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Is Canada Cheap at Last? - Views from the North

FICC Podcasts July 08, 2021
FICC Podcasts July 08, 2021

 

This week, Austin Derris, Boston-based fixed income sales, joins me to discuss the upcoming Bank of Canada policy meeting, swap spreads, whether Canada is finally cheap cross market.

As always, all feedback welcome.


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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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Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week, I'm joined by BMO's Boston-based fixed income salesmen, Austin Derris. Austin is a resident of Boston and does sales out of Boston for us. He covers a number of US clients. Hopefully we can get his views, his client's views, on how they're looking at Canada through this challenging period. This week's episode is titled, Is Canada Cheap At Last?

Ben Reitzes:

I'm Ben Reitzes, and welcome to Views from the North. Each episode, I will be joined by members of BMO's FIC sales and trading desk to bring you perspectives on the Canadian rates market and the macro economy.

Ben Reitzes:

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.

Ben Reitzes:

I can be found on Bloomberg or via email at Benjamin.reitzes@bmo.com, that's Benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

Speaker 2:

The views expressed here are those of the participants and not those of female capital markets, its affiliates or subsidiaries.

Ben Reitzes:

Awesome, welcome back to the show.

Austin Derris:

Thanks for having me, Ben. I feel like a rock star now. I think this is the third time, so I'm doing something right or we're both doing something wrong.

Ben Reitzes:

Both of those are very possible. either way, I guess we'll let our audience decide on that one. Next week is The Bank of Canada, so that'll be the focus today. There's a fair amount to talk about on that front, but lots of market stuff as well.

Ben Reitzes:

I mean, things have gone, what word would you use, maybe haywire would be one, over the past couple of weeks or so. Vicious rally and duration in both Canada and the US. Meantime, the front end has been stubborn, to put it kindly.

Ben Reitzes:

I guess that shouldn't be that much of a shock, if what I'm going to say shortly about the bank Canada is true, and they continue to move down the path to tapering and eventual rate hikes. It does make some sense that the market is priced, I guess, relatively aggressively for them while the fed stays, compared to the Canada, at least a little bit patient.

Ben Reitzes:

Why don't we open this way? What are your thoughts on the market here? Then we can move on to The Bank of Canada.

Austin Derris:

Yeah, I mean, we're sitting here Wednesday afternoon after Fed minutes, and nothing really changed there. The last big thing to move the market I'd say was probably FOMC a few weeks back. Canada was cheap and got cheaper. It seems to only get cheaper.

Austin Derris:

We tend to underperform in rallies and sell offs, and that seems to be happening again as we sit here this afternoon, H3 bedspreads and M3 bedspreads are at around 80 to 83. That's about as cheap as I've seen them when your one year Cora is high 80s, also as cheap as I've seen it locally.

Austin Derris:

So, Canada just sticks out as extremely cheap outright, and cross-market versus anything you want to look at. I think we've been saying that for some time, it's optically been cheap, and it remains cheap, and it's even cheaper. But now we're getting to points where I think the math is on the side of getting long for sure. We have actual hikes that are being priced in the front end. We have a path of hikes that are being priced as more aggressive than others.

Austin Derris:

I do think there are compelling things to do in this market and hopefully, our clients and our listeners agree.

Ben Reitzes:

Fair enough. The only counter to all that would be, I mean, we've been cheap for so long, so what's the catalyst at this point, especially if you look forward to next week? The Bank of Canada is almost certainly going to be tapering again. I think that is the broad expectation right now.

Ben Reitzes:

As they cut their purchases, that brings them that much closer to rate hikes, whereas the Fed still at least probably a couple of months away from even announcing tapering, maybe a full quarter away from actually starting tapering. Then their rate hikes are that much further away, given the process involved with tapering.

Ben Reitzes:

So, I guess what would be the catalyst to get Canada to move? Or alternatively, is it more of a US-driven trade? Does the catalyst have to be a US sell-off when the Fed starts to sound a little more hawkish, generally?

