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Here Comes the Boom - Views from the North

FICC Podcasts Podcasts October 20, 2022
FICC Podcasts Podcasts October 20, 2022

 

In this episode, Adam Whitlam, part of the Toronto-based fixed income sales team, joins me to discuss the outlook for next week’s Bank of Canada policy announcement, the risks to the economy, as well as his views on duration, provincial spreads and the market backdrop heading into bank year end.

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 Adam Whitlam from BMO's Fixed Income Sales Team. This episode is titled, Here Comes The Boom.

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.reitzes@bmo.com your input is valued and greatly appreciated.

Adam, welcome back. Pleasure having you. I think the last time you were on was June, so it has been a while.

Speaker 3:

Yeah. It has been a while. Absolutely. Thank you for having me back. Last time I was here we were talking about high ocean temperatures and what that was going to mean for hurricane season. And then ironically enough, it ended up being one of the quietest hurricane seasons at the beginning and we're making up for lost time now.

Ben Reitzes:

We're going to try and stay a little more on topic this time around. And since the Bank of Canada is next week, I think we're start there. It's been a very eventful week on the data front heading into the bank. We had the business outlook survey on Monday and that was pretty soft, pretty much across the board. And the weakness there suggests that we are going to see a slowdown in the broader economy. GDP growth's slowing down. We'll get maybe a taste of that next week. And business inflation expectations pulling back a little bit, still staying high, but pulling back a little bit.

But unfortunately the consumer survey that goes along with the business outlook survey, the Bank of Canada's survey of consumer expectations showed that consumer household expectations are still very high and really, really haven't packed off at all yet. And that is clearly a big concern for the bank.

And then we got, on Wednesday, the September CPI numbers and they were much too hot. A couple takes above consensus, one take above our call, and probably more importantly than the headline number was that the core numbers were steady and the hurdle for the cores to stay steady was actually pretty high. Last year, the cores were quite strong, so the year ago comparables were pretty favorable and then we still got a steady reading. So that shows that the breadth of inflation is still very problematic. And that's something the bank has highlighted in recent months and I'm sure they will again.

And on the back of that, we changed our call to 75 basis points for the October 26th meeting and then 25 beeps penciled in for December. And that's really subject to the data flow over the coming few weeks or so. Adam, heading into the bank, what do you think? We're priced for about 75%, 70% to 75% of a 75 basis point rate hike. Are you in that camp or you still think maybe 50?

Speaker 3:

I don't think 50 is on the table at all. I think the bank has been very clear in all of the various media endeavors in which they've partake in that the threat of doing too little far outweighs the threat of doing too much. I think CPI gives them a great cover to go ahead and raise 75 basis points. And if I was a central bank, given the rhetoric that we're hearing, and how they feel about the psychology of inflation and the importance of that, I think I would be incentivized to raise rates too much too fast and then take a nice pause more so than do it gradually and let inflation psychology become more entrenched.

And so I think the bank will use that cover to hike 75 basis points. I think they'll lean on the business outlook survey, not so much the business outlook sentiment, which was negative, which I think the market really leaned on that pretty heavily after we got that survey, the market was very well bid. Now we did have a bail-in note come through the market for 2 billion, which put a pretty strong bid into the five year part of the curve. And there are some other reasons behind that given the time of year. But the market narrative definitely leaned on that part of the business outlook survey and kind of ignored the inflation sentiment.

And then I think we just got reinforcement today. You know, saw UK inflation coming hotter than expected. You saw US inflation come in hatter than expected. Now Canadian inflation hatter than expected. This is a global problem. So if you're the Bank of Canada, I think you're 75 beeps locked and loaded and maybe 50 at the next one.

Ben Reitzes:

God, I hope not. So airing on the side of doing too much, you said, and that definitely seems to be where they think is the right way to make the mistake. And to some extent I get that, but at some point policy makers need to explain to the public that policy takes time to work. And even if inflation is remaining sticky in which it is for the moment, there's a limit to how high they should be raising rates.

