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Growth Worries Ramp Up - Views from the North

FICC Podcasts Podcasts November 03, 2022
FICC Podcasts Podcasts November 03, 2022

 

This week, Dave Moore, who recently moved back to London to join the fixed income sales team, joins me to discuss the reaction to last week’s surprisingly smaller Bank of Canada rate hike among European-based investors, his views on volatility, Canada-US divergence, and favorite 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 Dave Moore, also known as D-Mo around these parts, from BMO's London fixed income sales team. This episode is titled Growth Worries Ramp Up. I'm Ben Reitzes, and welcome to Views from the North. Each episode I will be joined by members of BMO's FICC, 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.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated. Dave, welcome back to the show. It has been a while but you changed locations and now you've moved from Hong Kong to London. So there was a period there where I couldn't quite get you but I'm glad to have you back on the show.

Dave Moore:                      It's great to be back. It’s been a wee while since we last spoken. Obviously the world's changed a lot since then. But transitioning both from Asia back to London as well as roles from trading into sales, it's been a fairly spicy three months or so for me, but it's great to be back on.

Ben Reitzes:                       Glad to have you and I'm sure the transition will work out well. I have good confidence in that. I'm going to start the Bank of Canada. I mean, we had their policy decision last week. They surprised with the 50 basis point rate hike instead of a 75 basis point move and they sounded much more concerned about the growth outlook. That was one of the big drivers behind the surprisingly smaller move. It seems as though Governor Macklem maybe didn't have the updated growth forecast when he spoke to the media post IMF. So that might be one reason why he still sounded hawkish at that time. They just didn't realize growth would be as bad as it looks like it's going to be. And then on top of that, it wouldn't shock me either if they just kept working on the math, the bank did, on the impact on mortgages because they have all the micro data there.

                                                They see everything and they see how big of an impact and how many households would struggle under the bigger rate hike and that could have had an impact as well I think. And so as much as I hate being wrong in our call and the fact that they went 50 instead of 75 like we called for does annoy me. I do think 50 basis points was probably the more appropriate move at this point given all the stuff I mentioned. And then we already, I mean, BMO already has a recession in the forecast for Canada, so growth is going to be pretty soft and the bank isn't quite there yet from a growth forecast perspective, but they did admit that it's kind of either way in the first half of next year. They have growth pretty much at zero from Q4 to Q2, which is very, very close to our call.

                                                And in their text of the monetary policy report they noted that growth could very well be negative over that period. And so, clearly they are much more concerned about the growth outlook. And inflation, while still important, undoubtedly, not the sole factor driving policy anymore. The bank does expect that that softer growth profile means weaker inflation through the course of 2023. We'll see if that plays out. But for now that's the narrative I think they're going to go with. Looking forward, we still have two 25 basis point rate hikes for the bank. So one 25 point move in December, one 25 point move in January. There's still some risk that they go 50 in December and then maybe pause after that. They just front load a little bit more. I am getting a very strong reading at the moment for October CPI. I've not quite finalized the forecast at this point but it's still pretty solid and that might put a little bit more pressure on the bank but we'll see how the rest of the data do.

                                                We'll get jobs in a couple days and there are a number of other data points before the December meeting, so still plenty of ways to go. It is Wednesday afternoon, four o'clock eastern time, so we just got the Fed here. And they didn't follow the path that the Bank of Canada laid out. They did not sound more dovish. They didn't surprise on that side. If anything, I mean Powell noting that rates could go higher than they thought at the last meeting hopefully was certainly more hawkish. And while the pace of rate hikes he noted will probably slow either at the next meeting or the meeting after, it still keeps the door wide open to 75 basis points at the December meeting. And I think the market wanted a little bit more dovish just than that. But for the Fed, the focus is still very much on inflation. I think, why don't I bring in Dave here? I think that divergence is a good starting point. How do you view the US backdrop, the policy backdrop and rates versus Canada at the moment?

