Avoiding market complacency

Keith Rofrano: Welcome to Markets in the Middle, a podcast series dedicated to delivering you insights into the current economic environment with specific focus on interest rates and foreign exchange and what it all means to the middle market segment. I’m your host, Keith Rofrano. I am joined by my colleagues Ian Pollick and Bipan Rai from the Fixed Income Currencies and Commodities Strategy Team at CIBC Capital Markets. It is more important, more important than anything, that when we think about market risk, i.e. the things we cannot control, that we put them in the framework of using data and figuring out where that data potentially has an impact on your business. And so when we develop hedging plans and when we start working with our clients, it’s all about risk mitigation. It’s great to be back together again. It is August summer. I hope everyone has had a chance to relax and spend some time with friends and family and hopefully a lot of outdoor time regardless of any wildfire smoke issues and just find some time to dial down a bit. As great as that is, as inviting as that sounds, the risk to hedging and best practices around hedging is that it invites complacency. So complacency as we see it in today’s environment is really just a lack of plan. And it makes sense, like why would there be a lack of plan? Well, there’s been some confusing signals, right? The Fed says one thing, market pricing says another. You have the aftershocks of supply chains. You have this constant repricing of some labelled definition of a recession. Are we going to go into one? Is it going to be light? Is it going to be a soft landing? Et cetera. Et cetera. So it just sort of creates this question mark, what do I do, if anything? Well, it sort of starts to feel safe to do nothing. And so what we want to talk about today is we really want to push against the doing nothing. And so doing nothing is literally just letting the market happen to you. And so doing something or, you know, not being complacent is pretty simple. It starts with just starting to assess the data and have a really healthy dialogue with your banking partners about what is the risk that I’m actually facing. And so we’re here to do that work for you. It doesn’t necessarily mean that you’re going to go run out and lock into a hedge, but it does mean that you’ll be equipped with the information and most importantly, be equipped with what is the worst case scenario based on certain market conditions that would be painful to our business. And our job, our sole job, is to clip that out of the equation so that anything you’re left with from a market perspective is something you can live with. So let’s talk a little bit about rates. We’ve got a lot of clients who feel like they’ve sort of missed the boat and they’re waiting for rates to come back down and maybe lock into the next round of hedging. First up as usual, is Ian. So Ian, could you help us make sense of the market as you see it?

Ian Pollick: Absolutely. And so thanks very much for having me on the show, Keith. It’s great to be here. And you’re absolutely right. I think you’ve gone through this environment where several times, at least in 2023, we’ve heard a lot of clients talk about the peak in interest rates only to see another subsequent 30, 40 basis point increase in the level of yields. If you take a step back and say, well, what’s going on right now? What is the difference today from three months ago or six months ago? And I think the most obvious is that you are inching closer to the very end of the rate hiking cycle. We see the Federal Reserve raising interest rates one more time. Other central banks like the Bank of Canada, we see them raising interest rates one more time. And that’s the key word, just once more. But what I think people are forgetting is this idea that even though you’re in a world where maybe terminal interest rates are getting very close to their peak, the real hard part of the story is trying to understand where interest rates will settle once the easing cycle begins, but also when that easing cycle begins. And we’ve talked about this all year, Keith. We saw interest rate cuts priced for June during the SVB collapse in March. We’ve seen subsequent market rallies which have brought forward interest rate cuts into 2023. Now, for the most part, most of that pricing has pushed out into 2024 and 2025. But there’s a lot of bifurcation globally. In a market like Canada, the first interest rate cut isn’t priced until the very end of the year, whereas in the United States you have midyear cuts being priced. And so this is obviously creating a bit of confusion for people. And I think the source of it is this idea that even though headline CPI is declining, that doesn’t necessarily mean that we’re out of this concern that you have structural sticky inflation. And so when you talk about complacency in the market, I think a big concern I have is complacency around the idea that we have reached peak inflation and that we are on this autopilot towards this magical beacon, towards that 2% target. And so to cross off the right hand side of the distribution really ignores some very key facts that have been happening lately. Number one is we’ve all seen the move in energy prices, energy prices, gasoline prices have rallied almost 10% in the last month. That is adding to our CPI estimate. It’s raising our full year estimates. We know that globally we are seeing many different types of strikes in many different jurisdictions that reinforces or reignites concerns about supply chain disruptions. And all the while we have a very tight labour market. And so to be complacent on the level of interest rates means you’re also complacent on the idea that you are heading to a soft landing in the economy and that we don’t have to worry about inflation. And I have a really hard time reconciling that with some of the facts that we’re seeing on the ground, Keith.

