Nobody Said It Was Easy - Views from the North

Ben Reitzes:

Welcome to Views from the North, Canadian rates and macro podcast. This week, I'm joined by Darren Campbell, head of FICC sales in Canada. This week's episode is titled Nobody Said It Was Easy.

I'm Ben Reitzes, and you're listening to Views from the North. Each episode, I will be joined by members of BMOs FICC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. 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.

Hi, Darren.

Darren Campbell:

Hey, Ben.

Ben Reitzes:

How's it going?

Darren Campbell:

It's going great, thank you.

Ben Reitzes:

Welcome to 2024 on the show. It's been three months since we started 2024, but first time for you here. Before we start, I need to apologize to our listeners. I tried to do something a little bit different a couple of weeks ago, before the bank, and my plans to record an interview with somebody blew up in my face. This episode is a couple weeks late, but I guess at least we have two more weeks of interesting things to talk about, one of which is the Bank of Canada. Darren and I are going to debate a lot of things today because we have very differing views. It should hopefully be interesting or entertaining. Hopefully we don't come to blows, but we'll see how that goes.

Darren Campbell:

Sounds good.

Ben Reitzes:

Thoughts on inflation and maybe the Bank of Canada, or any questions that you have on the bank and Canada's inflation next week even?

Darren Campbell:

Well, I have a lot of questions and I'm not sure I have the answers. It seems like the client base has a lot of questions as well. I think I'd probably start by saying it's a really difficult environment. I think it feels like this is one of the lowest conviction environments we've been in, in a long time, in a lot of the core trades that people have had their eye on for a long time. There's been either false starts or there's just not clear catalysts to get them to really perform. The curve steepening is the obvious one. Now we're just in this, it feels like this state of limbo where we're waiting for something to push the narrative in a certain direction and it makes it tricky. We're spending time focused on provincial budgets, and thinking about different timing between the Bank and the Fed.

I think the biggest question in some of the things that we appear to be debating a lot these days is around the health of the Canadian consumer. The override message from the bank right now is they don't want to be early, that's just the main thing. It seems to be that's the case with the Bank of Canada for sure, and it appears to be the case with the Fed. That's number one. Until you're convinced, until you know that you've got things under control, you just don't want to be early.

At the same time, to me it feels as though there's stuff brewing below the surface that hasn't necessarily made its way into the data yet. I think that a lot of people have ... We're under the assumption that you'd be able to just ride things out, that yes rates had shot up, but you'd gotten used to the fact, centered banks often came to the rescue. Maybe you'd had this assumption that yeah, rates are high, but we're going to get two, 300 basis points of cuts at some point soon. I think what everybody's realizing now is that's just not a reality. Rates are going to come down, but it's off in the distance and it's probably going to be a lot more muted than people think. I think people are readjusting to that reality, tightening belts. You're seeing it just anecdotally, friends, family that you talk to, you can have a chat with a local retailer, and it's pretty obvious that things are starting to turn. We look at something like the flash on retail sales for Jan, it's a clear sign that I think people's behavior is starting to change.

Now you got things like huge auto sales numbers and things like that, which ... It's clear sensitivity from the bank to be very cautious around how they communicate any potential easing, because they're concerned the housing market will just start to rip again. That all suggests that there's, I don't know, a bit of a bifurcated consumer, a certain group that's fine, and then obviously a certain group that's really struggling.

Anyway, that's a lot of things that are out there, on my mind. It's not obvious, but I think push comes to shove, what it feels like the Bank of Canada in particular is going to wait as long as they possibly can until they're sure that they have things under control. Then maybe, be forced to act more abruptly, more aggressively. To me, that suggests a flatter meeting date curve for the Bank of Canada. But beyond that, there's a lot of confusion.

Ben Reitzes:

Let me take the other side of this a little bit. I've been talking about the weakness in Canada for a long time. Let me start off that that hasn't changed. Canada, I'm under no illusions, the Canadian economy is not in good shape. On a per capita basis, we're in terrible shape. Look at the numbers, consumption has been pretty weak for a number of quarters now. Domestic demand was negative in the fourth quarter. Consumption likely isn't going to pick up a lot. Auto sales are higher because they were so weak through the pandemic and post-pandemic times because there just weren't enough cars, so now the availability of supply is there in a way that it wasn't. That pent-up demand is being unleashed, people need cars. It's that simple.

But my rebuttal is that you are seeing those purchases in autos, for example. If things were that bad, you wouldn't see auto sales as high as they are at the moment, even with all the pent-up demand. People just wouldn't be taking that plunge. That part, I think is important.

