Carnage - 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 Carnage.

I'm Ben Reitzes and you're listening to Views from the North. Each episode, I'll be joined by members of BMO's FIC, sales, and trading team to bring you perspectives on the Canadian Rates market and the Macro economy. 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.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

Adam, welcome back. I'm back from two weeks of traveling, so this episode is delayed one or two weeks, I can't even remember on timing, but thanks for coming on the show this week.

Adam Whitlam:

Thanks for getting me off the desk and away from the bloodbath for a little bit.

Ben Reitzes:

I'm going to change things up a little bit this week and instead of me pummeling you with questions, I'm going to let you decide which way we go. You're a bright guy, we're going to use that intellect, and we're going to see where you take us.

Adam Whitlam:

You may have set the bar a little high here. Well, first off, I think there's a lot to talk about because there's a lot going on in the market. But first, I know you've been out of town doing a lot of marketing. You were in New York, you were in Hong Kong, you were in Tokyo. So, I'd love to find out and glean some insight from what you heard from a lot of our international investors, kind of the view of Canada, North American rates, credit. What is the rest of the world thinking about the Canadian market here?

Ben Reitzes:

Excellent question. Full disclosure, I didn't go to Hong Kong because New York got me sick, so I had to miss that part of the trip, but that's okay. I don't blame New York at all. I don't hold grudges against cities. New York, so the different strokes for different folks, I guess. In New York, the focus was mostly short end of the curve of the front end and lots of discussion about bank versus Fed and just the macro backdrop in Canada versus the macro backdrop in the US, and how Canada is relatively weaker. And it's funny, there's no question. You look at any piece of data and you'll see that Canada is in more shape than the US at the moment and the only thing that's keeping Canada from really shifting gears from a rate perspective and from a bank in Canada perspective is inflation. And the inflation number came out the week after I was in New York, so when I was in Tokyo, but it was kind of looking ahead to that number.

It was going to be a big number on the headline, but it was also a big number on the core and again, that just kind of reinforces the market's fear of the bag of Canada and that fear is ever present after many years of surprises. And so, as much as Canada looks cheap on a one-year basis, you just look at the next few meeting gaps. There's just under 30 beeps priced for the bank Canada by call it April, but really, there's a full hike price by January and for the Fed, at least until a few hours ago. I think it's a little bit higher now, but there was only 14 or 15. Maybe now, there's 17 or 18 basis points priced in rate hikes from the Fed and that just doesn't make any sense. If you consider one, Canada is a more interest rate sensitive economy and the economy's already under a lot of pressure.

We shrunk in the second quarter, the US grew, we'll get the third reading out on Q2 GDP on Thursday tomorrow and that'll be somewhere close to 2.5% is consensus, 2.4 I think. So, massive gap in growth there and Canada doesn't look a whole lot better in the third quarter. We'll see, we get GDP on Friday for July, but things just don't look good in Canada and they look all right in the US, yet there's more price than the Canada. It doesn't make a whole lot of sense, but such is life. On Tokyo, different investors there are much more focused further out the curve, much more focused on the provincial space and CMBs. We can talk more about CMBS later because that's always fun. There is a lot of interest in Canada, a lot. We had 11 meetings in two and a half days and strong interest in the long end of Canada and yield levels I think same for Us, given where yield levels are now.

But the issue with Japanese investors is the hedge back to yen is problematic to say the least. It is extraordinarily expensive for them to hedge any Canadian or US purchase for that matter given the overnight rate differentials and that in turn, has kept them on the sidelines for now. So, if you look at even the highest yielding, Canadian provincial bond, which would be like let's say Ontario, highest yielding Ontario bond in the 20-year space is about 4.95%. Maybe it's probably 5% after today, but the hedging cost is about 5.3%. So, you're still offside and you're still running a negative carry of 20, 25, 30 basis points.

If we keep selling off, maybe you'll see them come in, but there was a lot of discussion about when the Bank of Canada will cut and that in turn would lower their hedging costs. So, a lot of focus on the bank there as well and when that cut would come, and the truth is what I told them, not until 2024 and BMO just pushed out our call for the first cut into toward the middle, just after the middle of the year.