Keith Rofrano: Yeah, we experienced a little bit of that last week with some client feedback where we talked about the sticky parts of inflation and yeah, I mean, it’s been a fun ride from, call it 8 to 3%, but what about the next leg? And so when we listen to our clients, they’re telling us, you know, what is still sticky? Labour costs are still sticky, things like freight costs, although they’ve come down, but they sort of levelled out and still in their minds thinks that there’s room to go, but it’s still sort of stuck. And then the last is supplier discounts are, you know, they’re reluctant to give those discounts though. So where people have increased prices and have been able to sustain or pass through, it’s not exactly elastic on the way down as it was on the way up. And so that’s still out there. We know that that’s still out there. And so when we try to think about, how does that transform into the market? And I want to go back to something you said earlier, Ian, and maybe reinterpret a question. If we think about where the market and the Fed aren’t necessarily in agreement, right? Is there a risk that at the moment and this risk is a good thing for clients, I assume, is there a risk that the market is interpreting any kind of pause as a sure signal that cuts are coming?

Ian Pollick: Oh, I think so. And I think it’s very natural in the world where you’ve gone through such a rapid tightening cycle that we’ve seen over the past two years. When the central bank says that they’re chilling out, they’re taking a pause. Your natural inclination is to think, well, maybe this is the last interest rate hike. And therefore, if it’s the last hike on the way up, we need to start thinking about what the other side of the cycle looks like, which is the start of interest rate cuts and where those cuts end. Now, one of the things that I often remind people is that regardless of where inflation is, you need to have some interest rate cuts priced into the curve. Because think about it like this, Keith. In a world where we only live with real interest rates, so the difference between a nominal yield and headline inflation, as inflation falls, that real interest rate gets more restrictive. And so one of the jobs the Fed has in 2024 and this is a very tough communication challenge, is to actually cut interest rates just to stand still. What I mean by that is if the Fed believes there’s a certain amount of basis points that they need to be above whatever their estimated neutral rate is, in real terms, inflation is going to fall and therefore your real rates are going to rise. To avoid any undue tightening in the economy, you have to cut rates. But that cutting rate is, like I said, it’s just to maintain the same policy stance. And that is not what we’ve seen in prior cycles. It is not a function of a concern that the economy is deteriorating rapidly. It’s really just to maintain this higher for longer environment. And that’s really what restrictive policy is all about.

Keith Rofrano: You know, we’re not talking as much or it seems like we’re not talking as much about QT over the next year or two. How do you reconcile that?

