It's Cuttin' Time! - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Chris D'Onofrio, one of our Canadian dollar swap traders. This episode is titled, It's Cutting Time. I'm Ben Reitzes and you're listening to Views from the North. Each episode I'll be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. 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, 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.

Chris, it's been way too long and I apologize for not having you back on the show for longer. The way I try to choose who comes on is I look at the history and I'm like, "That person has not been on for a while. Why don't I see what they have to say? And if they can come on." I feel like probably you're such a popular guy, you're probably too busy to come back on.

Chris D’Onofrio:

Sure. That's a nice way of saying you forgot. I'm just happy to be here. It's all good.

Ben Reitzes:

Chris and I were just in London together on a marketing trip visiting clients and I thought it was particularly important to bring Chris on for this week. And luckily he's available too because again, very important guy.

Chris D’Onofrio:

Usually I am, but that's okay.

Ben Reitzes:

Before we get to the takeaways from the trip, why don't we quickly go over, I guess the banks in two weeks and since nothing's going to change between now and next week, this will be the pre-Bank of Canada show rather than recording another one next week. And we got April CPI yesterday and that came in tame again on the underlying side. Core inflation came in soft for the fourth consecutive month. It's averaged 0.1 for both the trim in the median on a month-over-month basis for four straight months, Jan to April, can't complain. The Bank of Canada said they want to see more sustained progress on inflation, on underlying inflation.

I'm not sure how two more months of 0.1 is not more sustained progress. You can't really ask for much more than that. And if you look at some of the other measures on underlying inflation, like old core inflation, CPIX, that's been extremely tame. You've had a few zeros on the month over month there and that's down to 1.6 year-over-year, sub 2% and I can now give a rant on that in a bit. And if you consider the breadth of inflation as well, one third of items are now running at 3% or higher on inflation and that's way down from where it has been and that's in line in the normal range you get historically. It's the upper half of the range, but it's still in the range versus way outside just a few months ago.

Everything seems to be coming together for the bank and a June cut looks pretty good at this point. That's our call. We'll see what GDP does next Friday. I don't think that we'll move the needle for them, but you never know if there's this big surprise. Remember last year you got a big positive surprise and that actually was one of the drivers behind their move to hike rates in June and July. If you got a really weak number, I think that would obviously cement a June move, but either way it looks like they're cutting either in June or July. At this point, I don't see why you would wait for July, personally. There's really no real upside to that, but it is the Bank of Canada and you never know. Where do you see things, Chris? Are they cutting in June?

Chris D’Onofrio:

You just touched upon this briefly and I wanted to dive deeper into it with you, but I think I agree with you in the camp that why would you wait if you don't have to, we're seeing what we need to see, but I guess this is my question, how high is the bar for GDP to take June off the table?

Ben Reitzes:

Oh geez, good question. I'm not even sure I can answer that. Let's see. We have two, three, anywhere two to two and a half is close enough for the bank's forecast. They're in that range as well and so are we. I think maybe the more important is not necessarily the quarter though, that obviously matters, but what April might look like, although now that I say it, I'm a little more skeptical as I talk here, but what we've seen in the data as it's unfolded in the past month or so is March activity actually hit a wall and January was really strong.

February was okay, and then March activity fell off a cliff like manufacturing down a ton, wholesale down a ton, retail we'll get on Friday, but maybe small positive on the volume side, but that's been pretty much flat for over a year now and home sales were more or less flat and it just looks and hours worked fell really sharply. You put all that together, you do get, I have a small negative, the flash estimate was flat, but I'm going to go with a small negative from March GDP, and again, that gets you to around just over 2% for GDP for the first quarter.

But April, we haven't had much so far. We had the job numbers were better than expected, but if activity ends up being really, really robust in April and it looks like the economy's revving back up, which I have trouble believing first.

Chris D’Onofrio:

Seems unlikely.

Ben Reitzes:

Exactly. Then I guess maybe that pushes you out to July, but even then, what would you be waiting for? The activity numbers shouldn't be the driver at this point. They know, we know, everyone knows that there's an output gap in Canada, and I think that's what you're seeing in the inflation numbers. It's been you have four straight months of soft underlying inflation and if you look at CPIX, it's actually five straight months I believe, and that's a sign that there is disinflationary pressure having an impact and that's what they've been looking for. How many months do you need? Maybe it's six, maybe it's 10, maybe it's 30. I don't know, but it's really hard for me to argue that policy and I don't think you could convince me otherwise, the policy isn't tight here. Policy is restrictive and if policy is restrictive and you're getting that disinflationary impulse, how long does it need to be this restrictive? And that's the question they need to ask themselves and that's why I think they should be cutting.

