Big conversations in the short-end

Ian Pollick: One of the things that you have done exceptionally well this year, other than get very, very good breakfasts on Fridays, is you’ve called the inversion between spot for OIS and kind of IMMs very well. All right, happy Monday, everybody. So we kick off the week. It’s a pretty big week ahead. We have the jobs reports at the end of the week and we’re going into Bank of Canada blackout. I’m joined today by my good friend. We sit next to each other on the trading floor, a newbie to the show, Brenden Donaher. Brendan, thanks for joining.

Brenden Donaher: Yeah, no problem. Thanks for having me, Ian.

Ian Pollick: Absolutely. Has a really nice, I’ve never been on a podcast voice before. OK. (laughs) So let’s just calm down. Let’s talk about what we think is going on. And where I want to start today is I want to understand from your perspective, and for those of you that don’t know Brenden, trades are short end with Todd Richards. And what I want to understand from you is Bank of Canada pricing, going into the meeting, we’re not at 50% chance, I think, of pricing a 50 basis point move. What from your perspective over the past, let’s say 2 to 3 weeks has changed in terms of just near-term OIS pricing?

Brenden Donaher: Sure. So I think to take it kind of back a step and talk about kind of where we’re going, I think the important thing is think about how far we’ve actually come and what the bank’s done. And the messaging change kind of occurred at the last meeting was a function of a few things. And going in now we have about, kind of 35 or 30 ish just around there, priced in for the next meeting, which is actually kind of fair, I think. The BoC has taken a lot already back. They’ve already taken a lot into the market. And I think when you actually kind of think about what’s left to do, the toss-up between 25 and 50 doesn’t really change the whole story that much.

Ian Pollick: So let me ask you this, because, you know, you went into the October meeting. Obviously, it was a disappointment in terms of what was delivered. But the immediate impact was interesting because, you know, you didn’t have a huge movement in the out dates in 2023. You kind of had it supplemented by some relatively hawkish Fed speak. And so you actually had kind of your late 2022, early 2023 meeting steepen. And remember, we had that Dec April trade on put on at 15 and kind of busted past 30. Let’s do a scenario analysis, OK? In the event that you get 50 next in two weeks’ time or next week. And the messaging doesn’t sound like they’re done done, but they’re shifting potentially to 25s, what needs to get repriced in the gaps in 23?

Brenden Donaher: So I think in that event, which is I actually think quite likely is you end up with some marginal increase in terms of terminals overall. But the actual structure of the meetings probably doesn’t change that much. You probably take some of the March, you say, okay, we did a little more in Dec than we had priced in, so you take some out of the back end and we’re talking marginal things here. I think, Jan to March, you maybe price in three or four basis points versus kind of 6 to 10. And then after that you probably just leave the curve kind of flat.

Ian Pollick: So like March, April zero?

Brenden Donaher: Yeah, exactly. Which I think is not necessarily unfair. You know, you have a point where I do think terminals will remain higher, but the whole story about cuts still doesn’t really make a ton of sense to me. So in terms of near-term kind of next year pricing, the risk, I think, is you either just kind of sustain higher levels and you take out the cuts, which is more of a kind of a late 23 thing than anything. So those gaps are probably pretty fair in the next six months. What’s going to happen, I think, is your 23 24 gaps. Those have the risk of steeping back out of potentially or at least have less of those inversion trades price.

Ian Pollick: So let’s talk about the other scenario, OK? So let’s say they go 25. And to me, you know, 25 in a weird way, would almost signify that they’re much closer to being done than 50, I think. And so in a world where they do 25, how would you perceive, let’s say, Jan, March, March, April, April, December to trade?

Brenden Donaher: Yeah. So that’s where I do think you take more out of the near term meetings in that sense is that exact point. We’re now entering this phase of tweaking more so than high end rates, right? We’ve done a lot of heavy lifting. We’ve seen a lot of adjustments globally, not just in Canada, which does have knock on effects to our currencies as well. So I think what that leaves you with is once you get to this 4% level, it’s kind of starting to just see adjustments coming through and less so about these big monster hikes. So if they’re happy to go 25, to me that is them saying, you know what, we’ve done a lot. We want to wait and see what happens and we want to see how the market develops. They always talk about these lags and monetary policy operating with a lag. So if they go 25, to me, that’s them saying we’re not worried as much as we were.