Ian Pollick: Well, I want to take a step back for a second, Keith, before we talk about QT. One of the things that I think everyone needs to be aware of is that over the past several weeks, there has been a very subtle sequencing of events that puts a brand new risk into the bond market, and the risk that it introduces is very reminiscent of the bond vigilante movement from the early 1980s, where governments were punished for having too large deficits. And what that does is it engenders a lot of weakness into the very back end of the yield curve. And I mention this because typically you would associate a steepening term structure with lower policy rates, with an environment where the economy is deteriorating. But what if I told you could be in a situation where the Fed hasn’t cut rates, the yield curve can steepen with interest rates rising. You know, that is not on many people’s bingo card. And so let’s just really talk quickly what that sequencing of events look like. First, you had normalization coming out of the Bank of Japan. You know, the Bank of Japan is perhaps the most heavily intervened bond market in the world. Indications that the Bank of Japan is starting to loosen up its grip on the bond market means that Japanese yields are going to rise. And so why does someone in the middle of America care about that? Well, because it’s going to shock the entire global duration complex. On top of that, you’ve had discussions from the Bank of England who are talking about increasing the pace and the size of actively selling down their bond portfolio through more active quantitative tightening. That’s another channel that disrupts the back end of the yield curve. But then you had, for example, the Reserve Bank of Australia, who was the first developed market central bank, to explicitly say we are choosing to preserve growth over concerns about inflation. And so in a world where you have trend like growth, above trend like inflation and a central bank that’s telling you they’re unlikely to hike again, all of that concern, all of that volatility has to be transmitted to the very back end of the curve. These are very new developments. Add on top of that, we had a US downgrade last week. We had a larger than expected Treasury refunding announcement. And so, again, these are the type of developments that rebuild your term premia. It puts a huge amount of weakness into the back end. And so to bring this full circle, when you’re thinking about quantitative tightening, all that does is it drains deposits somewhere in the system, it reduces liquidity, and therefore more and more issuance has to be shouldered by the domestic public. They’re going to demand a concession.

Keith Rofrano: And so that is what you see as a potential kind of macro catalyst to a curve steepening?

Ian Pollick: Absolutely. And that is not what we would normally associate with the type of steepening of the term structure that we usually talk about at the end of the cycle.

Keith Rofrano: Okay. And do you have a time thought on that, Ian? Is that a six month evolution? Is it a one year?

Ian Pollick: Look, it’s not in my base case and I don’t think it’s going to stick. But if it did stick, then what we’re talking about has already started, you know, and this is something that it can creep up very quickly and then linger. And it’s kind of the reverse of what a normal steepening cycle would look like, where you slowly see the curve start to steepen as you get closer to interest rate cuts and then you maintain there for a while. This could be the reverse operation or the reverse sequencing. So if it happens, it’s going to happen now. Now, I’m not fully convinced, but we need to talk to our clients about these risks.

Keith Rofrano: And so exactly what you said there is the fight against complacency is if it happens, right? And so today we’re sitting here with a market. If we look at hedge rates, whether it’s a three year or five year swap against current spot starting interest rates, there is a significant advantage and that is the discount in the curve. And so while I said earlier, it is very healthy to have a view, it’s healthy to debate the view, it’s not so healthy to not have a plan. And so when we look at today’s environment and we’re talking with clients who are feeling like they’ve missed the boat, I guess we would argue you really haven’t missed the boat. There is a discount in current hedge pricing and it is something that could go away. We’re not saying it will, but it certainly could. And as you’ve just pointed out, Ian, it can happen pretty quick.

Ian Pollick: Well, I mean there’s a couple of ways to think about this, right? We are living in a world where you have extreme and significant inversion in the term structure. And so what you’re supposed to do, even if you believe interest rates have peaked and that they will fall, because you have such a wide differential, by moving further out the yield curve, you are literally being paid to put on a hedge and it provides a huge amount of buffer for any rally that you see in the interest rate market. Those are much easier discussions to have.

Keith Rofrano: Excellent. It really is an amazing time. And you had mentioned something earlier that really was about a tradeoff between inflation and growth. And you also mentioned several other central banks. And actually I think that’s a great entry point into bringing our friend Bipan into the discussion and talk about how does the US dollar in terms of how do other participants globally look at this balance between inflation and growth? Before I do that, though, I must say we are in the presence of greatness, and I have to congratulate my colleague here as being the number one globally ranked forecaster of dollar CAD for the second quarter, that award given by Bloomberg. So, you know, virtual claps and high fives abound for you, Sir Bipan.