Chris D’Onofrio:

I agree with you. I think I'm in the June camp too. I don't think it should be a lock, but I think we should probably go into the meeting at around a 75% chance, something like that.

Ben Reitzes:

I'm lower, I'm thinking like 65 to 70.

Chris D’Onofrio:

Something like that I think is fair here. Really the only reservation I have not against June, but perhaps against being really cranked along the entire one-year point of the curve is the chance of inflationary pressure in other currencies coming into play. And we talked about this a lot when we were in London, the Bank of Canada obviously doesn't want to be cutting more aggressively than they should be, should for instance Trump get reelected. But that could be an inflationary pressure. That's all I'm saying. The risk to being along the front end as I see it is only that the US never really cuts and we cut 25 or we cut 50 and then we don't go anymore and that's fine.

Ben Reitzes:

Even in that case you're still going to get rewarded. We're only Z4 Canada-US.

Chris D’Onofrio:

This is what I wanted to talk about too. There is a risk there and this is what a lot of people talk about, but we're not quite at the point where that risk matters yet. The Z4 contract cross-market is around 55 basis points right now, which I think is still quite cheap. That puts us at just over two cuts for the remainder of 2024. What's implied by Z4 Canada is that we have just over two cuts by the end of this year. Now, like I said before, the one risk to being along the front end is that there's inflationary pressure in the US and that prevents us from cutting more than 50 let's say.

But the risk return there still looks quite good because if monetary policy lags in the US and they catch up in four months’ time or six months’ time or whatever, or even sooner than that, and if the election goes in favor of the Democrats or even if Trump wins the election and it's not an inflationary pressure, there's so many scenarios in this distribution of outcomes that lead to us cutting more than 50 basis points this year that I think the risk return at, I think we're implying about 56 basis points as we speak right now of cuts this year.

I think the risk return there is just too attractive to pass up at this point. I think once we get closer to the 70 or 75 range, then those risks that I've talked about that the US catch up, the US has sustained inflation, other currencies as well, UK or whatever you're looking at in terms of G10 rates, then okay, fine. Those are a reason to not get long. And those are valid concerns that I've heard from a number of counterparties, but at this point I think we are still quite rich both on an outright and a cross-market basis.

Ben Reitzes:

Agree. I'm going to do my quick rant now. If you go back to 2016 when the Bank of Canada adopted their new core inflations, just think about the time before that. Think about any previous iteration of the Bank of Canada from I'd say the early nineties. They adopted inflation targeting in the very early nineties, maybe a little bit into that, but until 2016, pretty much any iteration of the bank would be cutting rates at this with CPIX at 1.6% and five straight months of near zero inflation really. And the only thing keeping them from doing that at this point is the two favored measures call it, and the fact that inflation expectations have stayed elevated and we're coming off this period of high inflation, I get all that, but the evidence is pretty clear at this point and waiting, there's no upside to that. And 50 beeps for the year, not a lot of downside for sure. And the Canada-US makes lots of sense.

Chris D’Onofrio:

Sorry, we didn't even really address that.

Ben Reitzes:

I was going to say, and that was one of the themes of London trip is we would go into most meetings and talk about Canada and rate cuts there and the question was value against other currencies and there's still lots there. And you look at one year-one year it's at 50 low fifties today Canada's through. There's still plenty of value there. You look at Z4, size similar ballpark, lots of value as well. Chris is saying that if Canada's priced for 75 basis points, sure at that point that's meaningful, but if you look at on a cross market basis at Canada trading only 55-ish through call it, you're only pricing one more rate cut from the bank than the fed and two seems actually a pretty good probability between the way things are going.

Chris D’Onofrio:

Totally.

Ben Reitzes:

And we did a dinner with a whole bunch of clients and the consensus and that was more than a consensus really.

Chris D’Onofrio:

90% of the people in the room.

Ben Reitzes:

Thought that the bank would go 50 ahead of the fed and then going around though the sentiment from almost everybody was, "Yeah, the bank will go first and probably 50, but I'm not comfortable putting this trade on."

Chris D’Onofrio:

That's it. What I took away from that trip is everybody agrees the front end is too cheap, whether you're looking at the first six months of the curve or the first two years of the curve, it's just that people have been burned on cross market levels before. We saw one year-one year, Canada-US completely different environment, but about a year ago go to 50 basis points cheap. Absolutely don't think in any scenario we could get there now, but I think a lot of people are just having not so short memories, or sorry, too short of memories from the last year or so and they're just hesitant. At least that was last week. Since this number now, everybody probably has a little more conviction, but then again, they missed the recent 10 basis point move and now those cross-market structures.