Austin Derris:

The answer is it could be either. Definitely the US side of it is going to help with regard to how cheap we are. But at the same time, you're at the point where you have a bunch of gaps in reds and greens, in backs that are pricing around 20.

Austin Derris:

We're so early in the cycle, and with a hiking path viewed as 25 basis points where we're getting close to where we're priced for perfection. Earlier this morning, and we're recording this again Wednesday afternoon, when Cora was at around 16 this morning, it did snap up two basis points.

Austin Derris:

A lot of that is just noise, but you were pricing March meeting next year in OIS at above a 50% chance of a hike. March is not an MPR meeting, and I think these are binary type meetings that, in my opinion, is probably something that can be viewed as carry from here to there. We're discussing really just when they actually hike and that path of hikes.

Ben Reitzes:

I like that and I liked the receiving March there. Makes a lot of sense. I think it's very, very difficult to see The Bank of Canada moving ... April 2022 is already super aggressive. But before that is, not impossible because nothing's ever impossible, but you'd need a pretty particular set of circumstances, and a pretty positive backdrop. I mean, probably massively positive backdrop to get anywhere close to that. So, receiving March does make a whole lot of sense to me at this point.

Ben Reitzes:

Why don't we head into the bank, and then we can come back to markets in a second? Briefly, again, consensus is for a taper next week. We expect one as well. They're going to cut their purchases from 3 billion, down to 2 billion per week. It's likely that we'll get the tapering coming across the curve again, So when they cut their purchase in April, they can proportionally right across the curve. I expect we'll get the same.

Ben Reitzes:

The rationale behind that is if in April, when there was significantly more uncertainty as to how the outlook was going to unfold, they chose to cut across the curve proportionately. Things are notably better now. Everything's kind of lined up in The Bank of Canada's favor.

Ben Reitzes:

So, with everything that way, with everything on the more positive side, I'm not sure why they would want to soften the taper by extending maturities of their purchases a little bit. So, softening that taper just doesn't make a whole lot of sense at this point.

Ben Reitzes:

If you look at how things have evolved since April and since June, there were a couple of potential speed bumps that would have put a taper in doubt for next week's meeting, but they've all resolved on the positive side.

Ben Reitzes:

For example, GDP growth, The Bank of Canada missed Q1 by 1.4 percentage points, so growth was weaker than they expected. But they shrugged that off in June. They said, "No big deal, no worries. That's not going to be a fuss for us."

Ben Reitzes:

Second quarter, they looked as though they were pretty upbeat at 3.5% for growth, given that the economy for most of the country was shut to some extent due to COVID. Ontario, where I am, was pretty tightly locked down. But GDP actually hung in extraordinarily well, falling just 0.3% in April, and it looks like a similar size decline in May, which is pretty darn good if you consider the extent of the restrictions in place.

Ben Reitzes:

So, that puts the second quarter, just because March was really strong, on pace for something two, 2.5%, maybe even 3% range. We'll see what the May actual is and what June is as well. But again, not far off from their forecast for Q2 in April. So, the economy has grown more or less as they expected. That keeps the output gap on pace to close in the second half of 2022, so nothing's changed on that front.

Ben Reitzes:

Meantime, the Canadian dollar has backed off notably in recent weeks. If you look at commodity prices in April, they're about 5% higher than where they stood at the April meeting. The Canadian dollar, pretty much little changed over that time, so there's no reason for them not to taper due to the Canadian dollar.

Ben Reitzes:

You can add to that, the Fed has started to talk about tapering, and that's kind of an important dynamic, I think, for the bank, and not wanting to get too far ahead of the Fed again. That's as much a Canadian dollar story as anything else. But the fact that the Fed's now started to talking about tapering, that does mean something, and it brings them closer to that eventual step, and it means that the differential between eventual rate hikes may not be as wide as it could have been if the bank continued on their aggressive path and the Fed stayed super conservative.