Bipan Rai: Thank you so very much, Keith.

Keith Rofrano: But the pressure’s on now. What are you going to do in the third quarter, right? The pressure’s on.

Bipan Rai: Absolutely. I’m glad you mentioned the relative inflation and growth dynamics and how they’re playing out globally. And really that’s going to be the prism with which, you know, not only do we characterize central bank moves, but also, you know, by extension foreign exchange movements as well. And again, don’t forget, you know, when we look at exchange rates, we’re really looking at relative valuation and, you know, this sort of environment with inflation being this high, it’s really all still going to be very much about the relative speed of the different central banks. So, you know, I mean, Ian spoke a little bit about what to expect from the Fed and the Bank of Canada next year and what the market is pricing in. And he’s right to a degree. I mean, from a currency lens, you know, where terminal rates are, I mean, we’re pretty much close to them. That’ll become less of a factor, you know, we suspect. But, you know, in the near term, you know, we do think that there is some meaningful two way risk to incoming data that maybe the market isn’t paying enough tribute to, which does skew the risk reward, at least in the near term, towards further US dollar strength. Now, when I say that, of course I’m speaking against some of the other major currencies out there, including the euro, the pound sterling, the Japanese yen and the Canadian dollar. But over time, and I think this is going to be very relevant for our listeners looking, say, 12 to 16 months out, I mean, I think it’s, if you do have exposures outside of the country in terms of sourcing materials or other goods that are demarked in other currencies, you know, maybe you want to use this US dollar rally to potentially look at hedging because over the next 12 to 24 months, we do have a downward profile for the US dollar. And again, that’s going to be driven not just by central bank expectations and what’s priced into the curve, but also some of the other major themes out there, including quantitative tightening and, you know, to the point or the degree of which that is not, or at least the slowing or stoppage of quantitative tightening is not necessarily being factored into current valuation when it comes to the US dollar. So that’s a significant risk factor that I think our audience should pay a little bit of attention to and we think that’s going to be a theme that comes into sharper relief potentially towards the end of this year and early next year.

Keith Rofrano: So where do you see the complications, the biggest threats to a forecast right now? How would you describe those?

Bipan Rai: As banal as it may seem? I mean, we still do have to pay attention to the incoming data. We’re at a point now where we could be looking at a generational shift in the way that labour markets are transitioning. I mean, we’ve got a significant number of retirees and not enough people to replace them. Inherent uncertainty premium when we’re talking about central banks and currencies and interest rates as well.

Keith Rofrano: So one of the things we also talked about a bit with Ian was the concept of real rates. How do you look at real rates in the FX market and how do you see that playing through for the balance of 23?

Bipan Rai: So if you look at what’s, you know, at least for the balance of 23, we do disagree with the whatever is being priced in terms of central bank rate cuts. We don’t think they’re at all a story for the end of this year. And as a result, I don’t think, you know, foreign exchange movements are really going to take any sort of cue from there. It’s, you know, once we hit terminal and I think it should become more and more clear that we’re at terminal for a lot of the major central banks by this fall. At that point, we’re going to have to pay attention to what’s being priced into the curve further out towards the end of 2024 in terms of rate cuts. Now, it does feel like there’s a significant amount of easing priced into the US curve and we do think that some of that does need to be taken back and it could emanate from stronger than expected data. But if we do see, say, for example, the degree of easing moderated a little bit in the US curve, that should translate into some near-term residual US dollar strength against some of the other currencies where we probably don’t see enough priced in in terms of easing. But, you know, real rates are going to be important insofar as the way that the curves are pricing them out to 2024 really reflecting the nature by which each central bank is making progress on its inflation mandate. And again, that’s going to be an important theme for currencies for sure.