Dave Moore:                      Yeah, I think we were talking about this last time we spoke is that there was going to be a transition away from economies going side by side and moving more towards their own paths. And we are seeing that. And obviously Canada was one of the early movers when it came to the hiking rates both in terms of when they did it and also in terms of size of move. And so there's always that kind of propensity for it to be the first mover or at least what people are called pivot or slow down. I think you're right on the mortgage side and I think that they obviously are very sensitive to that but I don't think a lot of press is kind of given to the home equity line of credit side of things because it's just not something as a credit tool that's often used outside of Canada. And where you have such large amounts of debt albeit secured by equity in the property that is linked to a floating rate.

                                                And if you're using that and it has a balance, I think that that's got much more of an impact, at least immediately, to the consumer than the fixed rates, whether it's five year fixed or the transition of floating rates into fixed rates. And I think the data suggests that a lot of consumers have moved from floating into fixed, at least from what I can gather. But I think that we are sitting now in a place where the underlying balance sheets of the consumer could get quite stretched, particularly when I look at the home equity line of credit side of things. And I think the bank are very sensitive to that. And while they probably wear a little bit more inflation, oil prices and energy prices up is generally good for Canada, might be bad for the economy, it's hard for the consumer, but it's generally good for the west coast and for businesses. And if lumber's doing well, that obviously bolsters further economic growth.

                                                But if the growth numbers are starting to look a little bit scary low, I think they're more likely to wear a little bit more inflation, tailor their language around the growth outlook and probably not be so vocal in terms of the housing debt, but will have that front and center in their mind. I think one of the main divergences between the US and Canada is just down to the liability structure of most people. And no, I'm not speaking to the corporate level here. I'm talking to personal balance sheets and discretionary spending choices made by the consumer. You have in the US 30 year mortgages, whereas Canada we've got five year fixed as kind of our standard, four year or five year rolling. You have the home equity line of credit which isn't something that really is that available in the US. I don't see an instance in which there's going to be material house price or housing shock in the US without a material labor market shock.

                                                And the Fed's not going to push the economy to the point where labor market gets really badly beaten up. They have to oversight and they have to try and get inflation under control for a few reasons. But I think one of the main points now is that the consumer, the general public, know Powell's name and that was from Trump's presidency. He made Powell known. And for the longest time, Central Bank policy makers would kind of act in the shadows in terms of the general public and the decisions they made would be swift and they would be cared about by people in our industry and people, our investors, our clients. But the general public probably didn't have much of an idea what the central bankers did. They probably didn't know the central banker's names. And now you have a name and now you have inflation. And so it's a dual edge sword for the US in particular because the consumer knows Powell's name, the consumer knows that he does something somewhere that changes something that might impact them somehow. The depth of their knowledge will vary.

                                                He's now a known entity. And before where the Fed could get away with being a little bit more liberal with their language because it was select participants in terms of the global population that was paying attention to it, I don't think they have that luxury anymore. And that, while they wouldn't want to admit it, I think will have an impact on the language they use and the decisions that they make and will likely force them to stay the course for longer. Because if rate hikes are the tool to solve the inflation problem and the general public know this or believe this to be true, the minute that he stops doing that or the Fed stops doing that, they might be seen to be pandering to the banking community, filling the purses of the wealthy and creating a bit of an issue there.

                                                Now, that's an outlier risk. I'm not sure if that happens and that the general public really care that much, but it's a risk that just hasn't existed in such a scale that it does today. And so that's why I think that you'll continue to see some divergence. So long as inflation is material and has ahold in the US, the Fed will almost be forced into action or maintaining action because they're now known. He is known, the Fed are now known and that will become really quite difficult.

