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Another Aggressive Hike Is Coming - Views from the North

FICC Podcasts Podcasts September 01, 2022
FICC Podcasts Podcasts September 01, 2022

 

In this episode, Sam Buckley, BMO’s head of Canada rates trading, and, Darren Campbell, from BMO’s rates sales desk, join me to discuss next week’s Bank of Canada policy announcement, what’s next for rates, where the Canada curve is heading, and their favourite trade ideas.

As always, all feedback is welcome.


Follow us on Apple PodcastsGoogle Podcasts and Spotify or your preferred podcast provider.


About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Speaker 1:

Welcome to Views From the North, a Canadian rates and macro podcast. This week, I'm joined by Sam Buckley, BMO's head of Canadian rates trading, and Darren Campbell from BMO's rate sales desk. This week's episode is titled Another Aggressive Rate hike is Coming.

Ben Reitzes:

I'm Ben Reitzes, and welcome to views from the north. Each episode, I will be joined by members of BMO's thick sales and trading desk to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep this 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 Benjamin.reitzes@bmo.com. That's Benjamin.reitzes@bmo.com. Your input is valued and greatly appreciated.

Ben Reitzes:

Sam, welcome to the show, first time on, and we're very happy to have you on.

Sam:

Thanks for having me.

Ben Reitzes:

And Darren, welcome back.

Darren:

Thanks, Ben.

Sam:

Many time guest. We're going to talk about the bank primarily this week, and if anything else comes up along the way, we'll cover that as well. But let's start with the bank out of their next week policy announcement. September 7th on Wednesday, markets are pricing about 70, 71 basis points of rate hikes at the moment. So pretty much 75 bps is what's expected by the market. Most economists are now looking for 75 as well. So I'd say that is the broad consensus. A little bit of chatter about maybe some more caution from the bank after today's GDP number. We got second quarter GDP and was disappointing today. So a little bit of chatter about maybe they'll be more cautious on the back of that. I will address that in a bit. But why don't we ask both of you gentlemen, what your expectations are for next week. Sam, why don't we start with you?

Sam:

Yeah, my expectations would be on consensus 75 basis points, but I think the risk, despite today's GDP data that we do get 100. I don't think the market's pricing that yet. And I think that given the last 100 basis points rate hike, plus the communication and data that we've had since that rate hike, I think that they're very in their right to go 100 basis points. I think that the market shouldn't be surprised if they do that, given the communication and the inflation data we've had since that. And the fact that we're online pricing 71 or 72 basis points is a bit of a surprise, but totally understandable given the backdrop of falling energy prices and inflation coming a bit down. I do think the bank is worried about the wage price spiral sticking around for a little while longer than they hope so I could see them being a bit more aggressive.

Darren:

Yeah. I'm with Sam. I mean, I don't think that the market can be too critical if the bank were to go 100 next week. I think that it's unlikely if the market hasn't sort of put a little more pricing in that I think that they'll hold off. I think they've been pretty respectful of that, but I just think that we got 100 last time. This is an exercise of getting rates up as quickly as possible and then kind of a wait and see. So I there's scope for sure to be doing another 100 and the market's priced for obviously a lot more than that. So for them to just be speeding up the process and then seeing where things settle, I think is where their mindset's been. They were a leader last time around going with 100. And so that type of activity is, you just can't be surprised.

Darren:

So we've seen some activity around that. We saw some paying of that September meeting today, which makes a lot of sense without 75 fully priced. We think, of course, that makes sense. And then why not be rolling the dice for 100 basis points? I just don't think that the data, the moment matters nearly as much as the message that we're getting from certainly the Fed, even last week. It's very clear that the confidence is just not there at the moment around inflation expectations. They know how risky and vulnerable that type of thing is and know that they just need to be on the front foot until there's a lot of confidence that that's under control. So for me, it's for sure, it's 75 minimum. You can't give them a hard time if they choose to go 100 next week. But I do think the market would need to probably creep up a little bit more for that to be realistic.

Ben Reitzes:

A few things there, last time the market was not priced anywhere for 100 and they went 100. So I don't think market pricing 70 or 73 or 72 or whatever it is will impact their thinking all that much, firstly. Second, they did make it very clear last time. They tossed out the narrative of front loading rate hikes. So if they stick to that and the bank's been known to change their mind on narratives from meeting to meetings, so anything's possible. But assuming they stick to that, it's got to be at least 85 and that's the starting point and 100 would make good sense to me. Could be 100 and then done that. That's possible as well. And then lastly, you talked about the data and I think that's what people probably overlooked in today's GDP numbers. So the headline looked not great and it wasn't as good as expected.