It's tough say what those same people are thinking now. Although to your point, if you think the Bank of Canada is going 50 ahead of the Fed, why not do something in the first six months of the curve if you think that's where the value lies, which I do. I think, and you and I talked about this too, if you go further out, the risk grows. There are some IMMs into the early reds which are definitely cheaper to the US into the forties for sure. But you run the risk there obviously if something cracking all at once in the US, them cutting a hundred basis points and you being on the wrong side of it. But for sure in the remainder of 2024, I think those trades have some juice in them both outright and cross-market, I think you're right about that.

Ben Reitzes:

What about the curve in Canada itself just on its own? One of the trades you highlighted on our voyage was one year-one year, two year-one year and the inversion there.

Chris D’Onofrio:

That's perhaps one manifestation of the real problem in Canada.

Ben Reitzes:

Real problem. We have so many problems.

Chris D’Onofrio:

The real problem with the Canadian swap curve, which I think that two-year point is just fundamentally wrong where it is right now, I like to look at in forward space because it's more intuitive to me, but I think the kernel of the issue is that two-year bonds are just cheap. There's structural flow that goes through our market, everybody knows that that's most of the time mortgage hedging related that keeps those two-year bonds cheap. But nonetheless, two-year rate is simply not where it ought to be if we are going into a cutting cycle, which I believe we are and you believe we are, and I think a lot of people believe we are. Now, I highlighted it as one year-one year, two year-one year because intuitively it makes no sense to me that we start cutting now and that two years from now versus three years from now, we're 50 basis points inverted still.

That's one way to look at it. A perhaps more RV-centric way of looking at it is one year-two year-three year or six months-six month, one year-one year, two year-one year. Any of these flies when you compare them to other currencies, both currently and at times when those currencies are going into cutting cycles should be far more inverted, AKA the two-year point should be far lower, far richer, however you want to say it than it currently is right now.

Now this structural flow that we see that keeps two-year bonds cheap, a lot of people say, "That's the reason why two's,-fives can't steepen." I have no issue with that. Two's-fives bonds can stay where it is, but something's got to give. This two-year rate very well may not settle over the next two years where it is implying right now. And if the difference has to come from the spread curve, I think that's fine. And that's truthfully, it's two sides of the same coin why we've seen two-year spreads underperform so much over the last couple of months. It's really just because something has got to give in the front end and the bonds are what the bonds are and this is the trend that I think needs to continue if the forwards are going to get in line from an expected value perspective, what's going to happen over the next couple of years here.

Ben Reitzes:

You hate two-year spreads?

Chris D’Onofrio:

I hate two-year spreads, yeah. That's it. They've been far too rich and they go down half to one basis point every day and people scream and shout. And you know what? I think they ought to keep doing that because two-year bonds don't seem to be going anywhere anytime soon.

Ben Reitzes:

To continue on the same topic, the 2s5s curve. Why don't we quickly delve into what is going on there?

Chris D’Onofrio:

For sure.

Ben Reitzes:

Because that's important and is a key part of really the Canadian market as a whole and I guess as much as that we can do that really quick, but expectations there and why I think neither of us think things are going to change materially in the near future at least. Why don't you run us through how mortgages and mortgage origination in Canada impacts the front end of the curve and how banks treat that?

Chris D’Onofrio:

And twos and fives lets talk about right because there's, as I mentioned before, two structural flows that keep that curve pinned down where it is. Now in the front end, particularly in the warmer months when most of the mortgage origination happens, as I'm led to believe, the bank treasuries are getting new mortgages, getting new fixed rate mortgages. Most of the time right now at least we're in an environment where people want to take out shorter-dated mortgages because rates are high and everyone thinks they're going lower and there's nothing wrong with that. And shape of the mortgage curve was quite flat for a long time. And by flat, I mean in absolute value terms, threes and fives were quite similar. A lot of people said why not take the three year instead of the five-year rates will be a hundred basis points lower in a few years time.

That's fine. With those flows coming into big, big mortgage books and big asset liability books, these guys need to come in and hedge their interest rate risk. Now they're getting fixed rate mortgage creation, AKA they need to sell duration or pay two year and three year swaps in order to get themselves flat. Now this is sometimes done as outright swap, but oftentimes it's pieced out more as selling cash bonds and then trading the actively managing rather the swap spread. That's why the demand for cash bonds is dwindling. And on the swap side we tend to have an offsetting flow because like I said, many people want to on the front end, we have two-way in the actual swap rates, swap spread, et cetera, which leads to two's trading heavy, everyone being the same way in two's every day throughout at least the last four to six weeks.