Ben Reitzes:                       Yeah, I hear you. I mean, it's a pretty notable divergence between the two countries is potentially coming. I see how the US is meaningfully more resilient to higher rates than Canada are. As you mentioned, our leverage ratios are just that much higher. It's just that much more punishing on the Canadian economy when rates go up. And so it is going to put the bank in a bit of a difficult spot in that, I mean, if the Fed let's say gets to five or north of 5%, how high does the bank have to go to make sure the Canadian dollar doesn't really weaken too much and drive inflation that much higher? And can it even do that?

                                                Maybe at some point, you know what, the bank will just choose to accept a weaker Canadian dollar because our economy can handle that rates at north of 4.5% or something along those lines if the Fed continues to move higher. That'll be a dilemma that the Bank of Canada could have to face at some point in 2023. Fortunately though we're not there yet. What is the European investor base saying about the Bank of Canada surprise last week? Was there much chatter or did it just fly under the radar given that we are going to see, or we have seen, the Fed was on deck next and that was a much bigger story?

Dave Moore:                      There's an obvious kind of undertone around Canada now over the last maybe 18 months or so where a lot of clients and investors who may have been active in the past are less so because there's opportunity sets away from Canada. So perhaps their focus just isn't as deeply ingrained in the Canadian monetary and fiscal policy landscape as you and I or locals back in Canada. But I think one of the notable comments from those that I expect to hear is that the bank had to do something. The bank will likely be forced to do more in terms of pivot more relative to the US but the opportunity set for Canadian trading, like from a discretionary standpoint, obviously I'm going to exclude those who have natural liabilities and Canadian dollar and are placing those dollars in assets, the discretionary account base, the discretionary choices that will be made likely don't go to Canada just because the dynamic has changed so, so much in the last little bit.

                                                When I look at say Canada versus US from a rates trade, we had Canada fives versus US fives go from essentially zero or positive, that is match yield, to 70 basis points negative. That is Canada through the US. And that signaled almost four and a half sigma on the six month average. And so something like that in the past would have traditionally brought out a lot of activity, a lot of activity just purely because mean reversion trades were the flavor and that's how a lot of people were trained and you would fade it. And if you look at the move now since the surprise and we'll talk to that in a second, but the surprise. Call it maybe two sigma on the six month. And so if you'd done that fade and thought at four and a half this is worth the fade and held it and kept onto it, obviously you would have lost your amounts now because we're minus what, minus eight or 80 basis point through the US. But we're still, from a sigma perspective, we're not nearly as overstretched as where we were in the initial move.

                                                But when we talk to clients and we talk about surprises, I look at it from a what is the median survey saying versus what actually happens. And over, let's call it, last 20 years or so of all the Bank of Canadas where we have a median forecast available and their action, they call 160 meetings in the past. There's really only been 13 instances where the survey deviated from actual policy and the most recent action was one of them. But 92% of the time, the surveys are pretty much bang on. And that's just one of the risks that we now face is that we're looking at history to try and predict what happens next. And we tend to do that, we tend to try and gauge where to go based on where we've been. And right now, we haven't seen action like this ever. We have seen periods of large scale inflation, of course we have, but not when central banks have been so active in the market.

                                                QE, QT and every iteration of central bank policy over the last decades since the global financial crisis, it's all new. This is all new to us, it's all new to financial market's history. And so when we look back and say, well, okay, we've seen this type of behavior before or we've seen divergence economically before and tried to use that as a measure or a gauge, it's just not as relevant or is not relevant at all. And this ends up sidelining so many people, because if you have the opportunity set in other perhaps deeper markets, and I mean that in the greatest respect and deference for Canada, Canadian bond market isn't as deep as the US. It isn't as deep as some of the Europeans. But you're seeing dislocations in the US and you're seeing dislocations in Europe which are far more extreme and probably warrant active allocation into those trades rather than going into Canada when you have week over week volatility, say in Canada twos versus the US, of 31 basis points.

                                                That's the change. We've tightened 31 beeps to the US over the last week. That's so material from a risk sizing perspective that you just have other options out there that don't have the same amount of inherent volatility in them relative to historical volatility norms that just don't blow you out of the water intraday. And I think that's where the international community now lies. They have the choice to do many markets. Why would you allocate out a large portion of your capital to Canada when the risk is just, it's just so big and the moves are so vast.