I would put a range there like second quarter to third quarter, so April to September. It's pretty wide but we live in a world with wide tails and I'm not going to beat that and the reality is there's too much uncertainty on inflation and growth and all that. Maybe growth trumps and we do it earlier or maybe inflation stay sticky for longer and they cut later. I don't know, but we'll see. But those were the main highlights I think and if I had to take away one thing, I think you'll see pretty good demand for provincial and Canada paper come out of Japan. When the hedged carry turns positive, I think you'll see very good demand. So, it makes me pretty encouraged on provincial spreads and this is at a time when I really think you're going to see issuance increase over the coming year. I don't know when that inflection point comes when more money's going to be needed, but slowing nominal growth means slowing revenue growth and you're going to see unions and others ask for more wage growth and so, revenues slowing, expenses accelerating, more debt.

Adam Whitlam:

Yeah, we saw some sampling of that from the Q1 public accounts that we saw out of Ontario, a deficit. Obviously, it was up and I think there is obviously some spending controls being discussed currently for the province, for the city of Toronto in particular, and like you said, if growth is going to be slower, it's hard to imagine a world where revenues are going to be increasing, but vis-a-vis, that probably also puts downward pressure on inflation. If government revenues are dropping, that should be downward pressure on inflation, as well. So, maybe that says you're April to October timeline for a potential cut from the Bank of Canada. Maybe that starts to get pulled forward if government revenues take a big enough decrease.

Ben Reitzes:

That's going to be tough before April. Just mathematically looking at inflation, I don't think the bank's going to be flexible unless things are really falling apart.

Adam Whitlam:

Or maybe the earlier part of the bank.

Ben Reitzes:

So, maybe it's...

Adam Whitlam:

It's more April than it is say October for the first potential cut, but again, a lot of that's going to ride on what happens in the US and what happens with their amount of monetary policy.

Ben Reitzes:

That was also one of the points is, can the bank cut that far ahead of the Fed and to some extent they can, but you're going to need to have some meaningful rate cuts priced into the US at the same time and you can't have Canada forward rates really rally outsized compared to the US. Otherwise, the dollar gets annihilated and you get that inflation impulse and then we have a problem.

Adam Whitlam:

Yeah, so interestingly, on the provincial side, some of that inherent demand, is that a spread call? Is that a risk call? Is that an all-in yield call? What is it that the sense that you got on why spread product would be in stronger demand from overseas investors, say in the next six to nine months?

Ben Reitzes:

All in yield. That simple, they're looking for carry and pickup and Canada just don't provide an attractive yield on a relative basis. Provinces are good credit. It's tough to believe there's going to be any issues from that perspective. The focus tends to be on the more liquid provinces, so Ontario, Quebec, to a lesser extent, BC, Alberta, Manitoba as well, discussions on all of those provinces, some deeper than others, but most everyone that's active in provincials over there looks at most if not all of those names.

Adam Whitlam:

Did the US come up at all? I know we've seen in some of the flow of funds data in the US that there actually has been some pretty significant foreign interest in treasuries over the last call, the last month, month and a half, that there has been a decent amount of buying. Did that come up at all that they might rotate out of say treasury holdings into Canada? Did they discuss at all sort of their increasing demand as yields sell off in treasuries as well, for dollar paper?

Ben Reitzes:

Your opinion of me is far too high. I'm the Canada guy. We focus on Canada and as much as I'd love to talk about treasuries in the US, those meetings don't last long enough and the fact of the matter is the hedged back to dollars also is very punitive, as well. Canada is not alone in that at all. In fact, it's worse to dollars so that you need an even larger pickup to make treasuries or dollar products worthwhile. I'm told there's still appetite to buy mortgages and that kind of stuff that the higher yielding type of products, that's not my wheelhouse. I don't play in that sandbox.

Adam Whitlam:

Fair enough. We'll stay in our lanes. Okay. Well, so you bring up another interesting discussion point. You mentioned CMBs. Obviously, very topical this week with the announcement that they're going to be increasing the cap on the CMB program from 40 billion to 60 billion. A little bit of a surprise announcement that came out yesterday that kind of put the market into a bit of a tizzy. What are your thoughts on that?