Moving out further along the curve, why this also contributes to the curve being flat is the five-year point. Now at the same time when a lot of these guys are getting their mortgage flows, they also have to hedge their deposit base, which for some reason, unbeknownst to me you probably have a better idea than me, deposits are valued in Canada as five-year duration. When these guys get inflows of deposits, they need to buy duration, AKA receive swaps, in the five-year sector. If there's no fixed rate mortgage origination in the five-year sector, they get no natural offset. Their, "Natural flow," is to receive three's-five's curve or receive two's-five's curve. This is the primary explanation I think for why the curve is where it is and why the curve is not going anywhere anytime soon unless, like we said, we start cutting rates and people want five-year mortgages and bank treasuries have natural offsets for these deposit hedges in their books.

Ben Reitzes:

What this tells us, taking it just a little step further, if you look at the twos-fives-tens curve in Canada, it is very rich. That is the driver of the richness of twos-fives-tens. Beyond that, I guess what's going to change? And if you look at the shape of the mortgage curve at the moment, the three-year, five-year curve is it's like minus-twenty or minus-thirty basis points. Three's are 20 or 30 above five-year and people are still taking out the three-year. Again, it is about people expecting rates to be lower two or three years from now. The problem is if you consider the depth of this rate-cutting cycle, how low are rates going to get? And this is something I wanted to ask earlier. It was like even if they are cutting rates and we're entering a rate-cutting cycle, the depth of that cycle matters a lot and we can talk about that later, but from a mortgage perspective, it matters a lot.

And if they're only going to cut three and a half or 4% or something, where's the mortgage curve really going to go? You're going to have, if anything, the mortgage curve is going to steepen out probably materially, fives probably don't have that much room to richen in reality. And if fives don't rich, then five-year mortgage rates probably don't move from here and we get stuck around five-ish. Maybe the two-year comes below five and then you get some steepness there and still people are going to take out the two and three-year, they're still going to say no to the five-year because rates still won't be that low.

And the level of the five-year mortgage just I suspect won't get low enough to really drive origination in that term. And you're going to have this continued dynamic of receiving a fives and paying of the two or three-year space that I don't think changes. And as rich as the five-year sector is, and twos-fives-tens is positive, carry you short fives, it is a positive carry trade. And from that perspective, you could just set it in and wait. But I don't know what the impetus is, what the catalyst is for fives to cheapen in any material way until something changes or I'm just very wrong and God knows I've been wrong a lot, so anything's possible.

Chris D’Onofrio:

I absolutely agree with you. The trouble is everybody's so used to the majority of their adult life having rates quite low.

Ben Reitzes:

Speak for yourself.

Chris D’Onofrio:

Fair enough. But many people, let's say, not most people. To your point, if we only cut 75 or a hundred and people are used to seeing 2% mortgages or whatever it was a couple of years ago.

Ben Reitzes:

Even 3% of entry at this point.

Chris D’Onofrio:

Absolutely. Then I think you're right, people are just going to at least in the next couple of years terms be looking for that low rate on the shorter period and hoping that when they renew they get something lower. I think it's very unlikely that this structural flow that keeps our curve the way it is going anywhere anytime soon.

Ben Reitzes:

Chris is part of the structural flow just for the viewer. Not only does he charge rates but he's part of the flow, recently purchasing a house.

Chris D’Onofrio:

I'm part of the problem, you're right.

Ben Reitzes:

That doesn't look like it's going to change, which we got very little pushback from that in London at all. If anything, I think one of the other major takeaways is just lack of conviction. You talked about people getting carried out on a stretcher in Canada for over the past whatever number of years, and that's always been a Canada thing for as long as I've been paying attention. Canada just goes wild one day and wipes everybody out and we all start again and try again. And I guess to some extent that might be some risk here, but it's hard to see a world in which Canada cheapens outright for sure on a relative basis, it would take the US collapsing effectively. And at the moment that doesn't seem particularly likely. Maybe you could go Canada-US trades and maybe overweight the Canada leg a little bit just to get a little bit more juice there in case things go wrong.

Chris D’Onofrio:

And while we're talking about Canada-US, I know we mentioned this earlier, but let's specify that not all Canada-US is alike. The front end of the curve is quite silly, and I think it's too cheap as we've established, but further out some of the forwards as you get into the belly can get silly in the other direction. I think the asymptotic or steady-state mean, or max, let's say difference between term rates for Canada and the US is probably around 75 basis points.

Ben Reitzes:

Sure. I'll take that. That's fair.

