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Fear Factor - Views from the North

FICC Podcasts March 10, 2022
FICC Podcasts March 10, 2022

 

This week, Jean-Michel Beaulieu, part of the Montreal-based fixed income sales team, and Francois Leclerc, one of our provincial bond traders, join me to share their insights on their take on last week’s Bank of Canada rate hike, provincial spreads, some broader macro themes, and their favourite trade ideas.

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 Jean-Michel Beaulieu, part of the Montreal-based fixed income sales team and Francois Leclerc, one of our provincial bond traders. This week's episode is titled, Fear Factor.

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 at benjamin.reitzes@bmo.com. That's Benjamin dot R-E-I-T-Z-E-S at bmo dot com. Your input is valued and greatly appreciated.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Ben Reitzes:

Guys, welcome back to the show. It's good to have both you back on. It has been quite some time. I think the last time I had you on here was in November, so it's been a number of months and it's a pleasure to have you back and I look forward to a lively discussion.

Jean-Michel Beaulieu:

Happy to be back, Ben.

Francois Leclerc:

Happy to be back, Ben.

Ben Reitzes:

Ah, let's start with the Bank of Canada. Last week, which feels like, I don't know, months, weeks, quarters ago with the market volatility that's gone on since then. But last week, we had the Bank of Canada deliver the first rate hike of the cycle for them. It is likely to be the first of many, or at least a few. I think, at a minimum, I think those are pretty much baked in. There weren't really any surprises from the bank, that there was some chance that they could've ended their reinvestment program last week. Deputy Governor Lane suggested that they would. At least he hinted in that direction, but I guess that was, maybe, inadvertent. And it looks like that's going to end in April, but I mean, really, not a huge impact from that perspective.

Ben Reitzes:

The rate hike itself was fully expected and we expect another in April. And the Bank of Canada's made it clear that if they're going to raise rates a few times, at least in a row here, that they're on a rate hike path. So that means we'll get a bunch of rate hikes. At this stage, we continue to call for four consecutive rate hikes, so three more at the next three meetings. That's April, June, and July. That would bring rates to one and a quarter. And then, after that, things could change a little bit.

Ben Reitzes:

At this point, with inflation where it is and inflation expectations, I mean, teetering on pushing higher, especially given what commodity prices are the past week, but we'll get to that in a second. That, I mean, it's hard to argue against the bank at least getting to 1% before starting to reevaluate things. And I'd make the same argument for the Fed and we'll hear from them next week. So we can talk about it that a little bit as well. Francois, what was your takeaway from the bank? Anything stand out or was it just plain vanilla, very straightforward?

Francois Leclerc:

Yeah, very straightforward in my opinion. No, I wasn't in the camp of expecting early 50bp hikes, and they stayed the course, and they went 25 and mentioned that they will keep going for the foreseeable future. Well, as we expect probably for the next four meetings, at least, right? I think that's just par for the course. And yeah, we saw a lot of selling going into that, lots of selling of fixed income. We can talk maybe about a buyer strike as well for everything that was new-issue credit, which could explain some of the widening in all credit, corporates, provincials and all that, leading into the bank. But I think they stayed the course and it was pretty much as expected, in my opinion.

Ben Reitzes:

Cool. JM? Any different thoughts there?

Jean-Michel Beaulieu:

Well, I don't think I can add anything to Francois's take, basically. Again, they made what they told us they would do, and so, no big surprise here.

Ben Reitzes:

How about client activity, JM? Was it...? I mean, did you see anything different from what Francois was mentioning earlier?

Jean-Michel Beaulieu:

Client activity is painfully slow, to be fairly honest. We've seen a big reduction in risk taking from a lot of hedge funds, domestic and international accounts. It seems like guys are not putting as much risk as they used to. I mean, we've definitely seen this trend starting in October when everything blew up, and it probably accelerated with this famous CPI print in the US. So what you see in the market is that liquidity is thin. You can see major, major reversal thinking here about the TIPS market.

Jean-Michel Beaulieu:

If you look at the TIPS market, the trend was pretty strong into selling TIPS to selling a real yield. Went from, minus 110 in 10-year TIPS to minus 40 or something. And the way we drastically reversed shows me that this market is just really, really hard to trade. So, to come back to Canada, again, from the bank perspective, there wasn't too much surprise. From client activity, there's therefore not much to add, I guess. And with basically everything that's going on, Russian and Ukraine and inflation, investors are generally much more nimble than they used to be.