Ian Pollick: Okay. And so let’s talk about this just to frame the conversation. When we think about the distribution of cuts priced into the curve, right? So last check, this is all kind of a Z3 story and then you reach kind of a critical point when you get to kind of H4. Is that still fair or?

Brenden Donaher: Yeah, and I think that’s two fold in the sense that that is predominantly, I think, a function more so of duration mechanics and duration bids and anyone kind of sitting there going, this is the pricing we expect. If you look at what’s happened in Canada over the last couple of weeks, a lot of it has been fueled by US curves. The US front end curve, a popular trade was to be in steepeners. That has not really panned out. So there’s been a very strong front end money market flattening response post CPI. That has fed its way into Canada, which has put pressure on that late 23 part of the curve. So I think that causation is more of a material driver of that part of the curve than the actual kind of absolute rate pricing.

Ian Pollick: Yeah, because you and I were looking at kind of these H4 flies and we’re like, why is this priced this way? And then we’re like, oh, wait a second. Maybe this has something to do with proximity to the US election? All of a sudden you’re talking about a potential change of the guard back to the old guard in 2024. And so maybe this is more of a duration story than it is a pure policy story. And so that’s hard, right? Because that doesn’t mean revert as fast. And it’s hard for you to get too cute from an RV perspective to trade that out.

Brenden Donaher: And I think the other side of that, too, is people aren’t comfortable with this level of rates. I think there is a general market consensus over the past 15 years or so of a QE environment where zero rates were kind of a gravitational point. It was always getting back to zero. That I think will change, and I think that needs to change. But there still seems to be the rhetoric or the momentum move into, rates aren’t supposed to be 4% or 5%. They’re supposed to be 2 to 3%. I don’t necessarily believe that to be true, but I think that’s what some of the flows and the momentum right now is telling you, or at least what people are trying to give.

Ian Pollick: Oh, I would agree. Like when I look at, you know, ten years in CAD versus like three month funding, you’re the most inverted you’ve been in 20 years. And so let’s say on the downside, the bank goes 25 and you’re at 4% next week and CAD ten years are sub 3%, like these are very negatively carrying trades all of a sudden. And so I think it takes a lot to sustain the pressure or it takes a lot to keep rates down here. And it’s kind of like that beach ball underwater scenario where that initial pressure on global duration at a time when the front ends, I think better behaved or better price than it has been. To me, that’s a bear steepening move. And so that may be you get your reds green steepening, your whites red steepening. And so maybe that’s the near-term opportunity for those thinking about trading shorts.

Brenden Donaher: Yeah, and I agree and I think that it’s a bit of a waiting game or a patience game. I do agree that’s ultimately going to be the trade. And I think looking at those kind of absolute rates is more of a function of getting back to that kind of 4 to 5% range. You’ll need to have that occur for reds and greens materially steepen. But I do think if you can warehouse that risk and you can kind of lay into some of the momentum that we’re seeing, that’s a good opportunity to hold those trades into 23.

