery inflation. Oh, it's not as if that money's not going to cause even more inflation. We really think through our policies here in Canada. Always brilliant. That's going to add to income, add to spending. Q3, we'll get a little bit of an income boost after Q1 saw somewhat of a decline because government clawing back some of the CERB overpayments in the pandemic.

Moving right along here and sticking with the rate theme, provincial spreads. We've seen with the curve inverting and with... We can start at 10/30s, I guess. You can talk about outright spreads as well because outright spreads have tightened a lot. We've also seen the 10s/30s probing box, Ontario box, not really steeping out the way you think it would... well, 10s/30s Canada, flattening the way that it has. What's the dynamic at play there for the box and for outright spreads? Are we too richer? Have we gone too far, or is there more room to rally?

Adam Whitlam:

Yeah. First off, I'll speak to spreads. I mean, in terms of talking to clients, that general consensus, I would say, is credit is too rich. All credit is too rich. Everything is a little bit overvalued. Everybody's looking for that crack, that crack in the economy, which is going to push things wider.

Ben Reitzes:

Sounds like the stock market.

Adam Whitlam:

Yeah. This is a view across the stock market as well. Stocks have melted up here. But we know a lot of the reasons for this. One is positioning. People are more defensively positioned. The path of the most pained is going to be a squeeze higher in risk, which... Maybe we look for that last gas before it really does actually turn around. Maybe we haven't quite got there yet.

Ben Reitzes:

I need to be buying, and then it's going to turn around.

Adam Whitlam:

Exactly. I haven't gone and loaded my PA up with a whole bunch of high beta stocks yet, but you'll know the day I do what's going to happen. There's the account base. I'd say overwhelmingly is looking for that next crack and waiting patiently for it. But also losing some patience with a lot of these trades. If you're going into more defensive credits and you're going to own those defensive credits against, say, corporates, these are negative carry trades. Your clock's ticking on how long you actually want to own that.

Provies are no different than this. If you look at them on their own, provy spreads are at the tighter end of the range. But if you look at them against things like the US corporate market, like CDX, for instance, provies have actually underperformed a lot. For something that would be a less risky, albeit maybe less liquid, but less risky view on credit, provies comparatively look quite cheap. I mean, another example of that now... And CMBS have their own idiosyncrasies with the potential cancellation of the program next year. Look at CMB versus Ontario spreads in five years. We've been highlighting that for a couple of weeks now. I mean, that spreads all the way down to eight basis points. That's about as tight as that ever gets.

You are seeing these situations where higher-quality credits do look fairly cheap. I think, at this point, provies, in the long end, probably still have room... or in 10 years probably still have room to perform just given where they are against state corporate credit. If you look at 30-year utility against Ontario spreads, that spread differential... At the wides, that's 70 or 80 basis points. We're at 55 basis points right now. The tight end of their range is probably around 50 to 45. We're definitely closer to the tighter end of that range. I think provies do have some room. Similarly, we've seen a massive amount of inverting in the curve. But that 10s/30s box has remained fairly stable. If/when we do see some reversion to the mean on the 10s/30s curve, that could be helpful for the box.

Ben Reitzes:

How many basis points do spreads have in 10s and longs to tighten? What do you think? Five BPS? 10 BPS?

Adam Whitlam:

Yeah. I would easily see 10-year provincials heading... 10-year Ontario's heading back down toward the 64/65 area. That's probably about five to six basis points from where we are right now. I mean, we've absolutely had longs in and around low 10s, for sure. You could easily get back down to 83, maybe as low as 80. But I think 81, if I remember correctly, was a pretty good resistance point. We could easily have nine to 10 basis points in longs to go.

Ben Reitzes:

Risk on then.

Adam Whitlam:

Well, yeah, risk on. But even in a risk-off environment, I would rather own these credits than I would, say... If that utility provincial spread is at 55, I would much rather own the Ontario's because I do think that they'll outperform in that environment.