Francois Leclerc:

I think to add to JM's point-

Ben Reitzes:

Sure.

Francois Leclerc:

... the risk taking of clients is, as we've noticed, has really gone down. And I think the fixed-income class has been the most damaged by it. You just look at where CDX IG is trading now. You just look at the significant illiquidity problems and new-issue concessions that's being priced in the corporate space and the outperformance of the stock market compared to, well, stock market, call it S&P, compared to these other metrics, cash, credit, and CDX hedge. We've just seen a massive under-performance of credit here. And the reason why is just shedding duration into the bank and shedding risks. So, selling provincials in Canada for cash, selling corporates and all that stuff, which has led to a significant widening to multi-year wides on credit spreads at the moment.

Ben Reitzes:

So JM, you mentioned Russia-Ukraine. Let's go there for a second and we'll talk about the market impact as well, and then just risk tolerance in general. But I mean, the Bank of Canada mentioned the conflict, I mean, as a new source of uncertainty, obviously, and that part's pretty clear. And the way that I'm looking at things right now is, it just increases the tail risk, generally, that are out there. Before Ukraine, we already had a notable tail of maybe significantly higher inflation, and inflation really gaining traction from an expectations perspective, and having a positive feedback loop there really pushing expectations higher and maybe causing bond yields to become a little bit more unhinged at the longer end of the curve.

Ben Reitzes:

Now, you have the risk of a, I mean, really World War III, or some version of it, even if that doesn't seem particularly likely, it is a risk out there that this conflict worsens, and a risk as well that the sanctions put in place might cause enough economic damage to Europe, and that causes a knock-on effect in North America and such that the growth outlook weakens that much more and rates should be lower. So you have, I mean, both sides of this, and I think both tails are not insubstantial in size. They're both pretty big tails. And I think that's part of what's going on, on the risk side.

Ben Reitzes:

Because there are big tails on both sides, it is really hard to have conviction in a call right now. I know I'm having trouble. And so, as long as that's the case, and so, as long as this conflict continues and you just don't know what's going to happen next, and you have inflation picking up even more, I think it's going to be very difficult to trade this market and risk is going to be, it is going to be challenging for clients to increase their risk appetite notably. We could be in for this for a little while yet, at least until something changes. I don't know what that will be. Hopefully, the conflict ends quickly and that'd be great. But those risks are a serious problem.

Ben Reitzes:

And as JM said, for Canada, this goes back to last year when the banks surprised the market too many times, they just wiped out too many market players. Even though they're being as predictable as possible now, it's going to take time to bring people back, and the geopolitical risk certainly is not helping things. And then, on top of that, again, inflation is a serious risk. And even if oil's down 10-plus dollars today, it's Wednesday, March 9th in the afternoon, no guarantee it doesn't end up back at 120 tomorrow or the next day. And add to that, the huge volatility in pretty much every asset class, which just makes it really, really hard to have a strong convicted view here.

Ben Reitzes:

JM, I mean, there are lots of uncertainties here, and the Russia-Ukraine conflict is really complicating things. Has your macro outlook changed at all? What's your base case here? Call it over the next three to six months.

Jean-Michel Beaulieu:

Well, I think you said it perfectly. Inflation is definitely the big tail. I feel like it's becoming less of a tail and more of a higher probability scenario. And to be honest with you, I've been totally wrong for, oh, I guess, the last five, six months when we started pricing more structural inflation. I was clearly doubting this hypothesis. I thought inflation would be front-loaded and it would drastically come down. I still thought the same way before Russia came in Ukraine. So I was still believing that we were reaching peak inflation with that famous 7% CPI print in the US.

Jean-Michel Beaulieu:

But now, I must say that I've completely changed my view. It seems like inflation is definitely here to stay. Inflation will keep going higher. We didn't reach the peak last month, given where food, metals and obviously oil is being priced right now. You've seen the huge impact at the gas pump. National average is making new high, with some region should have around $5.50 per gallon in the US, which is huge move in not a lot of months. And so, the issue to me, as you said, there's a lot of tail risk, a lot of volatility, but it seems to me the stagflation scenario is probably a 70, 80% base case scenario at this point, where inflation went high so fast with oil and food, it's going to impact the economy, it's going to impact the growth, for sure. I think the odds of a recession coming in the next year, year and a half just increase dramatically.