Ian Pollick: Yeah. So let’s just talk quickly our expectation for the bank. We do believe the bank goes 50 basis points next week. You know, you kind of look at the intermeeting period and a lot’s got on right? I mean, number one is the currency’s moved $0.06 to the downside, right? Dollar CAD was very close to 140. When we’re recording today, it’s kind of close to that 133 level. And there was that narrative where the currency is not going to behave, then policy has to work harder than the other side. It’s kind of a negative to the view that they have to go more. But against that, though, I would say you had a very, very strong labour market report. We’ll see what happens this week. But, you know, you basically unwound almost three months of weakness before. And the story there, we think, is that the weakness wasn’t necessarily real. It was more statistical, It was a lot of seasonal noise. And so it’s not that the CAD labour market is strong, it’s just not as weak as we thought. But that preexisting level is still one that’s arguably too tight given the level of policy. And so it has to do more. And then, you know, GDP numbers to me I think are going to come in much hotter. We’ve seen some of the very near term activity data. You’ve had upward revisions, you’ve had general beats to the consensus. And so that one and one half level, we’re actually tracking a little bit higher than that. Not to say growth is strong, but it’s not as weak and it’s this weakness in growth that’s helping to price the belly, the ten year sector. And so I just don’t know how the bank looks at recent data and believes that 25 is the path of least resistance. But against that you have CPI, right? And CPI did miss. There was weakness kind of in a lot of different places in the report, but from an absolute level it was still very high. So you kind of look at financial conditions, they’ve been easing a little bit in Canada. Net net, it’s one of those strange middle of the road meetings. I think. There’s nothing screaming in either direction, but I just cling back to this idea that in a risk management environment, you’re supposed to do more rather than less.

Brenden Donaher: And that’s actually a very good point. I was talking to someone about this yesterday, but I think the thing that the bank is more concerned about, at least from an inflationary standpoint, is an easier task to manage now. If you do more today and you take out inflation or take it back to the levels that you kind of are happier with, you can always take back policy later. If you don’t do enough now, it’s very hard to catch up to that, which is what we saw at the beginning of the cycle anyway. If you go back to when the BoC started, the whole conversation was should they have gone in Jan? Probably. When they were late to the draw, we saw this kind of catch up effect and it’s been difficult to maintain that. So I think that’s a situation we’re in where if central banks do more now, they’re going to have at least some ammo or some capacity to take that back in a large economic drawdown. Now, the other side of that is if you don’t do enough now and inflation doesn’t become under control or continues to remain elevated, it’s very, very difficult to catch up with that. And that’s, I think, the thing we saw early in the cycle that banks are a little more cognizant to prevent now. So in terms of trading that way, I still think you want to trade with a bit of a bearish view or a bearish bias to doing more. I think now you talk about the floor and rates being closer to like a three and one half to 4%, more so than zero bound.

Ian Pollick: You know what’s interesting though, is that, you know, there’s a God, I miss this guy. But ex-Governor Stephen Poloz was on the wires yesterday. What he said was trying to slow inflation with interest rate hikes is like trying to stop a car with bad brakes. It takes a long time to actually slow down and so you stand on the brake really hard. Well, then you’re going to cause an accident too. And so, A, I miss those analogies. You know, I didn’t appreciate at the time. But number two is, I mean, he has a point there. And I think what he is saying is that you’re still supposed to hike rates, but you’re not supposed to move so far into restrictive territory, but you’re supposed to hold those rates for a very, very long period of time. And that’s really consistent with our idea that whatever terminal rate they get to, whether it’s four or four and a quarter or four and one half, the timing before they ease from the last hike to the first cut is much longer than usual because that’s the only way that you can actually manage this. That’s restrictive policy.

Brenden Donaher: And I think the other side of that, too, is governments globally have kind of shown their hand and that I think any fiscal response mechanisms now will be of a greater magnitude, broadly speaking, which puts further kind of pressure on the bank’s ability to control things we want to see policy.

Ian Pollick: Well, let’s talk about how you trade this, right? So let’s say you’re in an environment where you’re one to three months away from peak terminal. Let’s say that peak terminal is below market pricing. So the bank stops. The bank’s on hold for a long period of time. So let’s say you invalidate the idea that cuts in late 2023 are real. Does the curve just shift everything to the right? How are banks going to trade this?

Brenden Donaher: I think so. I think the easy trade or the kind of high level trade is just remain short somewhere in the belly where you have that deep inversion price. That’s kind of, I think, something you put on. You kind of wait and be patient.

Ian Pollick: Where is that exactly?

Brenden Donaher: So I think like kind of the end of 23 is still a good point for that, because I also think you get a bit of a potential catalyst for a duration sell off, which I do think could occur broadly. I think going back to your point about Canada tens at 3%, that’s a slow moving trade in terms of a rotation of investment. But if buyers step away from duration and large scales, that will be felt across the curve. And I think that 3% level is starting to trigger some of that conversation in Canada tens and I think that’s something where you want some downside exposure to a duration shift as well outside of just terminal rates.