Chris D’Onofrio:

I think that's a good bound, let's say.

Ben Reitzes:

It's a fair point, yes.

Chris D’Onofrio:

And what we've seen is just because of the flatness of the two-fives curve, richness of fives rather some of those forwards three year-one year, three year-two year, two year-two year, things like that on days when Canada really outperforms, we've seen those forwards versus the US get into the mid-seventies or even I think high seventies, maybe low eighties at one point in the last couple of months, which I think is an extreme. Yes, on the one hand you do probably want to belong the front end of the Canadian curve against the US or against the US really at this point, but that's not to say go crank along in twos and fives and tens and thirties and everywhere against the US I think it's localized and probably the smartest way to trade that is when things are cheap receive the front end and when things get too rich, pay those forwards, and then you have the curve on cross market and that just carries an absolute dream.

I think it's important that people keep in mind which part of the curve we mean when we say Canada-US because the five-year point just is a slippery one.

Ben Reitzes:

Very front-ended, I like that. And then trade the curve, I guess effectively at the end of the day it's a twos-fives Canada steepener against a twos-fives US flattener. But in forward space where the carry looks a lot better and makes a lot more logical sense to me, but that's effectively the same thing.

Chris D’Onofrio:

For sure.

Ben Reitzes:

That works for me. I have no qualms with that. Before we wrap up, I have a question for you. It's May 22nd, we are seven weeks into the Canadian fiscal year and provincial fiscal years. And what we've seen is discussed many times huge provincial issuance overseas in non-Canadian dollars, and that issuance all gets swapped back and that puts upward pressure on swap spreads. A lot of that's been in the ten-year space. There is a limit as to how long this is going to continue. The provinces have been super aggressive. They're really well funded already. I think nearing 40% funded.

Chris D’Onofrio:

That was the most recent figure I saw.

Ben Reitzes:

Seven weeks into the year, again, that's really aggressive, really fast. This pace of issuance will not continue. While they may do more and not at this pace, that's for sure. What does that mean for swap spreads? Will ten-year spreads given you've had this consistent flow from the provinces pushing them higher, does that mean they're going to lurch lower once that flow dries up?

Chris D’Onofrio:

I think in short, yes, but I don't think it's a screaming sale. I think actually, and I've talked to a lot of people who agree on this, we've seen a good absorption rate of those spreads that have left the street on the back of those new issues. If you compare versus last year we saw a couple of big offshore issuances in the spring, I believe it was in May, possibly April, and that's when ten-year spreads really just took off for the year five to 10 basis points type thing. But nowadays, there's this persistent, like I said, structural flow in fives, which gives a lot of spreads to the street. We've seen them absorbed relatively well. Although I do think, like I said before, the answer is still yes, the only major, major offer side flow that's been going through is what you're talking about. It's only logical to think once that subsides if this structural flow remains the same, as long as deposits aren't going anywhere, and you tell me if deposits are going anywhere, but I don't think they are.

Ben Reitzes:

I don't think so.

Chris D’Onofrio:

Then fives will probably be the pain point, twos and fives at least for the short term, but tens should absolutely get dragged along with it. I don't think we're on the order of 10 basis points here, but a few basis points probably make sense to me. I think just from an absolutely macro lens, if you just consider the sheer amount of issuance that we've seen go through this year, swap spreads should be tighter.

Ben Reitzes:

That was my thinking. I'm a macro guy.

Chris D’Onofrio:

The government is not all of a sudden going to stop issuing more bonds and stop running a deficit. Provided that that doesn't happen, yes, I think you're right. Although I do think it is a very, very similar trade to anywhere else in the belly. I think that the catalyst for those to cheapen still comes from the five-year point. Fives, CN, tens, anything like that, yes, they should not be going up unless the Canada-US story drastically changes.

Ben Reitzes:

You noted the fives-tens curve swap spread curve before and it's not that steep in the first place, it limits how far tens can really fall.

Chris D’Onofrio:

Absolutely. But I think it's a parallel shift regardless. I think fives go down, maybe tens go down 25% less than fives go down, but nonetheless, they still go down. I think you need, in short, materially lower rates in Canada to the point where maybe people start wanting to pay Canada-US and that becomes a trade as opposed to receiving it in size or you need, I don't know, less bonds, less cash bonds to hit the street, which is never going to happen. I do think once that flow dries up from the provinces, we should absolutely see suppress continue to trickle left.

Ben Reitzes:

Chris, we will leave it there. Thank you very much for coming on the show, and I will not wait a year before having you back on again, I promise.

Chris D’Onofrio:

I hope so. Thanks for having me.

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:

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