Ben Reitzes:

Surprised and not surprised all, at the same time. The fact that it was a bit of a surprise, it shouldn't be all that surprising given the way that these folks have functioned in the past here with the ultra longs and with reviews both just kind of disappearing surprisingly. When the announcement that they were going to increase the program came out in that at the bottom, it says it's independent of their decision on what to do with the program as a whole. Maybe in theory, it is, but in practice...

Adam Whitlam:

I just don't believe it.

Ben Reitzes:

Well, that's it.

Adam Whitlam:

I don't believe it.

Ben Reitzes:

I don't believe it. So, we need more details for starters and it does feel like this announcement maybe was a little bit rushed to change the narrative on the headlines, a tad from what's going on domestically politically. But until we get more details of it, my first thought is, okay, well, they're going to increase the program from 40 to 60. The government was considering issuing Canadas to buy the whole program. That was one of the options they're thinking of and now you've increased the size of the program to 60 billion from 40 billion. Do they really want to issue an additional 60 billion Canadas? It just makes it even less likely to me that they're going to can the whole program and take it all in-house what seems more likely, and I can say that this is the story I was spinning in New York, was that they would increase the program to support housing, which is exactly what they've done and buy the additional whatever, 10 to 20 billion.

It ends up being 20 billion and keep the 40 billion as a public float annually. So, we'll see what the details are. That seems like the most likely outcome to me. It's the one that makes the most sense and everybody saves face and wins all at the same time. So, we'll see where we go, but that's my thinking now. We have to wait until November probably in the Fall Economic Statement to get more details. Hopefully, they come then and the can does not get kicked further down the road because the market does not like uncertainty and they don't like more supply without knowing who's going to take it down.

Adam Whitlam:

Yeah, I completely agree with you. I think the likelihood of the hybrid model like that has increased significantly with sort of the way that they've rolled this out. If you're going to cancel the program and if that's your intention, to increase the issuance cap before you take the whole program out, is basically just saying we're going to cost everybody who owns CMBs a bunch of money before we completely wipe out their liquidity. It would be absolutely absurd. Now, we've seen absurd things happen through government initiatives before, but I have to think in this case, they undertook a consultation period. I think, and I can tell you this based on investors that I've talked to, the response on that consultation was that you're not going to be able to capture the level of savings that you think you're going to just because government of Canadas are here and CMBs have a spread to the back of it.

It's not as simple as we'll just issue Canadas to buy CBMs and that spread will remain constant and we'll be able to capture that difference and save the fees that we pay to investment banks. So, I think the consultation response that they got was 98% against them winding down the program. So, a hybrid model is probably a great way to save face. We've come up with an idea, here's a way that the program continues to exist, but we also go out and say, "Hey look, we are doing something for affordable housing." So, "Everybody wins."

Ben Reitzes:

And they capture some spread.

Adam Whitlam:

Yeah, and they capture some spread and in this case, an additional 20 billion worth of Canadas. Yes. Will it have some impact on the cost of financing across the government curve?

Ben Reitzes:

Probably not. I don't know if it does.

Adam Whitlam:

Maybe. But how do you even measure that? When yields are moving 10 basis points a day on nothing, it's almost impossible to even know what that impact is. So, I'd say if anything increases, the likelihood of the hybrid model should be a net positive for spreads. Interesting to kind of note sitting here, whatever, it's Wednesday afternoon, CMB 10-year spreads have definitely taken the brunt of the hit, the bid offer in 10 years. At this point's probably two and a half, three basis points wide, the bid offer in fives is maybe a half, so you can really see the pressure in the tenure sector. A lot of that's because we know affordable housing is usually longer term mortgage pools. However, they were pretty clear about it being anything from fives to tens.

So, if I'm them, I'm probably saying, "We're going to keep a very similar structure for the CMB program and we're just going to take down proportional amounts between fives and tens." So, it makes the argument that maybe tens shouldn't be unfairly punished and so that the steepening in that fives tens CMB curve might be an opportunity. This could also be a net positive for credit spreads in general. Provincial spreads too, because even 20 billion worth of additional issuance in Canada, theoretically, maybe that does cost them a beep or two beeps in Canada yields relative to credit yields. So, in effect, that would also compress credit spread. I do think there's a bit of an opportunity in CMBs here.