Ben Reitzes:                       You hit the nail right on the head. We're seeing still very, very good activity here. But just from a global perspective, Canada's not as intensely followed as it would've been a few years ago. And you're exactly right. When US treasuries, when 10 year yields are moving 10 basis points on a Tuesday when nothing happens, it's hard to get too excited about Canada and that kind of environment. There is money to be made in those bigger, deeper liquid markets and when they calm down eventually you'll get more attention paid to Canada for sure. And I get that from an international perspective. There's still real money activity still and then domestic activity here is still very strong. So that is definitely a positive. But it is clear, you're exactly right, that from a global perspective, Canada is just not as exciting when you have such high volatility and that's the key word.

                                                Volatility is still extreme. And given the uncertainty around policy and how that's probably not going away, I'd say for at least about six months, maybe eight months, the middle of next year, I think we'll have at least more clarity on the inflation profile going forward. That should help and then how sticky core inflation is. But in the meantime, get used to these crazy wild days with rates swinging back and forth consistently.

Dave Moore:                      But I think that's really valid is that I'm quite simple when I think of volatility and I don't trade options and I've very rarely have been active either as an end user or in terms of pricing. It's just not something I'm really that familiar with from a really deep technical standpoint. So I like to bring volatility to its most simplest terms and something that people can really get their heads around. You speak to the intraday ranges in yields. And you take Canada twos, for example, and let's just say in really simple terms the high yield versus a low yield of that day, the intraday high and the intraday low, that range. If you look at the last year, so year to date, so we're going in November now. Year to date we've had 24% of this year, Canada twos have had more than 10 basis point range intraday.

                                                And the last time we had this type of volatility was in 2008. And year to date 2008, so the equivalent date to where we are now, it was at 28% for the year of 10 basis point or more intraday volatility. And then from 2012 to 2021, this is including COVID, 2012 to 2021. The average amount of time where there was more than 10 basis points intraday range is around 3%, two or 3% across the entire decade. So you have people coming into this market who have 10 years worth of experience, a decade worth of experience, and they've only seen 10 basis point or more ranges in Canada twos 3% of their career. 3%. I remember Levent here at Bank Montreal was doing a call and he's talking about how he looks at the markets and how he thinks about volatility and he said something like, and I'm paraphrasing, he thinks the market has a fever when the VIX has an absolute value of more than 25.

                                                And so I thought, okay, that would be an interesting way to look at things and let's look at from 2006 or 2007 until now and really what does that look like? And 61% of this year, VIX has been above 25. 100% of October, 100% of May. And the last time we saw this was during COVID, it was similar this time in 2020. 67% of the year the VIX had been above 25. But if you go back to 2012 and we take that entire decade, even including the 67% year to date number to include the COVID time, the average has been 8%. That's with a 67% number for one of those years or one 10th of those years. If we strip out the 2020 number, the VIX was above 25 from 2012 to 2021 x 2020 2% of the time.

                                                So we have people now who are trading these markets with a decade worth of experience who have never seen anything like this, who have no idea what this is like and don't know how to trade it, don't know how to think about it. And I think that exacerbates the problem. I think that makes things much, much worse. And it's something that I'm very cognizant of because in the past, and as I said, people would step in and defend the top and the bottom side of a range or step in where they think that the value makes sense to be long or short. And now what ends up happening is these price moves happen so swiftly and so aggressively and we're not seeing that defense or it just doesn't take as much size to cause a lot of pain or a lot of gain.