It's not as if the consumer's been strong for the past year plus. They've been consistently soft through this entire period. Retail's been soft for this whole period and I just don't see that changing. The reality is, is that we have been weak, we'll continue to be weak. We're not falling off a cliff. If you look at, for example, it came out today in the national balance sheet numbers, the debt service ratio was pretty much steady at 15%. It went up .01%, so let's say that's steady. Consumers are seeing pretty good income growth, it seems. That's allowing people to hang in there. Unless you're going to have rates go up even further, which I am highly doubtful of given what the economy's doing, people will be able to hang in there.

The issue is that you're seeing still more mortgage resets, every day, every month, every quarter. I've been saying this for a while. That just means there's a headwind on consumption and that is not going away. This headwind is going to be in place for maybe as long as the next two to three years, and you have Canadian economic under performance over that period if you don't have rates pulling back. When rates pull back, that headwind subsides a bit, growth is able to pick up because people don't have as much money flowing into their mortgages. But absent that, it is this headwind that is not going away anytime soon.

It is weakness, yes. What does that mean for the bank? Well, it should mean more dis-inflationary pressure, so downward pressure on inflation. We haven't seen that necessarily, not in a big way at least. Inflation's been coming down. Maybe January reflected that, we're going to get a Fed next week. I have a super estimate for February, admittedly, but it's fully dependent on discretionary items. You had huge price declines in December and January on discretionary items like clothing, like travel tours. They usually bounce back in February and in pretty big size. We'll see if that happens again, or if the weakness in the consumer keeps them from being able to raise prices as much as they have historically in that month. The big estimate I have is based on those things rebounding, but I don't rule out that they just won't be able to raise prices as much as normal. Also, I was very wrong on January CPI, so a little bit gun shy on that front.

Darren Campbell:

Just to challenge that point that you made earlier. What you're suggesting is a fairly orderly adjustment, and I guess to challenge that, you have an interest rate sensitive economy where you've abruptly raised interest rates 400 basis points.

Ben Reitzes:

475 basis points.

Darren Campbell:

475 basis points. You're suggesting that we can just adjust to it, that it's just going to be a fairly orderly adjustment by the consumers. Yeah, it'll remain weak but that there's no cliff.

Ben Reitzes:

It doesn't seem that way. I don't know why there would be. Rule of thumb, and this is not right but just rule of thumb, 20% of market just reset every year. You would have this steady stream of resets coming. But you have to keep in mind, if you had a five-year mortgage, you also have five years of income growth. Your income is larger than your mortgage payments. I really hope it is at least, for everybody. If your income's rising at three, four, five percent a year, give or take, the compounded growth rate of that is north of 20% over five years. Well north of 20% if it's 5% per year. Your mortgage payment, even if it doubles, your income is still likely going to grow more, you'll still have more disposable income at the end of those five years than you did at the start of those five years, likely. Not for everybody, but for a lot of people. It's important to remember that math. For others, it's going to be far more challenging. Variable rate folks are in a much more challenging situation, admittedly.

I just don't know why we need to fall off a cliff. From a US perspective, they've raised rates over 500 basis points and yeah, there's some cracks here and there, admittedly. Regional banks, commercial real estate, there are problems for sure. But consumers' hanging in there and that's 70% of the economy, and hanging in there pretty well so far at least. We'll see if that continues. Which then, bigger picture and for both sides of the border, and you can take this globally also, it's okay, well we've raised rates a ton over the past couple of years. We need it matters to some extent, you've seen some cooling, the economy's not quite as strong as it was as when they started raising rates. But maybe rates aren't as important as we think they are. Maybe central bankers are not the superheroes that we thought they were. Maybe fiscal policy matters more than central bank policy. The fact that we've hung in there so well is because fiscal policy's still pretty darn loose, and that really what matters at the end of the day.

If you go back to the prior 15 years, 10 plus years post crisis, when the economy was weak forever and inflation just would not go up, maybe that's because governments were tightening their belts the entire time and just not loosening at all. Maybe central bankers just aren't as powerful as we thought they were and rates don't matter as much as you think they do.