Ben Reitzes:

The bank was looking for four. It was 3.3 that's below expected. July, the flash estimate on July GDP was negative. So that's not a great start to the third quarter, but the GDP deflator was 14% annualized. That's the highest since 1974. That's GDP inflation for those who aren't economics nerds. And so you're looking at inflation in the broader economy in the double digits in the second quarter. And while inflation might have peaked in June, CPI inflation might have peaked in June, the bank cannot be comfortable with seeing the deflator that high. And it'll probably come down on the third quarter, but again, the breadth and depth of inflation is so far beyond what they're comfortable with. It's really hard for me to see them backing off at all from their aggressive stance at this point. So 75 with the potential for 100. 50 Just doesn't make any sense to me. That would only bring them to the top of their neutral range.

Ben Reitzes:

And they've said very clearly they want dampen demand. If you want to dampen demand, you need to be above neutral. Although the question for me is, how high above neutral? And the terminal rate is, I don't know where that is. I don't know what the bank thinks it is. It's probably not 325, I'll tell you that. 350 would probably be my minimum. So that's where you get 100 and then maybe a pause, but it could be 100 and then another 50 or 25. 4% could be the terminal rate, I don't know. Where do you guys think the bank ends up pausing here at least? And I'm saying pausing because I think they leave the door open no matter where they end up.

Sam:

I think they could pause at 350. I think that they could easily go 100 this time. And if they don't go 100 this time, if they go 75, then I could see it going to 375 and then pausing to see how the right hikes kind of filter through the economy, how it affects housing. One interesting thing about the bank though, that I think is a bit different than the Fed is, in terms of their front loading, I think they're much more worried about what's on the front page of the paper and what's in people's pocket books than... Not that the Fed's not worried about that, but I think they also have a different worry in terms of them being the global currency and more concerned a little bit about the wealth effect that I think the Bank of Canada is. I mean the Bank of Canada and the Canadians in general, have seen their wealth increase a lot over the past few years, past five years based off of housing.

Sam:

And that's really just been fueled by zero rates. So I think to put a bit of a dampen on that, I don't think the bank is too worried about that. Given a lot of the increase was in the past couple years through the COVID zero interest rates and stimulus packages. So I think that the bank can afford to be a little bit less worried about a harder landing than I think the Fed is trying to achieve if the bank is really serious. And again, inflation is their only real mandate here. So I think that they can afford to be a little bit more aggressive in front loader than the Fed.

Ben Reitzes:

Darren. Terminal?

Darren:

Yeah. 100 percent agree with everything they say. I'm just said, I think that's when you weigh up the concern of house prices and other assets coming off versus the risks of an inflationary environment, that's spiraling under control, it just doesn't compare in the conversation right now at the table. There's such a gap between those two concerns that for the time being, it's just, they have to lean on this, they to be aggressive.

Darren:

And then so it's really just a conversation around cadence. So I do think that the conversation is probably going to be shifting more to a four handle, to be honest, for terminal. I just think it's going to be clear to the market that things just aren't under control once you're kind of in that, call it mid threes range. And so it's sort of, what's another 25, 50 basis point's going to do, right? It's probably going to be pulling into question the need for more just drastic measures to get things, to make sure that you have things under control. So whether or not we get to that or not, I think we're going to be ha-, the conversation's going to shift a little bit more to that.

Ben Reitzes:

Because to some extent we've seen that terminal now when Canada's 385-ish or so, but by the middle of next year. And the rate cuts that were in 2023 are mostly gone. The inversion in that curve, in the BAX curve in 2023 is mostly gone. There's still a little bit there, but slowly but surely that's getting taken out as well. And then the reality again, even when the bank ends up pausing at whatever level that is, they're still going to say, we may have to keep going. We do not know yet. The inflation math does not start to really work in their favor until we're getting much closer to the middle of the next year. That is a long time away. So they can't afford to really back off until then, unless you get some kind of massive collapse in commodity prices, which maybe we're seeing the start of. I kind of doubt it, but oil prices sub 90 definitely have an impact. Where you are going to see inflation slow again in August, it's going to come down because gas prices are down another eight to 10%.

Ben Reitzes:

So you are going to see some deceleration, but you're still looking at seven plus percent on the headline, 5% on the cores. All way too high and go back two weeks to when the last Canadian CPI number came out and recall the Macklem put out an op-ed the same day sounding very hawkish. I think people have already forgotten about that article, but he was pretty clear that the bank is not backing off one iota given where inflation is, even though it looks like it has peaked. Let's change gears here a little bit. Talk a little bit more about the market curve, duration, views here. Sam, you're trading Canadas all day. What are your thoughts on duration here and what are your curve thoughts as well?