And you can already see on the Canadian side, housing is already buckled, clearly. The activity data are starting to slow. I mean, we're so far lagged with our data. We're only getting August GDP next week. We're only going to get August retail sales on Friday. So I mean we're way back in time here. We're still looking at summer data, but things have likely already slowed given where rates are and what inflation's doing and how people are reacting to that. And we're probably only going to slow further in the coming weeks and months.

And so assuming they do 75 beeps next week, that takes us to 4%. At what point is it worth just kind of taking stock of things and pausing, maybe not immediately, but sooner rather than later because it is going to cause a problem. And this goes for the US as well, for the Fed. The issue for the bank is arguably that the currency is a problem. And Macklem made that pretty clear in as recent post IMF media round table, there was clear concern about the loonie. If it were to weaken further, that would've I think also pushed them to be a little more aggressive. It's bounced back a little bit here on the strong CPI and it was doing a little bit better with risk this week. But there's a limit to how far the bank and the Fed can be in policy.

And probably 50 basis points give or take is the max on that spread. If it were to move further, then you're probably facing the Canadian dollar at C$1.45 or something like that. And then you're looking at another at least half, if not full percentage point on inflation next year just because of the exchange rate.

My modeling suggests that dollar's weakness is already going to add half a percentage point next year, so another 5 cents or so would probably add, I ballpark, another half percentage point. So that's something the bank needs to remain cognizant of. But at the same time, again, the domestic economy is likely going to suffer pretty badly here and the higher rates go, the deeper the suffering is going to be on the domestic side. So I think there at least should be some thoughts to that even though they're trying to contain inflation expectations.

Speaker 3:

And part of that, because you brought up the currency, because that's definitely been on my mind very heavily, in some of the weakness we've seen in the Canadian dollar and the fear of importing inflation, we were doing a lot of investor meetings last week with some of our US trading and US strategy team and one of the big topics that was coming up over and over and over was terminal. And so we saw US terminal kind of push up from that 460 dot indication up to 490, 485. And in some of the conversations I was having, the expectations were really getting up more like five and a half. So if we're talking about interest rate differentials that are 50 through now, we're talking about 5% overnight in Canada. So that's why I think 75 beeps, absolutely. 50, yeah. There's a good chance. Maybe they take a pause after that. But if we're talking five and a half in the US, 475 to five seems well within the realm of possibility in Canada

Ben Reitzes:

It's possible. And I'm not debating the possibility. I'm debating the appropriateness of it. And if policy makers on both sides of the border are going to use on the ground CPI data to drive policy on a month to month basis, then yeah, rates probably still have a ways to go. The problem is that you've already raised rates. After they go next week, let's say it is that 75, they'll have raised rates 375 basis points in, I don't know, eight, nine months. And that is a pace of which we have not seen for decades. We don't know what the impact is. We don't know how much this is going to weigh on consumers. We're only seeing the beginning of mortgages hitting rate triggers and pushing payments higher. And so you need to see that play out a bit before you continue with rate hikes and you need to see what the impact of all that is.

I get they don't want to let things get out of hand but they risk it getting out of hand the other way. So I mean, they put themselves in the corner here. They made a mistake in the first place, not raising rates sooner. I pinned this entirely on central bankers globally, policy too easy for too long, and just really failing to read the T leaves around the turn of the year when the core inflation numbers in Canada were strong, except for one and they only used the one. Now they disavowed that common component. Oops. That's not good enough for me. So I mean it, we're in for I think a pretty tough spell here.

And then you can add on top of that the fact that rates generally are just pushing higher and that also is going to cause some pain. We've seen US 10s push through 4% and now they're fully through 4% and the next levels, I mean, seeing 450 on US 10s is not out of the realm at all and Canada would see 4% in that world as well. And so what does that do to five year rates? They're probably in that neighborhood too. And so how much higher do mortgage rates go? How much more pain is there in the housing market? And then you cycle on that negative spiral and geez, that's pretty depressing. I don't really want to see that world. So I'm hopeful that policy makers have an understanding of the damage they can do here.