Ben Reitzes:

So, everything's lined up in the bank of Canada's favor at this point, so no reason to expect anything but a taper next week. I guess, from there, it's more a question of what they do next. What I'd like to see is a little bit more clarity on what they mean, or how they're going to execute the reinvestment phase of things, how they treat the auctions and whether they do you want to keep the balance sheet steady after auction purchases, or whether they want to keep growing the balance sheet at kind of a normal rate, which would be just kind of allowing auction purchases to grow the balance sheet slowly but surely, and maybe just reinvest the maturities.

Ben Reitzes:

So, there's some ambiguity there. Hopefully they address that in the July MPR. Austin, is there anything else you think I might've missed? You have any questions on The Bank of Canada's meeting next week?

Austin Derris:

It's similar to the last go round, and the one main question is really taper and how they do it? But it's likely that they do exactly what they did last time. There's really no reason to tweak it, despite what we might like to see, with considering where cash versus OIS is pricing, and spreads are pricing, and all of that fun stuff. But very likely that they just go across the curve.

Austin Derris:

Then is there any reason for them to give us any SRO, or any surprise on the Friday following, which seems to be their MO? It seems like there's less of a reason this time. Do you have any view on that, Ben?

Ben Reitzes:

Yeah, I don't see any reason why they would make any tweaks on the SRO at this point. We're not bumping up counterparty limits at this point, so I don't know why they'd have to bump that up.

Ben Reitzes:

You are seeing a pretty decent usage, and it's kind of perking up a little bit. I don't think that should be a big shock as they continue to do QE, which adds more liquidity to the system, and then that gets pushed into the SRO. So, no changes expected there, I guess, is the simple way to put it.

Ben Reitzes:

Expect Cora to trade in kind of 15 to 20 basis points in that neighborhood, maybe kind of 16 to 20 basis points in that neighborhood, pretty consistently. I think that's interestingly something they'll kind of look forward to. You look out into 2022, and it's important to take that into account when you're looking at Bank of Canada pricing.

Ben Reitzes:

Because I don't see how they're going to be able to control Cora, and get it to behave, and make it set closer to target in the future. They're not likely to drain liquidity and aggressive fashion anytime soon. They'd really have to run down their balance sheet aggressively for that. I just don't see them being able to do that and raise rates at the same time.

Ben Reitzes:

So, get used to Cora setting through the target, or maybe, just maybe, The Bank of Canada changes to some kind of a target range, as opposed to using a point target for rates. Maybe they do something that looks more like the Fed at the end of the day as they just kind of acquiesce to the fact that they just don't have the control over Cora that they once did.

Austin Derris:

I think you're spot on. I think at the end of the day, what we're talking about, really, is if they care about where Cora sets. Everything's kind of gone their way, and there's a very, very good chance they don't care.

Ben Reitzes:

I just don't know why they would. I mean, if it was really an issue, they probably would put a little bit more effort into it at the moment. Because they're not, it just tells you ... I mean, taking all of that liquidity out of the market is just not something I think they're really able to do. Same way the Fed just kind of has to live with that range. I mean, going back to point targets is not happening anytime soon, as long as the balance sheet is as massive as it is. There's just no way to unwind all that. So, I mean, I guess welcome to the Fed's conundrum for Bank of Canada, and good luck getting out of it. It's just not particularly likely to happen.

Austin Derris:

Sure, agreed.

Ben Reitzes:

Let's turn back a little bit to the market here. I mean, that pretty much covers the bank at this point. It's unfortunately a little more straight forward. I'd love to be a little more contrarian, a little less consensus.

Ben Reitzes:

But everything's lined up one way. I've done my best to take the other side, but there just isn't one at this point. So, maybe it will get more interesting in September and October, but for now the path ahead for the bank is pretty straightforward. Except for whether they tell us or not what they'll do next and how reinvestment will work. That part is a bit of an open question mark.