I understand why a lot of the international community was saying, "We'd like to be on hold with regards to CMB purchases until we get further clarity." Obviously, we saw this with the Canada 50-year auction when it suddenly disappeared and the RRB program, which also is I think an asterisk line in the budget and so, I can understand why they would want to get something more definitive, but I do think there's an opportunity.

Ben Reitzes:

When they get that more definitive answer, assuming it's that the program stays. I think you see buyers come back. I think that's maybe the bigger opportunity than Canadas themselves cheapening. You're going to get, spreads will tighten based off that. A lot of buyers that are sidelined at the moment will come back to the market that have been fully absent for a year at that point. Probably, it'll be November by the time we get any information or most of a year. And that will drive spreads right in probably immediately. And I think anyways, liquidity matters and the program sticking around means liquidity will be here to stay and so that aspect of pricing will help, as well. Even if it means more supply, I think liquidity probably matters more on the margin, at least in my opinion.

Adam Whitlam:

And the rate at which yields are cheapening on a day-by-day basis, these things are going to be a six and a half percent yield by the time we get that November announcement

Ben Reitzes:

On that front. Why don't we talk about that? Oh, I forgot you're in charge today.

Adam Whitlam:

Oh, yeah. Yes. Speaking of, so obviously, we're seeing some unbelievable market volatility out there. The sell-off in yields has been dramatic to say the least. I would say at one point today, it almost felt like the US treasury market was completely bidless and an absolute free fall. We've had a similar setup pattern now, definitely this week, but over the last couple of weeks, where we might see some relief rally into the overnight session, but the minute North America walks in, things just continue to push wider and wider and wider, higher and higher and higher in yield. We've broken through all kinds of support lines. I think the question that most people listen to this podcast would want to know is, when does it stop?

Ben Reitzes:

When does the hurting stop? When does the carnage end? I don't have an answer. The answer is probably when something breaks. So, there's a couple of ways this can go. So, either the economy slows, rate hikes have their impact, we see things slow down, one thing after the next, one domino falls, the next domino falls, the next domino falls. Eventually, you get to the end of it. The end of it is a weaker economy and rates can finally come down as inflation slows. Unfortunately, that takes time, a long time it seems since the US economy is still in pretty good shape and even Canada arguably given where rates are, we're actually not in as bad a shape as anyone would've thought a few years ago, given yield levels.

The other possibility is rates go up, rates go up, rates go up, rates go up, and then one day, the market says, "These are way too high. Maybe I shouldn't be valuing stocks at these levels. Maybe asset prices, maybe the discount rate I'm using isn't quite right. Let's look at this new discount rate which is percentage points higher and maybe with this percentage point higher rate, also earnings growth isn't quite as good as I thought it was. I don't want these assets at these price as yours," and we just get some kind of crazy sell off in all assets and that scares me a bit more. I feel like given the way the market is behaving and the kind of indiscriminate selling in rates every day, and you can see it again as Adam mentioned, the morning, and it's even not even overnight, this morning we came in, the market was bid and did well for the morning and then just flipped and that's it.

And it's been one way ride higher in rates and every day we're like five to 10 basis points higher. At least it feels that way, and at some point, there will be a reckoning. Somehow, stocks are higher today. I actually don't even understand how that's possible, but they are, which is kind of my point in that. At some point, this will cause some kind of reckoning somewhere in some asset class that is meaningful from a macro perspective and meaningful from a financial system perspective, and then we start to rethink whether the Fed swoops in and cuts immediately. I really doubt that. I don't think this is that kind of cycle and I think maybe that's where the debate should be, whether they do that as they have in the past. But what it'll do is it'll drive the curve flatter I think, and you'll get some reversal from the selloff and to some extent and longs, as well.