Ben Reitzes:

That makes good sense to me. It sounds like you've already given us all your trade ideas. We got the CTD 10-year-old. We got utilities against Ontario. We have Ontario's against CMVs. You just want to upgrade credit and maybe put a little bit of steepening on, just micro steepening. Go ahead. Why don't you lay it out for us, even though I just spoiled everything?

Adam Whitlam:

Yeah. I mean, you've basically summed it up. I like that CMB Ontario trade. I think that makes sense, especially if you look at it versus the neighbors. June 28th: that spread is eight basis points. The mortgage originator selling is now going to be focused on D28s, not June 28ths. You don't have to worry about these guys coming in and selling a whole bunch.

Oh, by the way, when mortgage originators sell, it's because they need to buy back into the new issue deal. I also think that with some of the questions behind the CMB program, I think the potential is there that what you'd expect to be in August, we're going to see a 10-year CMB, that you're going to have a bunch of mortgage originators selling into that.

I think they might look for other ways to hedge some of their rate risk that doesn't involve selling CMBs. You might not see that big backup. I think CMBS are primed for a move tighter relative to other credits. That's one that I really like. I like fading some of the inversions in long provincial boxes, things like Ontario 46s relative to Ontario 53s. Those are about as inverted as they ever get. The Ontario 46s don't have anywhere near the same roll-up. It's a part of the curve where we've actually seen a lot of LDI buying. There is a natural demand for that 20-year sector. We've seen it in Canada too.

I don't know if you've been watching what's going on in the long Canada rolls, things like 10 years versus 41s versus longs. I mean, a lot of those roles have really ground in. We haven't seen the same move in provies. I think, on a relative value basis, some of that stuff looks really attractive.

I'd love to go out there and say, "Put on a steepener. Today's the day." But every time I've done that, I've been completely wrong. Maybe because I'm not going to say that, it'll go my way. I still like the short end of the curve. I still think there's value in things like one years and two years relative to fives. I don't like fives, even though 2s/5s/10s curve is getting to a cheaper end of the range. But I think the negative roll on fives looks painful.

Ben Reitzes:

Still historically rich, even if it's locally cheaper than it was three months ago. Look at the bigger chart. It's still not a value proposition at these levels.

Adam Whitlam:

Oh, swap spreads. I think Canadian swap spreads... Those have rallied like crazy. I think you're probably getting to a point now where it makes sense to take some sales. If you get 10s... 10s traded as high as 1975, 10-year core spreads. That is extraordinarily rich by any measure, even if you take CDOR spreads and go all the way back. I mean, 10-year constant maturity spreads look very expensive.

What's interesting is, conversely, US swap spreads don't. They actually look fairly cheap if you can get things like seven-year US spreads back down around... I think it got as low as about negative 30. I think today they're probably negative 28. You've got a little bit of a cross-market trade and swaps that you can put on. Sell Canadian spreads. Buy us spreads. It's a mean reversion trade. But I think as we go through the summer and mortgage growth slows down, I think you're going to see some of these bank Treasuries get forced into receive to replace duration in the asset book. That is going to push spreads lower in Canada.

Ben Reitzes:

That is interesting. Yeah, the mortgage picture is something I'm definitely watching. We'll get some home sales numbers this week from the cities. That'll give us maybe an early indication on whether the June rate hike had any impact. I mean, it probably shouldn't because people have their mortgage rates locked in ahead of time. But I don't know. You never know. We'll see if that pans out. Then, if they hike again this next week, that probably weighs a decent amount on the mortgage market. Then, you get that bank Treasury impact coming in and really pulling things down on the spread side. We shall see on that front.

Adam, thanks for coming on. One more show until I take the summer off, at least from podcasting. Still got to work. But August is not a prime podcasting month in my mind.

Adam Whitlam:

How European of you?

Ben Reitzes:

Well, I'm doing my best to be as global as I can. One more podcast after the next week's Bank Canada meeting, and then we'll take it off. But Adam, thanks for joining. I will have you on again in the next few months.

Adam Whitlam:

Thank you so much, Ben.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.