Ben Reitzes:

Austin, we were discussing before we came on, you mentioned the four-year part of the spread curve as particularly attractive. Can you tell us a bit more why that is? There aren't that many interesting parts in Canada right now, especially given kind of the directionality and rates. But I think that is one where there's something to talk about.

Austin Derris:

I think we've probably had this conversation a bunch by now, Ben. I think it's mostly related to the fact that spreads in general in Canada are extremely elevated. You have three-year, four-year, and five-year spreads, all between 45 and 50, and that's just headline spreads.

Austin Derris:

So, we can talk about why that is, but I think we've done that a lot before. The peak of the asset swap curve does seem to be that off-the-run, four-year part of the curve, which is something that's definitely worth watching. Any of that paper around June 25, Sep 25 and all of that stuff, trades somewhere between 45 and 50 on a match maturity swap basis.

Austin Derris:

Since it's the peak, selling that, and taking a view that spreads are a little too wide and Canada, which does seem to be a popular expression, picks up a nice little bit of carry and roll to hold that. So, anywhere you get close to around 50 basis points on a spread like that, it shouldn't be sneezed at. There's definitely a good rationale to hold a short there, in my opinion.

Ben Reitzes:

Okay. I mean, what's the roll there? So, what do two-year and three-year spreads, where they at, so what's the roll down?

Austin Derris:

So, threes versus twos is a little less than 10 basis points on a headline basis. Don't forget the way spreads trade in Canada. You do have an exchange of twos and five-year benchmark at that point. So, trading MMS is just trading those one bonds. In this case, it would be Sep 25s, or June 25s, just to capitalize on the peak of that curve.

Austin Derris:

I think another way to play that four-year spreads, or the 2025 paper, is if you had a curve view. What happened post-Fed a few weeks back was that the cash curves flattened aggressively, and the swap curves never steep into adjust for that.

Austin Derris:

So, what you have here is a nice inversion of something like fives, 10 swap spread curve, and a nice RB slant on it would be to do something like four-year versus June 31s or something like that just to add a RV slant to that as well, and pick up a few extra basis points of roll in your direction in both of those bonds, where June 25s are a nice sell, and June 31s are a nice buy, in my opinion, as well.

Ben Reitzes:

I think that's a good opportunity in Canada at a time where again, it's been pretty challenging the way the market's gone. I've been more than outspoken in my kind of macro bullishness. The rate outlook that goes along with that is, it tends to be higher rates. I mean, from a macro perspective, I still can't get away from my thesis. I'm not there yet. I don't see any reason to change my mind.

Ben Reitzes:

The market generally right now, I think combination positioning is a big part of this, with 10-year yields hitting their lowest levels since February as that flashes on the television in front of me. Positioning is a big part of that, still lots of shorts out there, and given summer months, there's tons of uncertainty still out there. Summer illiquidity you call it, man, do I get a lot of out of office's when I send out emails lately.

Ben Reitzes:

I think all of that together, and people just kind of throwing in the towel on their shorts, and the punishing carrier profile for that has kind of driven this summer seasonality matters, as well. Summer tends to be a pretty good time for bonds. I think we are seeing some of that.

Ben Reitzes:

So, put all that together and that's where we are. I'm still of the belief that we get higher yields at the end of the year than where we are now. But the next few weeks are probably a grind sideways, just as the summer kind of drags on.

Ben Reitzes:

So, probably get used to the price action of the past little while. Maybe not as violent, and maybe not the same type of strength, but we could definitely grind stronger. What do you think there, Austin?

Austin Derris:

I agree. I mean, we've been talking about Canada 10-year rate, and also provies, and just long-Canada versus US for quite some time. It seems to get cheaper in both rallies and sell offs, as I mentioned earlier. But I do think positioning in the US is not clean yet, and it's definitely what's driving the bus, so to speak.