Adam Whitlam:

I think the Fed is going to be reluctant to step in and cut. I think a great example of that would be that stock market last year had terrible performance. Stock market last year was down 25%. I guess it would be maybe the end of 21, but down 25%, and the Fed didn't really feel inclined to kind of make any moves to prop up risk markets. That would kind of imply that if you got a protracted move down in stocks that they wouldn't necessarily step in to support it. Now, does that change... If you recall sort of the beginning of the pandemic or pre-pandemic, whatever you want to call it, the beginning of 2020 when we did hit a couple of circuit breakers on stocks where we did have this sort of 15-minute reset and the 7.5% downdraft in stocks in a day on the S&P.

And so, are we maybe getting close to where that happens? Currently, it feels like we're getting that 1% bleed a day. You might get 1% here, three quarters of a percent here, and it becomes sort of day after day after day as rates push up and we're seeing it again in regional bank spreads, regional bank spreads today we're about 20 basis points wider. So, you're starting to see regional bank spreads in the US really start to widen out again and this is reminiscent of what we saw last time when we had a huge rate selloff, which eventually caused a big blowup in risk assets. So, the market setup here feels very similar. The selloff in rates hasn't been disorderly. It's been very, very fast. And with the amount of leverage that we've built into our economy at this point, after 20 years of low rates, we're definitely more sensitive.

So, we're not built for this type of disorderly selloff in such a short period of time. So yeah, I wouldn't want to be short fixed income here, but it does feel a little bit like getting in front of a train and in talking to a lot of the clients, there are a lot of longs out there and they're very frustrated because I will say Canada tens looked like great value at 3.75 and here we are today, it's about 4.10 right now as we're sitting here. Same with the US. US tens at 4.22, 4.23, looked like a great level to buy on the charts and then we blew to 4.50 and blew right through 4.50, no problem. So, I think there are a lot of frustrated longs. Most of the sellers have been CTA-type sellers. OI is creeping higher. Open interest in futures is positively correlated with yields.

So, as you see open interest increase, that's indicative of fresh shorts which are CTA momentum type sellers and they're selling generally to real money, who has deeper pockets but is getting very frustrated. So, the question is, how will this tug of war resolve? Does it require some big move that rallies rates, 15 beeps, 20 beeps and all of the momentum players turn around and start buying and then you see a protracted rally? It's hard to know, and when do you buy it? I don't mind getting along the market here, but that's not to say it won't be 25 basis points cheaper in two weeks time.

Ben Reitzes:

I think you have to scale in. So, if you're already long, this is clearly more difficult. But if you're not long yet, as I was talking to somebody today, add a little bit of duration every 15 basis points, every 20 basis points, add a 10th, a quarter depending on how short you were and slowly but surely get there because you don't know when it's going to turn. And a year from now, I think you look pretty good buying at these levels because it's challenging for me to think that the economy is not starting to slow down broadly, both Canada and the US. The US might be lagged, but from Canada and being better off generally, but you got to think it's coming and it's not like the US is going to increase their deficit to 15% of GDP at least I don't think they will, as they've kind of increased it substantially this year by about a trillion or so.

And most of that's not interest payments. There's more to it than that. So, the supports for the US I think will start to fade a little bit. There's an election next year, so that makes it more challenging definitely. But yeah, it's a tough market and I do prefer being long at these levels and slowly getting into positions and just being a little bit patient. I don't think you have much of a choice. Other than that, do you want to be short at multi-decade highs? Probably not. So, frustration or not, that's probably the way to go at this point.

There were two things, as you were talking, that I thought of. So one, both of us don't think the Fed steps in probably or the bank for that matter and what kind of reinforces that oils up, I think 4% today, at least it was last look or 3.8%, something like that, heading to the mid-nineties. That's more inflation. That's not good. At this point, it feels like it's going to be more of a tax on consumers as much as anything else. So, it's going to be a negative macro impact and a positive inflation impact. That's not good for anybody. But the inflation side of things and probably especially in Canada is more likely to keep the central banks a little more conservative on when they cut rates and maybe waiting longer than perhaps they should, but we'll have to see on that.