Darren Campbell:

Which is a nice segue into the provincials. Provincials and the increased deficits is a major area of focus at the moment, and a lot of investors asking questions around what this means for credit spreads, and people trying to wrap their head around future issuance. The main takeaway is that I think a lot of provinces are going to need to diversify. They're going to need to be looking at outside of Canada to be financing. We expect that. We have the Ontario budget coming up in just under two weeks, I think. Once we get past that, we've had Quebec. I think that's definitely a theme that will be front and center, and will have implications for the swap market, so we're paying attention to the potential pay flow that comes in on the back of that and could provide a little bit more support, a bit of a base to spreads at the moment. We like swap spreads. Expect some of that to probably be biased a little bit further out of the curve.

The big question is do you see the mortgage market rate night, do we see that happen? I think the longer that the bank can hold the line, the less likely that is. I think that if it becomes clear that the bank is going to be forced to do something sooner than later, call it the summer, than people might feel a little bit more comfortable to start stepping in. That could lead to that fairly robust mortgage pay season in Canada.

Ben Reitzes:

You already saw that in the winter-

Darren Campbell:

Right.

Ben Reitzes:

When they were done, it was like, "They're done?"

Darren Campbell:

Exactly.

Ben Reitzes:

Rates rally and people jump right in.

Darren Campbell:

Exactly. But if it's inflation sticky, bank's still very patient, then I think we're just not going to see that pay flow materialize in the front end of the curve in Canada. That suggests a steeper spread curve in Canada. We're paying attention to that theme.

As far as credit spreads generally, again it's the provincial spreads, the standard is very good value. I think what we've seen is, even on the back of the Quebec budget, there's dip buyers. There's people who are just waiting in the wings and happy enough to be stepping in on a couple basis points of weakness, and not concerned about the big picture economics of a province like Quebec. Yes, these are big numbers but it's a stable enough economy that comfortable holding the credit. But a lot going on in that space and it is interesting to be tracking that theme.

Ben Reitzes:

Yeah. I am very curious what we get out of Ontario, if they post worse numbers. They already widened their deficit forecast in the fall and increased their issuance forecast in the fall, so we'll see if they actually get worse than where they were. There's no way they're not suffering from the same things the other provinces are. Higher costs, slower revenue growth, those are unavoidable. We'll see how much of an impact that has, relative to what they said in the fall. Probably somewhat, but it probably won't be as drastic as what we've seen from Quebec. Again, if they were impacted as well, maybe it highlights that the relative cheapening we've seen of Quebec and BC for example, against Ontario, maybe that's run its course for now and things can stabilize a little bit.

One of the big questions is whether all of this provincial issuance, and I'm going to touch on the macro side of this in a second, but whether all this provincial issuance is more impactful on spreads, or on curve, or on outright rate? Or curve, either way, I guess. Because you're going to get a lot of long issuance out of provinces, more than you've seen in a long time. The most since COVID, for sure. I think outside of COVID, it'll be the largest issuance year ever. That means a lot of 30-year bonds, even if they do look abroad, which they will for a decent amount. Is that worse for spreads or is that worse for rate?

You're going to have Canada, also. We don't get the Canadian budget for another month, but I'm expecting issuance to be about in line with what we've seen in the first quarter of this year. Which is the fourth quarter of the government's year, but the first quarter of the calendar, which equates to about 244-ish billion in bond issuance for the year. Which is up a lot from last year, but it's clear that the market can handle it after we've done pretty well in the first quarter here. I don't know what the answer is, but it's a good question out there, and I think one that is definitely floating around.

Darren Campbell:

It feels like it's going to mean more for rate. There's a lot of focus, from the leveraged account base on the CAD US spread, that's hard. I think it's difficult to be expressing the view that way. You either look at it and say yes, this is a lot of supply coming and thus, it means for probably a bit of a steepening bias in Canada on its own is probably the right way to be thinking about it. We've seen Canada move that 10s30s box versus the US has moved for sure. It's moved on the back of some of these increased budgets. That's been a knee-jerk reaction. It's hard to not see that huge amount of supply, especially when you factor in some of the out-sized demand that you saw for the long into Canada through the back half of last year, which I think it's hard to bet on something like that reemerging. Without that, and just enormous coming through, it's hard to not see pressure on the back end in Canada.

Ben Reitzes:

I'm with you there. I noted when I started that I'll touch on the macro part of this provincial side of things. If part of the reason that the budgets have deteriorated is because spending is higher, some of that is wages. If you translate that in onto the macro side, that's just more support for the economy. It's just more folks with more money to spend, and one more reason why we're not going to fall off a cliff because guess what? Government spending matters. It's more stimulus, it's never ending.