Speaker 3:

Yeah, I mean I agree. And it could be very violent, especially for an economy like the Canadian one, which has higher debt ratios and is more levered to housing. So yeah, it could be quite painful. In that same vein, should the market be pricing in cuts in June, 2023? Absolutely not. Looking today at March, 2023, June 23 boxes having minus 10 beeps inversion, I don't know why the market is determined to hold onto this narrative that the bank will not have the ability to hold rates at a high level to see what happens and that they will turn and balk at the first sign of concern about growth.

But I think this time ... they've said many times don't fight the Fed and the Fed has made it pretty clear that there isn't really a pivot coming. You know, you might get a pause. And I think a pause is totally reasonable for the exact reasons you described. See the impact on the economy, see what happens to inflation. Maybe that way you can avoid really crushing your economy. But a pivot I think is miles away. So the fact that we keep trying to price that into our curve is ludicrous.

Ben Reitzes:

I agree on the rate cut side. I mean the earliest day any of them can cut is probably the fourth quarter. We won't get a good idea on inflation, again, until it's around the middle of the year. It's a little before that. The year ago comparables are very favorable around the April May period and again, kind of similar to the reading we got today for September. If you don't see a deceleration in those months, that is going to be a very big red flag and then you'll see that 5%, nice around 5% plus number, for rates probably right across the curve.

Why don't we talk a little bit about the flows that you're seeing in recent days? And heading into bank year end, how do you think this all plays out with rates? I mean, it's seemingly still one way duration, consistently under pressure.

Speaker 3:

Yeah. Yeah, duration's been under pressure. I mean we've had in the last week or so we've had some pretty significant Canada out-performance which has been really notable. A lot of that kind of occurred after that business outlook survey. I think it's kind of worth noting like this Canadian bank year end is a big deal as it pertains to dealer abilities to take risk.

What we're finding is trades in the market that, say you went back a month or a month and a half ago, wouldn't have had much of an impact or having a much larger impact. I mean we might see a situation where 40 million long bonds will trade and usually that'd be kind of no problem to take down, but we're seeing the market steepen three beeps as a result. So I think it's setting up very volatile. There's a lot of hot potato going on with risk.

The last couple of days we saw a lot of selling into the Canada out-performance. Some of it was cross market, some of it was outright, you wouldn't know that based on the fact that Canada outperformed so heavily. But to the point about risk taking, I mentioned earlier there was a bail-in deal for $2 billion in the five year part of the curve. That was the entire explanation for the massive out-performance of Canada all across the curve.

And yeah, a $2 billion deposit note deal or a bail-in deal is not small. But a month and a half ago it certainly wasn't going to cause Canada to out-perform by seven to eight basis points. So there really is a hot potato risk environment going on. Doesn't take much to move the market. There are some opportunities that are kind of coming out of it. I think one of those big opportunities has been in the long end. Sam's been kind of highlighting it and I'm in complete agreement with them.

If you can get 10s, 30s curve close to zero, which today actually it was negative three plus two, negative three plus two, back to negative three. So it's not outside the realm of possibilities, but if you can get the 10s, 30s curve kind of back to zero, especially on a cross market box, versus the US, that looks really good. We're going into ... it's bank year end means there's not a lot of propensity for risk. But once we get past that, the conversations are going to start about December one, index extension, coupon payment, and that typically is favorable for flatteners, in particular on the long end.

So I think you might get an opportunity to get some duration on for cheap if you can weather some of the volatility over the next two weeks. Because I think once you get through October 31st and November 1st, you're going to start to see market participants talk more about that, the ability to take risk will be better and they'll be a much stronger bid for longs to set up for that flow. So if you can get ahead of it, now's the time.

Ben Reitzes:

Just to add to the kind of I guess liquidity vacuum that we're kind of headed into, the bank meeting's on October 26th and that makes it, even if it weren't coming into year end, liquidity would still be challenging heading into the bank when there is this much volatility generally. And really you never know with the bank. They have surprise in the past. They could surprise again and so that dampens risk taking appetite in the first place and then again you have year-end on top of that. And so that's exactly what happened last year. I mean the bank really surprised the market, it sideswiped it ahead of your end and thing. Liquidity got hammered and took really months and months and months to recover. So-

Speaker 3:

The last year cost millions of dollars to all the dealer desks and lots of jobs to people that were market participants. So I think that was almost a year ago exactly and that is fresh in people's minds and I think, like you said, it's right before bank year end, the propensity for risk is very low.