The other thing, Doug Porter, on my internal chatter, our Chief Economist, Doug Porter, put a chart up of 1987 just looking at US 10-year yields and the S&P, 500 and yields rocketed through the course of the year and really, really sold off in August and September into October. And then eventually, they hit 10%. Yes, 10, double digits. And when they did that, the stock market said, "No mas, we're done." The carnage is over and the carnage began in stocks and rates rallied like stink. And so, that type of scenario, I'm not saying rates are going to 10% because they're not, but you can get to a level where it's just like, "No, this is not okay. We can no longer stomach this." And then risk assets just fall out of bed completely and totally. Again, they don't need to fall 20%. It doesn't need to be black money. It doesn't need to be that extreme. But just an example of something to consider maybe a historical example if the current move in rates continues.

Adam Whitlam:

Yeah, I'd say, and there were some other great charts he was putting out with regards to S&P earnings relative to real yields, that's negative, S&P yields versus nominal yields, that's negative. So, you have a lot of different identifying factors that suggest that risk assets are overpriced or real yields are too cheap. You're getting developed market real yields at a 2.30 or 2.40. That's a real growth rate for developed economies that looks pretty favorable. So yeah, I tend to agree something has to break.

Ben Reitzes:

I might say that reals, maybe are where they should be. I'm going to take the other side of that and go back to pre-financial crisis. The problem is the pre-financial crisis tips were kind of a garbage market still just starting out, so I don't know how much that history is worth, but really those don't need to be zero or half a percent or 1%, especially if you are concerned about the fiscal outlook and all that kind of stuff. Maybe there's a price to be paid for that and it gets paid in real, for now at least. You just got to build in that term premium if you're not going to inflate it away. You got to put it somewhere in, so maybe it's there for now. I don't know, but that's one area where I think they're cheap, but I don't know if they rich in a whole lot. I don't think.

Adam Whitlam:

I have to see some big productivity growth, productivity increases to justify real yields in that context.

Ben Reitzes:

Maybe they should be kind of in the mid-high ones rather than north of 2% because I'm not sure inflation expectations will come down all that much either, which then makes me question my view on the market as a whole. But I could see the other side of it I guess at this point. And that's why rates could still sell off another whatever, 50 basis points wouldn't be. If we hit 5% in tens, would that be outlandish? Would you be completely shocked?

Adam Whitlam:

It'd be enough for me to put them into my PA.

Ben Reitzes:

Well, exactly. I don't think you're the only one. And then you go back to where we started. You go back to Japan and at those levels, I think they're close to buyers on the Canada side, carry would probably turn positive well before that. I think we're not all that far at this point, at least in the 20-year sector, as I mentioned. And so you'll see buyers step in a little bit more once we cross those thresholds. I just don't think we're there quite yet, so we'll see. That's a lot for one day. Why don't we... We both like being along the market and so maybe that can be our trade for today.

Adam Whitlam:

Yeah, don't be short, be long.

Ben Reitzes:

Yeah, don't be short, leg in the long, slowly but surely, and the reckoning will come for this market. It is just a matter of time. The rate carnage almost makes it so automatically.

Adam Whitlam:

As a lower beta way, you can play it in curve structures, fives, tens, thirties for instance. I still don't mind some of the forward receives, whether it's US or Canada, either or. I think Canada still looks cheap relative to the US in the forward market if you're looking at the one-year forwards. We talked a little bit about how I was looking at our gaps earlier this week and Bank of Canada gaps. You can trade like November versus October of 2024 and your give is five basis points versus in the US, it's a give of 50 basis points. So, trades like that still identify that Canada is still relatively cheap. So, if you're going to play those forwards, I prefer being long Canada, but I think duration will, if you're talking about your ability to earn, then being long duration, say tens is probably where you want to be to make the most bang for your buck.

Ben Reitzes:

All right, let's call it a day then. Adam, thanks for coming on the show.

Adam Whitlam:

Thank you very much for having me.

Ben Reitzes:

Appreciate you hosting me on my show.

Adam Whitlam:

That was a pleasure to interview you.

Ben Reitzes:

All right, and you'll be back again soon.

Adam Whitlam:

Okay, great. Thanks so much.

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, it's affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.