                                                And depending on your perspective, that as a bond, as a rates person, I tend to think of things from pain rather than gain. I leave that for people maybe in the equity side, they're fairly optimistic and they do well when the world is doing well and bond investors tend to do well when the world isn't doing so well. So I say that from a pain perspective, you can be stopped out three or four times over in a day on some of these moves. And so I think that combined with lower subscription, combined with more electronification, with more activity in futures rather than in the cash market, it just will exacerbate and get worse until there's a semblance of control, semblance of stability, whether it's in the inflation profile or we accept that the next part of this cycle is more recessionary, that job losses are imminent and once we get through that phase of the cycle, then hopefully things will settle down and we can go back to somewhat more stable, more normal markets.

                                                But the hope is that that will be a move perhaps away from autonomy, from an electronic or algorithmic trading perspective and more towards autonomy at the human level where investors, dealers, traders are given more to be able to manage this without it being so punitive in terms of holding assets on the balance sheet.

Ben Reitzes:                       Yeah, well, we'll see if we get there. But you mentioned, I mean, a decade of traders just not really having experienced this type of volatility. And I mean, that's what happens when you have 10 plus years of rates close to zero and massive QE through large chunks of that time and now you're getting the opposite. And so, if central banks were volatility dampeners from the kind of financial crisis easing period until through the end of COVID pretty much, it's going the other way now as they tighten policy and then they pull back on all their liquidity provisions. So it's probably going to be bumpy for a while, maybe not as bumpy as it has been this year, but definitely bumpy. One of the last things you mentioned was recession and I'm going to kind of change gears a little bit here because we get the Canadian fiscal update on Thursday tomorrow and nothing's really expected there.

                                                I don't think it's going to be a big event at this point though I guess you really never know, but the government has said they're not going to work counter to the Bank of Canada's battle against inflation so that's a relatively clear sign that they're not going to spring any big measures on us. No new big spending measures though I'm sure that there will probably be some goodies for some people, but it doesn't preclude that they could still spend more money and put more stimulus in place in next year's budget. If we're right about our forecast and then there is a recession at that time, it might be hard for them to refrain from stimulus.

                                                We could already see inflation pulling back a little bit, so gives them a little bit more license to spend more. We'll see on that front. But why don't you give us a little bit of flavor on what's gone on in the UK over the past couple of months and how that's a cautionary tale for the rest of us. And we're coming up on 30 minutes, so let's keep it to two to three minutes and then we'll talk about trade ideas.

Dave Moore:                      Yeah, I think chaos seems to follow the Moors. We moved to London 2018, Brexit 2020, COVID in Hong Kong and now what looked like economic collapse in the UK when we return. Pretty much within two weeks there'll be a petition for the Moors to be taken out of the UK imminently. So best of luck Canada, I think. But it's really important what's happened here, and it's a shot across about to both the fiscal and the monetary policy makers, that their words carry a lot of weight. You can't go in with policy in either fiscal or monetary that is so clearly divisive and it's so clearly wrong. The markets will tell you. But the move is exacerbated here because of the structure of the fixed income market and the general same way risk that tends to happen particularly further out the curve. But I do think that it's been a really important point. And I think you said exactly right that the government and the mandatory policy makers will have to align a little closer now.

                                                They're not going to be in each other's pockets and their mandates are different and I don't see any way in which there isn't some spending or a hat tip to spending in 2023 regardless of what the bank is trying to do because the mandate of the government, when as you say, there is no real near term risk of an election, as we probably thought that here in the UK too. And now we've went through, we're on our third prime minister, so they might not have the election, but there certainly has been a fair amount of change. But I do think that it does show just how quickly the market will price this now and how much the market is listening. And I think that there's very little wiggle room for mistake when it comes to language, when it comes to policy and when it comes to perception. And I think that's one of the biggest pieces here is the perception.

                                                What the UK now probably requires is a period of balance and patience in terms of both fiscal and monetary policy where we can collectively take a sigh of relief and look at the markets calming down, allow financial institutions buy and sell side to get their houses in order to ensure that they're well positioned. That decade of low volatility and almost zero rates tends to lead to larger positions and leverage. And so there was a natural unwinding of some of that. There is a structural risk in the UK that is quite unique to here under the LDI side of things that you probably don't see elsewhere, but you still have the risk that policy makers, when they speak, they can move the markets. And if their speech is not well thought out or it seems kind of off piece or going rogue, the markets will tell you.