Jean-Michel Beaulieu:

And so, what we got is, basically, a stagflation scenario, which is the worst scenario possible for risk, usually. And this is why I think we have probably one of the worst setup for risk asset we've had since, basically, the '07, '08 great financial crisis. Simply because if growth tends to slow down and central bank cannot help in pushing rates lower, or printing more money, and fiscal can't either because there's too much inflation, basically, central banks are stuck between a rock and a hard place, right?

Jean-Michel Beaulieu:

So multiples in stocks should come down much more and we should see some credit stress. This is, actually, what you're starting to see at this moment is that this commodity volatility is being funneled through the credit and the funding market. And so, you've started seeing FRA market, FRA/OIS market, LIBOR/OIS market significantly widen out. And you're starting to see that funding pressure pretty much everywhere across every country.

Jean-Michel Beaulieu:

So, this is where we are. It's just a tough, tough place to be in terms of risk. In terms of rates, they got to stay the course. They'll have to fight that inflation. So they'll have to raise. I thought those rate hike, I thought the central bank wouldn't raise into that market pricing. But nowadays, I just think they'll have to do it. It is possible that they might raise even more to fight this inflation problem. So it could give you a flatter curve. I mean, I was in a flat flattening camp. I think that the curve could effectively inverse sooner than the forward price of pricing.

Ben Reitzes:

That's fair. I'm with you on that. I think there's a decent chance that you get some inversion at some point, probably. I mean, not all that far from now, later this year, early second half or something like that is certainly impossible, given how flat the curve already is. But I must say that is a very bearish, dark view on the future that you have at the moment, worse since before the financial crisis. I don't really like that. Francois, can you make me happier?

Francois Leclerc:

Not really. Well, I think JM nailed it on a lot of points there. The credit market is telling a very much darker story right now than the equities market I would find. Just because that's exactly what we seem to be pricing war-induced recession and central banks, it obligated to hike in the face of a recession, and it almost seems like that's what we're pricing. You look at CDX IG, we're rolling the contract this month. It's at 90. Well, tighter early in the last two sessions, but high 80s on the new series. So it is at multi, multi-year highs despite stocks in the 4,300 level. It's just telling a very, very different story.

Francois Leclerc:

If you recall, just pre-pandemic, we were around 46 on CDX IG series, so a significantly darker picture painted by credit right now. And I think it's exactly the points that JM touched. Recession-induced war, inflation being the worst outcome and central bank that need to hike in the face of it, no matter what, and have no bullets to cut. And now all governments will be stuck with a much bigger fiscal drag from all of this stimulus spending over the last two years.

Ben Reitzes:

So I mean, I could sympathize with that view a little bit, at least. I mean, I suspect about this. There's good odds that the central banks are going to have to be a little more aggressive on inflation if things continue here. And I've been on this bandwagon for a while and I'm not getting off now. But I'm not quite in the stagflation camp. I mean, for me, it really, I mean, I cannot emphasize this enough, really depends on what happens over the next month or two with commodity prices. If oil stays all the way up here, stays 120 bucks and commodity pricing indices stay at record highs and wheat prices continue to go to the moon, and so on and so forth, then we're going to have potentially a much more challenging period, because central banks are really going to be under pressure. Because then, you'll be looking at every day prices going higher, generally.

Ben Reitzes:

When food prices and energy prices are rocketing higher, that's when inflation expectations are going to become a real issue and probably pretty quickly. So it really depends on how this Russia-Ukraine war ends or how quickly it ends, and how quickly markets can come to terms and stabilize with where commodity prices should be, and I don't know where that is. I think to some extent, we'll have to wait and see, but oil probably not at 120 once things stabilize. I think probably maybe closer to a hundred, but triple digit seems decently likely here.

Ben Reitzes:

Food prices, I think we'll have to wait and see on how the harvest goes. Not that I'm a farmer or know all that much, but I do know that if you're fighting a war, it's pretty hard to plant your wheat and it's going to be pretty hard to harvest it if you're not planting it. The outlook there is definitely challenging. I'm not quite in the stagflation camp yet, but the risk is definitely growing. I wouldn't say 70 to 80% chance, but I mean, 30, 40 for me, somewhere in that neighborhood, and it'll move with commodity prices and with this Russian-Ukraine conflict and how that goes.