Sam:

Yeah, so we'll start off with duration. I mean, today we're at month end today. The US gave quite a bit back after the 3:00 PM. And I think a lot of market participants are looking for higher yields in September, whether that's because of issuance or just generally inflation is sticking around for a little bit longer and higher inflation prints globally are bringing the need for higher yields. Did Canadian long bonds really need to be at 3% when inflation is running at where it is or where when terminal is going to get to where it's going to? Probably not. So I think that in general, people are looking for higher yields. And in Canada, that means a couple things I could see that twos fives over time, depending on what the bank does, steepening out a little bit and more of the flattening going. That's in twos fives going into fives tens.

Sam:

If we are getting a backup in yields, I do think that tens bonds over times is just going to continue to flatten, just given the dynamics of Canada and what drives the end user in Canada, whether it be asset managers, insurance companies, and just the lack of supply in the long end that we've seen from the Bank of Canada. And we're also looking at better fiscal situations from the provinces as well, putting less pressure on the back end of the curve. So I do think that over time, tens bonds could, if we do see higher yields, which the market's expecting, I can see tens bonds kind of test that negative 20 level that we saw. We have seen profit taking on flatteners, kind of initiated in the positive range and we've seen profit taking into month end and the extension in Canada tomorrow and September one. But a lot of these accounts aren't looking at putting on steepeners yet. They're more looking at taking off flatteners or reducing their exposure to flattener before putting steepeners on.

Sam:

And that's the general real money consensus. I would say that people are more interested in looking at something like a fives, 10 steepener or fives bonds steepener from the fast money community, more as a tactical trade into September, more than anything longer term.

Sam:

So I think longer term you're probably looking at a flatter curve further out and depending on what the bank does, I could see two fives steeped a touch depending on the messaging from the bank. Like we said, they did take out the cuts in 23. Fives have really come off their richest levels after the Fed came out and basically said that hikes are on the table and cuts are kind of off the table for 23. So I think that the more messaging you get from central banks and more consistent inflation prints like Ben said, I mean, we're really not looking at the base effects coming off into the middle of next year. So higher inflation could be around for a while off if we don't get the commodity collapse. So that could lead to a steeper curve kind of in that twos fives area, but it could also lead to flatter fives tens.

Darren:

Duration, I mean, it feels like... To think about this year, it seems like everybody came into the year short. It was obvious it was the right trade. People I think did pretty well on that trade and then started to flatten out late spring and into the summer. And then it just feels like as the recession theme narrative picks up speed, it's like, that's when you start to see some buying emerge from various pockets of the world. Age is obviously going to be a key determinant, I think. But it just seems when you're out up in that 325 range in the US and above, there's demand, the demand emerges. And I just think that the data is going to just continue to bolster the recession narrative. So from a duration standpoint, pretty constructive, anything close to 325 or above in the US, whatever that means for Canada.

Darren:

Curve is tricky because everything you're hearing right now is just saying, you can't really have steepening. The curve is flat. It's been a massive move, but all signs still point to that flattening pressure on the curve. Does it mean that it's got a lot more that it can run, the twos 10s part of the curve? Is there a lot of room that it can run? If you don't have the trade on at the moment, it's hard to justify. But if you've got the trade on and it's worked out and I think you can be a bit greedy with the exit. There's no doubt that everybody's kind of focused on steepening and when that ultimately will be the trade, but when is the timing for that? And I just think it's not now it has us looking at a lot of the forwards and you look at when these curves do typically start to steepen.

Darren:

And I think it's always before you actually hit terminal. I think it's sooner than you think. And so you can look at the forwards and you can look at a 530 in Canada and that's at neg 22 or something like that at the moment and 18 months forwards at neg five. So that's a position where you can get that trade on and it's costing a basis point a month to be sitting in that trade. And you're kind of saying over the next 18 months is the bank pivoting and needing to come to the rescue and change? I'd say, absolutely, we're going to be seeing that, right? It's just more sort of what's going to be happening over the next three, four, five months to that position. So yeah, for the time being, it's still very difficult to be comfortably sitting in any kind of steeping trade, but there are some interesting things to be focusing on in the forward space.

Ben Reitzes:

Curve wise, it just feels like the front ends that are too much pressure to be in any steeping at this point. And that's not going to change. Especially if the bank goes 100 next week. That's a nontrivial risk at this point and the data and Canada are... I mean, it's hard for me to see them not weakening. Our forecast is for growth to pretty much stall out by the end of the year and stay that way into next year. So softness there. The question I guess, is whether we're in a different era now and in higher inflation means central banks can't come in and ride to the rescue. I don't know the answer to that. Well we'll have to wait and see. And keep in mind and consumers still have, and households still have plenty of savings in the bank from the pandemic days. And maybe that's enough to get us through this period here without too much weakness in the economy.