Austin Derris:

But it's definitely cleaner. You have an area where 10-year swap rates or cross market levels are compelling to be long Canada in a similar vein. I don't know if it's a defacto rate short, which is what I thought into the year. But I do think you're at the point where positioning is likely much cleaner in the US. Probably still has a little bit to go, but I do think those levels in Canada cross-market 10-year rate are compelling to take a stab again from the long end.

Ben Reitzes:

I suspect the cheapening does reflect very much the probably cleaner positioning in Canada. We've had a number of washouts here so far this year. So. I think people are slightly cleaner on this front than they are in the US at this point. So, that probably reflects a lot of the cheapness in Canada at the moment.

Ben Reitzes:

I think at this point, it's kind of related, I guess my question would be, what's the catalyst to drive Canada to outperform on a relative basis? Is it tapering? Is it the Fed actually announcing that maybe at Jackson Hole, or in September? If that's the case, then I guess, you probably don't want to put that trade on yet, but definitely something to keep on the radar. As Canada tends trade above the US end rate, maybe then you put that trade on.

Austin Derris:

I mean, it could be a reinitiation of shorts in the US. I mean, it could either work in a taper or a non-taper situation in the US, in my opinion. Because if taper's off the board, then maybe reflation is hot again. I don't know if you can rinse that off and play that card again, but that's another way to view it as well.

Austin Derris:

But if positioning is cleaner, and most guys I speak to want to have shorts on you, either real money guys or hedge fund guys, they want to have shorts. On even here, even 10 basis points ago. I think those themes are going to exist, and now it's 10 basis points better for those guys to reinitiate.

Austin Derris:

So, it really depends on if you're clean, or if you still need to get clean, and what that actual positioning looks like.

Ben Reitzes:

Austin, earlier you talked about the curve flattening aggressively. Well, that's been the theme for the past week plus, aggressive flattening in Canada led by tens. We've also seen some notable cheapening in the five-year sector on the curve.

Ben Reitzes:

What is your view on the curve from here? Have we flattened too much? Is there a steepening to come? Are fives actually cheap? They look like they're the cheapest in a decade or so, or darn close to it. Are they a buy here?

Austin Derris:

In my opinion, yes. I mean, when you're talking about something like five years on the curve, to me, you're talking not about when hikes come, but more about the pace of hikes. I think fives stick out is cheap for sure.

Austin Derris:

Twos, fives, tens swap fly above 20, looks like a good receive. We've seen a little of that. You know, it just depends on what kind of pricing we're going to get in Canada. We did see fives get hit on the curve yesterday on Tuesday in a rally. So, something I wouldn't expect to see, but it just isn't the main liquidity point in Canada either, so it's something to watch out for.

Austin Derris:

But twos, fives, tens above 20, and swap land, definitely a nice place to take step from the long side. I do think with where we're pricing hikes and pace of hike, I do think steeper curves in Canada make a lot more sense than flatter curves from here, and also provide a nice bit of positive carry, something to hold on to as well.

Ben Reitzes:

Definitely agreed on that front. Any other trades that you like before we wrap up this week?

Austin Derris:

All of my trades seem to be from the long side either twos, five, tens, or 10-year swap or the front end. Pick your poison, but at this point, I think March OIS sticks out to me for sure, and I would start to put some on here. I'd happily add, if that goes against me, I do think that is going to be free money that's found under the couch cushions. Something I like here, for sure.

Ben Reitzes:

Fully agree there, and something I'll definitely be looking at over the coming days and weeks. Austin, thanks for joining me again, and hope you have a great afternoon.

Austin Derris:

Thanks a lot for having me, 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 2:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation. Together, BMO, who are involved in fixed-income and foreign exchange sales and marketing efforts.

Speaker 2:

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Speaker 2:

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Speaker 2:

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Speaker 2:

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Speaker 2:

(silence).

 

Benjamin Reitzes Director, Canadian Rates & Macro Strategist

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