Ben Reitzes:

I guess that's enough musings from me on inflation. Francois, can you give us some particulars on the provincial market right now? I guess, what have you seen? What is most interesting? And I think what's most interesting, from my perspective, at least, the 10s/30s box has steepened a lot. I was hoping you could give us a bit of an update on that as well.

Francois Leclerc:

Yeah. So obviously budget season just right out of the way, very encouraging from many issuers and encouraging for the global picture of provincial issuance as a whole, right? We're going to close it roughly around a hundred billion for the fiscal year this year of total issuance. That's expected to go down again next year. We've been talking about commodity prices, but Alberta with some very encouraging numbers and using very conservative estimates for revenues next year. So, we should definitely run into surplus for the next fiscal year with very little issuance, if any, at all to do, considering where commodity prices are in the moment.

Francois Leclerc:

So, it's very encouraging for the broader picture for provincials. That being said, long-end spreads have really underperformed recently. Going into Bank of Canada hiking, we did see a lot of chips being taken off the table and some real money, some pension funds on programs selling both 10s and longs for spread. And as I mentioned, there's a bit of a buyer's strike and just nobody to catch the falling knife, so it moved pretty quickly and it's stabilized wider. Now, that being said, there are some pipelines in the short term that are heavy on the long end. We've seen Rogers, for example, with corporate issuance.

Francois Leclerc:

And as I mentioned earlier, corporate spreads to provis has widened quite significantly. So we are seeing some of the interest for those deals being against provincial credit. So it's generated a lot of pressure out the curve, and there's some other pipelines like that in the upcoming weeks that should continue to weigh on the long end. But that being said, there's no imminent provincial-specific issuance out of the curve unless significant material demand shows up. Nobody's stressed to issue longs at the moment and issuance is going to go down, so there's going to be less pressure. So if we just go look back at where the insurance profile was in 2018, 2019, I think we have to expect something very similar to that for the upcoming year.

Francois Leclerc:

And obviously, 10s/30s curve box was significantly flatter back then, hovering in the average mid-12s call it. So I do expect that to perform. Obviously, it's still far away, but not that far away. We'll soon be talking about June coupon payment, too, and extensions in Canada. So we'll definitely be seeing some performance there, as it's one of the biggest seasonality we see in Canada every year. So, I really like the long end here. I think it's a good spot to be. I also think five to seven years getting more and more attractive as swap spreads have narrowed significantly, while credit remains pretty offered in there. We've started to see some significant picking away from bank Treasuries on asset swap in that term. So I like that, too. One sector I would dislike the most on a curve would probably be 10 years.

Ben Reitzes:

And why is that?

Francois Leclerc:

Just because the steepness of 10s/30s. So if I don't credit further out the curve and for the nicest roll-down, I'd go in the five to seven year sector where you've got still some pretty steep credit curves. Just look at 24s, 25s. June 25s definitely the inflection point on the curve where you get the most benefit. But all kinds of curve in Canada right now, even CMB curve here in Canada, you do get the nicest credit pick in that tenor, the 2025 tenor. And then it flattens out into 10s pretty aggressively, and then you have the nice pickup for the long end. Obviously, out of the curve, I continue still to favor the back dates, 2050s, 2051s. You still get a really nice credit pick from selling the benchmark and rolling back into 2050s, for example.

Ben Reitzes:

That makes good sense to me. Pretty much all of that sounds good. One question on something I've been pondering and I don't necessarily have an answer is, through this Russia-Ukraine episode, we haven't really seen CMBs outperform to the extent that you would think. I mean, it had a bit and was pretty temporarily. But I mean, do you have a good explanation as to why CMBs just aren't able to perform versus provis?

Francois Leclerc:

Yeah. It's a trait that people have been trading tactically recently. But the overall outperformance, like we saw in a risk-off event like we'd expect in March, 2020, for example, provis significantly widened versus CMBs. We're not seeing it right now. The reason I'd say is there was significant cash selling going into the bank. And a lot of people use CMBs as a proxy for cash. So if nobody is buying duration through CMBs, well, if they're selling it, it puts pressure on CMB spreads because they're just cash sellers, right? So it is definitely a big reason why CMB spreads on a standalone loan credit product haven't been able to perform. It's because of cash selling and strike of cash buyers into yields going higher environment.