Ben Reitzes:

Well hopefully the bank doesn't surprise because that would just make the bloodshed that much worse I think with already elevated volatility. One thing Governor Macklem has talked about in his past couple of appearances consistently is the concept that the economy is in excess demand. So we're operating above potential. And so what the bank wants to see is a few quarters of below potential growth.

It seems as though he's kind of starting to set up how the bank's going to end up pausing at the end of the day. We'll get August GDP next week, and with that will come the flash estimate for September and the third quarter. And so August looks to be flat plus or minus a 10th, probably lean the plus rather than minus, but we'll see retail sales does on Friday to make that determination. But September I guess a bit more interesting. We'll see what the flash estimate is there and for Q3. We have 1% for Q3 at the moment, probably have a one hand will be my guess and maybe that's the beginnings of the bank being satisfied with that weaker growth profile.

But I suspect once we get into the fall, you're going to see growth often pretty notably. Again, the data just lags so much where we're not there quite yet. But something I think to keep in mind for everybody out there and that him harping on excess demand so many times there, there's something to that. They're not just words. The bank tends not to really emphasize things unless they're actually worthwhile. So we'll see what GDP does next week. It sets up again a very interesting week as a whole between the bank and GDP.

So let's change gears a bit. We've seen the market generally come under a bit of pressure here, risk come under a bit of pressure. Long Ontario spreads have broken 100 for the first time in since COCVID broke out and spreads moved up to I think a peak of 105, 106. What are your thoughts on spreads here? They've come back a little bit since then. Are we going to continue to widen? Are we going to retest the wides of around 120? Or is it safe and everyone can hop in the pool?

Speaker 3:

I think it depends a little bit on the part of the curve you're looking at. I think looking at say provincials, looking at the 10s, 30s credit box, not being God, but as wide as maybe 20, 24.2, maybe 24 and a half. That's on a generic basis about as wide as it's been since 2006. If you think that the Canada curve is going to flatten like I do and that there's an opportunity around zero, that should be a net positive for that credit box.

So I think getting involved in that curve makes sense and buying long provies should be supportive. There's also a couple of fundamental factors. You have Ontario, who's obviously one of the larger issuers, is in an unofficial blackout until the middle of November. We have the same index extension that I was talking about, which goes through on D two for provincials. So that's again another supportive factor. You have, last year, some of the larger issuers like IE Alberta which are now out of the market. So I think you have less supply coming through in provies, at least for the next couple of weeks combined with some pretty positive factors which should help that box.

Now credit in general, that's a whole different story. I mean I think it made pretty clear. I think rates are going up and I think that's going to be a net negative for risk and I think the market sentiment is probably the same. I mean just the other day when we got better than expected CPI in the US and a big bash up in front end rates, suddenly equities rallied 600 points and every news article on CNBC was trying to explain why that was happening. Because the market is set up for bearishness. They're set up for equities to perform poorly as we get higher inflation data and higher rates.

So maybe it's a buy the rumor, sell the news. Maybe that means that equities won't perform as poorly as the broad market is kind of expecting. So there could be some aspect to that. But you know S&P's 3,200. I don't think that's outside the realm of possibility. So I would say in general spreads will probably be wider, but I think more of that pain will be felt in belly spreads and things like 10s 30s box at these wides should be bought.

Ben Reitzes:

I would agree with that sentiment. There's another down in risk. I don't think we're done yet. Until you can rule out the fed getting well north of 5%, I don't know why anyone would have any serious appetite to buy any real risk assets here. And so that uncertainty is going to keep things under pressure. Anytime you get a data print that suggests they may have to be more aggressive or terminal sets higher, at the end of the day that we'll be negative for risk.

That big rally on CBI day was weird. I was in Japan and from there we were very confused given the time zone and I didn't know what day it was or what time it was, yet stocks were significantly higher after that very strong CBI print. I think it's just short covering, I guess just positioning and then we've seen a reversal of that a little bit here. So I think that that's all it was, just a positioning move.