Keith Rofrano: So it’s very interesting, as we talked about, like the theme of this whole discussion is around complacency and avoiding complacency. You know, when I take a look at FX volatility, particularly the currency pairs that our clients trade mostly in, which is CAD euro sterling, some of the peak of vol in 22 till now, it’s literally cut in half, right? And so it certainly, it just invites complacency. It invites the thought around stability in the market where, you know, stability is certainly not something that can be trusted in the FX market. And I know that we’re not quite into the planning season for clients yet, but that doesn’t negate the fact that we really need to take a look at exposures and think about not if but when Vol picks back up. How could that negatively or positively impact your business and then develop a plan around there?

Bipan Rai: Absolutely. And I think this is the point that the volatility cycle where everyone gets complacent and everyone sort of pushes out the decision making to when Vols actually do pick up. But, you know, one thing I do want to emphasize to our listeners is that when we’re talking about volatility, especially in the foreign exchange asset class, it is cyclical. I mean, this decline that we’ve seen, I mean, if you’re betting on a structural change involves lower, the chances are extremely high that you’re going to be disappointed. And again, you know, one of the things that I’ve been highlighting to several clients that I’ve spoken to over the last little bit is that this lull in volatility is to be expected because we’ve got a high degree of coordination when it comes to central banking policy. It’s really the points at which we start to see material deviations in the way that central banks are moving, which is when FX volatility tends to pick up. Now we expect that’s going to be a story potentially next year and that’s going to be reflective of how each central bank has made progress on its inflation mandate. You’re going to get relative or at least divergences in terms of relative speeds between the different central banks. That is fertile ground potentially for FX volatility to pick up. So again, you know, use this opportunity to plan ahead, but don’t get sucked into the view that, you know, this lull in FX volatility has a structural element to it. I don’t think that’s the case at all.

Keith Rofrano: Agreed. I have to ask Bipan because I am talking to the world champ of forecasting right now. Where do you see if you had to pin that tail to the donkey? Where do we end up Q3 dollar CAD?

Bipan Rai: Well, you know what? Q3, we’re actually expecting a slight uptick in dollar CAD, and that’s based on a couple of themes that I’ve already touched upon, one of which is, you know, the market is underestimating the degree to which the US data could strengthen. And right now, the way that the US curve is priced, I would argue that you could probably see at least one more hike fully priced in and that should take the dollar higher against the Canadian dollar by the end of Q3. Right now we’re expecting a level around 133. You know, could that move up to 134? Potentially. But I think the important message, Keith, over the medium to long term is that’s the level potentially to look at locking into hedges if you’re exposed to Canadian imports. From there, we’re still projecting a move lower in dollar Canada, potentially to as low as 128 by the end of 2024. I would even dare say that the risks are below there, and that’s going to be a story primarily driven by US dollar weakness.

Keith Rofrano: Excellent. So like I said earlier, first of all, thank you, Bipan, thank you for giving a very specific answer, that maybe we close on this point. It is more important, more important than anything that when we think about market risk, i.e. the things we cannot control, that we put them in the framework of using data and figuring out where that data potentially has an impact on your business. And so when we develop hedging plans and when we start working with our clients, it’s all about risk mitigation. And so, you know, there’s plenty of things we can’t control out there. But one thing we can control is how we plan, how we organize and how we develop any action against, you know, negative or adverse market risks. And I can speak for any bank on the planet. We love when our clients think about risk mitigation for the things they can’t control. And you know, ten times out of ten, particularly CIBC clients, they’re very thoughtful when they put their mind to this. And so we’re here to help on that. I would encourage you very strongly to reach out to your bankers prior to going into your planning season and make sure that we’ve got a good organized, healthy discussion around market risks. So, Ian, Bipan, thank you.

Bipan Rai: Thank you.

Keith Rofrano: Thank you again Ian and Bipan for joining me on this episode. Please join us next time for a fresh perspective on the economic environment and how it affects the middle market and most importantly, what you can do about it. I’m your host, Keith Rofrano, and this is Markets in the Middle. Thanks for listening.

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