Ben Reitzes:

Okay. Uh-huh (affirmative). Thanks for that. I guess coming up on time here. So let's get your guys' favorite trade ideas. JM, why don't we start with you, and I will not hold it against if you don't have one, because as we mentioned earlier, the trading environment is extraordinarily challenging.

Jean-Michel Beaulieu:

Yeah. No, I don't have much. I've been suggesting the one-year versus five-year swap in Canada, which is doing, it's doing okay. It's not moving anyway. If you're liking flattener and some risk-off trades, that could be an edge. Because as we know, if we start to price less of rates hike, that one could steepen out. And so I like the carry of the trade. I like the optionality of having it in the worst possible level since basically the beginning of swaps market in Canada. Where I think right around minus 19, minus 20 right now in this one. But otherwise, I would quickly say I'm probably not as bearish as I did sound on risk either.

Jean-Michel Beaulieu:

We got to keep in mind that the market is flooded with cash, flooded with liquidity, and what creates big selloff in risk or anything is lack of liquidity. And it's credit event. It's not recession, because we don't really care about... Recession lasts for a few months, maybe a year and markets are forward-looking. Markets crashes because the market, the system doesn't work and there's some margin call. You can see it in the commodity market, the way it trades. I still have difficulty to see that coming with the amount of cash that is sitting at a reverse repo facility at the Fed, for example. And all the swap lines that the Fed has with all the countries right now, it's just tough to see big explosion in the funding market and stuff like that.

Jean-Michel Beaulieu:

And so, what I think is, you probably don't want to be too long a risk here. But if there's some interesting sell-off. I mean, spreads above a hundred in long, Ontario, for example, could be an interesting place to start putting your money to work. So, just being patient. Keep in mind that it's definitely risk-off situation with high volatility, but I think you can see it right now, even in credit, even in corps, that there's still a lot, and a lot of money that is just waiting here for better entry points. So you can't be too secure and too safe. I think this market will bring you some nice entry point for credits.

Ben Reitzes:

I think you saw that a bit today, too, didn't you, at the monster AT&T deal? They had huge demand for that $30 billion deal, I think. Francois, favorite ideas here?

Francois Leclerc:

Yeah. As JM mentioned, I think it's really a good time, a good opportunity for real money accounts, long-term investment horizon, where close to a hundred in long provincials. You haven't been wrong very often, adding at those levels. And it's just some entry points you don't see stay in the market for a very long time. I think there's a big fear factor index right now. Obviously, some high volatility, but if you can chip away and pick away at these nice entry points, just inside of a hundred, maybe, or even at a hundred, if you get there, I think these represent very, very good buying opportunities for longer-time, longer-term holders.

Ben Reitzes:

Totally agree there. Fear factor, that's a good word. I think there's plenty of fear out there right now, day-to-day, minute-to-minute, depending on the headline. Why don't we leave it there? Thanks. Thanks, guys for coming on the show today. Thanks, guys, for coming on the show today, and I hope to have you on again soon.

Jean-Michel Beaulieu:

Thank you, Ben. Thanks for having us.

Francois Leclerc:

Much fun, Ben. Thanks for having us.

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 Inc., and BMO Capital Markets Corporation, together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses, generally, and not a research report that reflects the views of disinterested research analysts.

Speaker 2:

Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast, it is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients.

Speaker 2:

Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options or any other activity, which would cause BMO or any of its affiliates to be considered a commodity-trading advisor under the U.S. Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you, or in your best interest in you. To the extent applicable, you'll rely solely on advice from your qualified, independent representative in making hedging or trading decisions.

Speaker 2:

This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters referred to herein, together with your qualified, independent representative, if applicable. BMO assumes no responsibility for verification of the information in this podcast. No representation or warranty is made as to the accuracy or completeness of such information, and BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to BMO and/or its affiliates that is not reflected herein.

Speaker 2:

BMO and its affiliates may have positions, long or shorts, and affect transactions or make markets in securities mentioned herein, or provide advice or loans to or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

 

Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist

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