I wouldn't read too much into that one day. I think the trend is still wider spreads, weaker risk, just a broader, challenging environment. Before we get to trade ideas, I should mention since I just mentioned Tokyo, because I forgot about that till now. Guess I'm still in the wrong time zone. The biggest takeaway from that, that trip was Japanese investors, the basis that they need to pay to hedge their purchases of really any North American securities is just so expensive at the moment that there's a broader reluctance to be buying anything in any Canadian dollar fixed income. And the same for US dollar fixed income. Very, very expensive to hedge. It's just more economical to be buying JGBs at the moment.

That could change at some point. You're going to need overnight rates to converge to some extent and that doesn't look like it's happening anytime soon. So that hedging cost is going to remain very high. But we'll see what happens in Japan with the Bank of Japan and yield curve control. And that could change the dynamic a bit.

And maybe we get to a point where yields get high enough and they're just attractive enough to bring in buyers and the hedging costs don't matter because there's too much upside on the bonds themselves. That's a possibility as well. I don't think we're there quite yet, but something definitely to keep in mind. But in the meantime, don't expect any support for rates markets coming out of Japan anytime soon. Adam, favorite trade.

Speaker 3:

I got a long list. So in the front end, I mean, I've alluded to some of them, but in the front end I think you got a fade inversion, in particular in kind of mid-2023. Whether you do it in BAX or whether you do it in OIS, it's hard to know. I mean the BAX pit, part of this ill liquidity vacuum and what happened a year ago, has meant that the depth in the backs market's a little light. Well, very light, but you have to look for opportunities to fade things like March, June, at negative 10. Those don't make sense. March, September, maybe you're getting closer, but I am a firm believer that we're not looking until at an absolute minimum Q4 before. Some central bank is even considering a rate cuts. So that that's another one. It would be March Sept fade that inversion.

A little further up the curve, there's some RV in the three year part of the curve, so like twos, threes, fives, those types of flies. The three year part of the curve doesn't look really all that inverted, versus twos when you compare it versus the twos fives curve. And I think if we're going to get higher terminal rates, which are probably going to get reflected in ones and twos, then you should see a deeper inversion in the curve.

And I think the best bang for your buck in that inversion is going to be twos threes more so than twos fives, because five years in Canada, I mean, they look atrociously expensive, as of this morning before the big sell-off we hide today, we were sitting around, I think it was negative 76 cross market versus the US, which is about as rich as they've been going back to September. They're a little cheaper now. If I had to guess, I'd probably say somewhere around minus 70, minus 68. But again, Canada five years look very expensive, especially relative to threes.

So if you want to play that game, I would say look at April 25s. Look at some of those three year bonds. I think there's more value to be had in those. I think the US twos tens curve, I think Ian and the team are on to something. I think that could get down toward negative 70. I mean it was negative 38 not that long ago and got down to negative 50 in a real hurry. So negative 70 I think is absolutely within the realm of possibility.

But same thing, I think Canada relatively is expensive. So if I was going to express that type of trade, I'd probably prefer to express it in US. I like that 10s 30s Ontario credit box. I think that's worth buying for the fundamental reasons I highlighted. And, I like that 10 30s Canada curve. If you get close to zero or if you get the cross-market box close to zero, you put on a flattener in Canada, steepener in the US or just a flattener in Canada.

Ben Reitzes:

I like that last one best for me. The 10s 30s Canada, US bucks, and zero doesn't tend to travel much above there. I guess in periods of extreme stress it might get there and maybe that's what we're in for. So maybe there's room for a bit of caution there. And that thing in positive territory, that trade in positive territory looks pretty attractive and really anywhere around zero should be attractive given where it's been over the past number of years.

Well, let's leave it there for the week and we'll see what the Bank of Canada delivers next week. No doubt they'll be bringing the boom with a 75 basis point rate hike and we'll see how the market reacts to that. Adam, thanks for coming on this week.

Speaker 3:

Thanks so much for having me, Ben. Always a pleasure.

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 4:

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/macro horizons/legal.

 

Benjamin Reitzes Managing Director, Canadian Rates & Macro Strategist

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