Ben Reitzes:

Those are questions that will determine the path for rates through the course of 2023. That definitely challenging time and still plenty of uncertainty, which I think is probably a bigger theme through the rest of decade. I can wax on about that another time. Why don't we get your guys' favorite trade ideas here and then we'll wrap things up. Sam.

Sam:

I think it's a popular trade in this room. I don't think the timing is yet. I definitely don't think it's yet. I think there's still a lot of people in it small looking forward to perform a little bit or maybe looking for a better level to add, but it's Canada, US. I definitely wouldn't want it ahead of the bank. I mean just given the risks that we've kind of flagged about them going more and I mean, you're probably looking at long Canada US. I would say more so in tens from my standpoint than anything else. Although I think that one of the risks to that is if we do get a backdrop of higher yields, there is a risk that CGBs, which is that the Canadian tenure future do push Canada a little bit quicker and faster than the US just given the nature of how that trades.

Sam:

So I think that is a risk, but I do think that coming to the bank, it's not a bad spot. I mean, you look at when the bank hiked 100 last time, I think Canada, US tens was sitting at positive 30 or close to that, maybe positive 25. And then after that, Richmond call 30 basis points to minus five where it got to. I think there were few accounts in that trade at that time, but I also think there was a lot of pain in and along the way from that plus five to plus 15. I think that was a very crowded trade. I think a lot of people got too early. So I think there was definitely a risk of people getting in too early this time around as well, especially if ahead of the bank. So it's definitely something that I'd like to watch along Canada, US kind of in that tenure space.

Ben Reitzes:

Where would you get into that trade? Where do you like it? What level?

Sam:

I'd like to see where it is after the bank to be honest. I don't think it's a level specific thing. I think that just kind of given the nature of what I'm doing, I can feel it a lot more, I would say in terms of how CGBs are trading and how that's going to perform. I mean, today we've reached four basis points or almost four basis points just based off of the US kind of giving it up after month end. I mean, I think you probably look at plus five, plus 10 to start piecing it in with the idea that it can go a little bit further, especially if CGBs are leading the way.

Ben Reitzes:

Is it at all encouraging that while rates have backed up over the past few weeks, Canada's held in there pretty nicely. We haven't seen that CGB led sell off. Canada really hasn't underperformed at all. We've kind of just held our ground.

Sam:

Yeah, no, that is very encouraging. It's very encouraging. I'm not sure if that's positioning, getting a little bit lighter and CGB is given the violent move that I think we had at the end of the June, beginning in July. I think maybe a lot of shorts were stopped at or taken off. So maybe the momentum behind that those trades are maybe gone for now. But again, I think that if we do backup and yields, then the momentum's going to be pretty quick to pile on there.

Sam:

So that's definitely something to watch. I mean, if we get back to positive on 10s bonds, I think that's definitely something you'd want to watch to get back into. I think that probably stays in inverted for a little while, especially we're given the backdrop on higher yields. I mean, I think Darren kind of touched on this, but you talk about a 325 long yield plus 95 basis point provincial spread, that starts to look pretty attractive to a lot of insurance companies and pension plans and real money, real money buyers and retail investors too. I mean, I think that would certainly look pretty attractive, that all in yield. So I think that's definitely something to watch for as we go forward.

Ben Reitzes:

Darren, and I think Sam's made your life difficult here because I'm pretty sure that's also your idea.

Darren:

Yeah. I appreciate you asking him every question first.

Ben Reitzes:

It's his first time on, so I thought I'd give him the show first.

Darren:

Next time we'll switch it up.

Darren:

That's fine, that's fine. Yes, that's the theme that to me makes the most sense obviously based on my view around the bank and how aggressive they can be. It's sort of staying away from the front end to express that view. And I'm with Sam probably more out around the tenure point.

Darren:

And then again with my sort of duration view, if we do see some, if 325 is sort of the high and we start to see ball market do a little bit better, then you can sort see that momentum buying in CGP. But you've covered a lot of this ground Ben and a lot of the stuff you've been writing recently, but if in Canada, the number of outstanding mortgages is floating right, is around 30%. We think it's a third of that in the US. And so US is maybe half of their economy is housing. 10% in Canada versus five or so in the US. But I think that the immediate sensitivity is around some of those floating rate mortgages. So if it's three times as much in Canada, then we're going to be feeling the pain a lot earlier and you're already seeing it anecdotally in people's behavior and things like that. So I think that starts to bite and Canada will do particularly well versus US starting mid to late fall, I think is when you want the trade on.

Ben Reitzes:

Very much on board with both those ideas. Gentlemen, thanks for coming on. Sam, appreciate you having you on for the first time here.

Sam:

Thanks for having me.

Ben Reitzes:

Hope to have you back again and Darren you're always welcome.

Sam:

Thank you, Ben.

Speaker 1:

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 5:

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.

 

Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist

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