Ben Reitzes:                       Politicians are always well thought out though. Come on.

Dave Moore:                      Well, I think that there's an element of, I laugh we were talking about this today, but I think that we have to accept that they know as much as they can know to make the decisions that they make and they make the best decisions they can with the information they have. I think that's rational behavior and that's true for politicians as it is for monetary policy makers. Whether they're right or not depends on your lean, but there's this almost condescension against the policy makers thinking that they're not really sure what they're doing. And I just don't buy that. I think that there's some very smart people doing the best they can with information they have, but when you go off piece, as we have seen here, or go rogue, as we have seen here in the UK, it will not go unnoticed and there will be a very large impact to it. No one saw this coming though. No one saw this type of price action. It was wild.

Ben Reitzes:                       That's for sure true. Yeah. I mean they're doing the best they can with the information they have. The problem is the information's not always that great. That's the secret, that's what makes my job as hard as it is. The data we have sometimes isn't great and that's the way the cookie crumbles. We do the best we can with what we got.

Dave Moore:                      Exactly.

Ben Reitzes:                       And so on and so forth. Let's get your favorite trade ideas here. Canada based of course. You can give me one, give me your highest conviction idea.

Dave Moore:                      It would be fade in Canada US, probably in the five year sector, not right here. I think maybe five to 10 basis points from here you start dipping the toe and then just be a net outright long position in the front end. Just generally makes a ton of sense when you look at some of these rates and you look at some of these levels now. It depends on the type of client and the type of account base or investor that we're talking about. But, if you have liabilities that are coming in the door, whether they're perpetual liabilities like a pension fund or you've relinquished a physical asset and now you're long the underlying currency and so you're not exactly reliant on the funding markets to make these trade decisions, I think some of those frontend trades just outright long, not even looking at carb, not making it overly fancy, are making a lot of sense, particularly in Canada.

                                                Even after the price action that we've seen, I'd be looking for opportunities to dip by and try and create a nice scaled long position across various tens, almost like a ladder type structure where I just create a really nice accrual stream in the book. That would be how I'd be positioning right now for sure.

Ben Reitzes:                       All right. I like the Canada US angle. I'm a little more focused further out the curve and in the long end, probably towards 100 basis points. I think it'd start maybe at 90, 90 through and then at 100 where we've only been once. You can, I think, put on a bigger position there. My only concern is, again, there are a fair amount of people looking at this and we're clearly not the only ones and so positioning isn't there yet because I don't think we've reached those levels, but if we start to see positioning build up ahead of these kind of extreme levels, then that'll be a big red flag that we could definitely pop to new extremes.

Dave Moore:                      Yeah, I just think it's a defensible idea. It's a defensible trade where you look at it and you see the divergence of the economies. Eventually they will align, whether it's a three or six month lag, they will start to have at least some form of cointegration. It's not going to be perfect, but it'll be something. And having the risk on for that event makes a lot of sense to me. And it's something that I think that you can defend from a theoretical, fundamental, and technical perspective, but it is not going to be a straight line. It's not going to be an obvious entry point and there could just be that last flush out of positions. And at that point, that's where I think if you get that kind of last wizzy feel of just gappy, grabby, chaotic type trade, that's probably the time to get involved. I'm just not sure if we're there yet.

Ben Reitzes:                       All right. Dave, on that note, thank you for coming on the show this week. Much appreciate it and now that you're settled, we'll have to have you on again soon.

Dave Moore:                      Wonderful. Thank you for having me. It's been great.

Ben Reitzes:                       Thanks for listening to Views from the North, a Canadian Rates and Macro podcast. I hope you'll join me again for another episode.

Speaker 3:                           The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

 

Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist

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