Again, the Feds are not going to be backing off. I expect the deficit probably about in line with their earlier projections, so not more, not less, but in line. But the province is more and that means more stimulus, so one more reason why Canada hangs in there. Not to mention population growth is going to stay strong. I don't think as strong as last year, still strong. One more reason we don't fall off a cliff.

Darren Campbell:

And probably another reason why inflation can remain fairly well-supported, fairly sticky.

Ben Reitzes:

Relatively, yeah.

Darren Campbell:

One thing we have seen is demand for real return bonds in Canada. It's a product that most had assumed was dead and we see a lot of activity in real return bonds. It's not the regular day-to-day activity, but it's big positional shifts that we're seeing. Structurally, accounts might be moving out of it for various reasons, but there's a lot of buyers who are looking at this product, that are patient on entry, that can build up a position. We're seeing a demand from a number of different fronts for that product. It is notable and it's definitely something that has flared up a little bit more over the last couple months, as you've seen some of these inflation prints hold in.

Ben Reitzes:

Yeah. They're cheap. Anyone that can hold them and hang onto them for a long period of time, they're cheap. It's not easy to get in or out, but it's cheap. Because of that, even if you're paying a bit of a premium to get into the product, if your horizon is years, they should perform pretty well especially relative to nominals, when the risk to inflation is, on the medium term, on the upside as I've been known to say many, many times. My view there hasn't changed. Still secular versus cyclical, cyclical I still think probably lowered, but secular is going to be pretty strong. Yeah, that's one reason why that product is attractive.

By the same token, one reason I think the curve should be steeper here generally, the nominal curve, given the risk to inflation over the medium term and how flat the curve is right now. It just doesn't make a lot of sense to me, generally. If central banks aren't going to be cutting aggressively, that steepening has got to come, at least from some extent, from the long end duration selling off. That's something that I stare at every day, and scratch my head, and wonder when this is going to happen. It doesn't seem like it's a now thing, but again, all that debt, US government, provinces, you name it, it doesn't matter who, everyone's issuing lots. I guess at some point, maybe we do have some kind of reckoning. Don't know when, but it's got to be a risk.

Darren Campbell:

Agreed. Can't argue too much with that.

Ben Reitzes:

Yeah. It's a tough environment though, when you're waiting for central banks to cut, or inflation to fall, or inflation to rise. We're waiting for something to happen and we're all middling. Inflation's not too high. It's still higher than target, but it's not accelerating by any means so it's not four, five, six percent anymore. But it's not low enough yet for them to cut. We're still seeing good enough demand on the duration front, because there are still more than enough investors afraid of some kind of downturn, be it from commercial real estate, or regional banks, or in Canada because the consumer, or housing in Canada, whatever it is. It makes for a very challenging environment. This is not an easy place, no one said it was going to be easy, but this is not an easy environment to be investing in.

There's a lot of thought needed, at the moment, on how to position yourself. Obviously, we're always here to talk to folks about that but it's not like we have all the answers either. But I think you work through some scenario analysis and go through what all the possibilities might be, and you can get to a place that at least you're a little bit more comfortable with.

So, Darren, before we wrap up, a couple of final thoughts from me and then I'll give you your say. The bigger picture, the bigger takeaway here is the markets’ in a tough spot. We just meander back and forth, not small range, but still range beyond generally for rates as we just get chopped up by the data going both ways. You get a good inflation number, then a bad inflation number, then a mediocre jobs number which has something for everybody if they want it, downward revisions. Other pauses, maybe wages are higher, or this, that, or the next thing. We just can't get a big theme to really drive direction for the market, to really drive trading generally, and have anyone have really meaningful conviction in their views to really drive things. That's how I see things at the moment. Just again, a challenging environment. You can rebut me or not, I guess. What are your final thoughts here?

Darren Campbell:

Yeah, Ben, I agree with everything that you've just summarized. I think that, given that backdrop as we've spoken about through this entire podcast, it's hard to have conviction. We thinking positioning is light. I think that the one thing that does still stand out is probably some out-sized positioning in steepening style trades and it's just something to be aware of. I think that if there's a catalyst to push the curve flatter for whatever reason, it could lead to a final flush in some of those positions that have been held onto and could provide an opportunity for those people that are looking to get the trade on. I think that's just one thing to be aware of because it feels like there was so much attention, so much positioning, a lot of that came off but it's still one of the risks in the market and something to be paying attention to.

Other than that, agree with everything you said. Thank you for the opportunity to join.

Ben Reitzes:

Thanks for coming on, Darren. Very much appreciate it.

Darren Campbell:

Thanks, Ben.