Ian Pollick: So let’s talk about this, right, because I think one of the things that facilitates this duration shift, obviously, is short end pricing and it’s just the movement of cash around the system. And so one of the biggest movements of cash around the system is year end. And when we think about just the year end turn, we’ve seen this huge repricing in Europe and the UK. So maybe walk us through what you’re seeing year end, what’s happening in Canada.

Brenden Donaher: Sure. So globally, That’s true. There has been decent repricing in terms of year end premiums. The US dollar funding is still relatively constrained. There’s still a decent global premium for US dollars right now. So I think there’s two kind of important ways to look at it. So step one is Canada has lagged the globe overall here. Our turn hasn’t really materially tightened. We’ve seen Europe and Yen, for instance, lead the charge and we’ve seen decent kind of dollar selling into those markets, easing up some of the costs there. Canada, we’re still quite rich or quite negative if you think about across your currency standpoint. A lot of that has been flow dynamics. What we’ve seen and what was I think a little surprising to us is there hasn’t been participants who generally have the ability to lend dollars into the market, buy cheap CAD, use that to fund their CAD operations. So namely Treasury types. They’ve been a little quiet right now. And so that’s led to a general lag in Canada participating in global basis tightening. With that being said, I still think it’s a fantastic opportunity and I think you will see people over the next few weeks start to come in and start to buy CAD and start to lend dollars into that system. I think reasons for that are A, now that we’re through Canadian bank year-end balance sheet to have a little more capacity, there’s a little less restriction on funding. Dollar funding on the SOFR side is still relatively expensive, but it’s a little more controllable now. So the overall capacity to do those trades is greater.

Ian Pollick: So let me ask you this, right, because one of the things that we’ve been talking about on the desk is just, you know, CORRA has been sitting about a basis point above target really since the last hike, right? And it’s been there every single day. And so you kind of look at some of the transaction data, it’s not clear to me that there’s a huge amount of catalyst there. Why do you think we’re so elevated and is that just part and parcel of this lack of flows that you’re seeing?

Brenden Donaher: I think that’s part of it. There hasn’t been large pressures in the repo markets yet. When these trades, particularly northbound, start to occur, that will continue to put more demand for Canadian repo. You’ll see guys have to do something with their CAD dollars. A lot of those dollars are still sitting at the BoC. When more dollars are out of the system incrementally, that’s going to put some downward pressure on CORRA. So I think those things will go hand in hand.

Ian Pollick: So let’s just talk about that, right, because obviously you think you take a step back and say, look, when you have a huge amount of excess settlement balances in the system, that pushes CORRA very low or puts downward pressure on it, you start QT, you stop doing active QE and then you get this kind of lift up. And so that kind of convergence that we had expected to occur, it did happen. We’re there. And then let’s look at the dynamics and let’s do like a mini preview for 2023. So we know that the bank’s balance sheet, you look at maturities across Government of Canada, CMBs, probes, corps, you have about, let’s call it 92 billion ish of maturities next year. Against that you have real time rail coming in early 2023. So you have almost 100 yards of cash that is going to be leaving the Bank of Canada’s balance sheet. That gets destroyed in the system, that puts upward pressure. You have real time rail that’s kicking in in, you know, five weeks. How are you thinking about when you look at FX OIS, for example, and you look at the current shape or even FRA OIS which is still deeply inverted, how are you thinking about some of those unwinding deleveraging dynamics in 23 versus spot levels?

Brenden Donaher: So I think there’s two sides to this and two things at play. So one of the things I’m broadly thinking is we’ll see elevated funding pressures or kind of funding spreads broadly going for the next few months. I think the movement of those balances is going to be somewhat of a slow moving target. I think things will take time to kind of manifest in the system. At the same time, you have a lot of US dollars kicking around now that can actually be bifurcated onto US bank balance sheets. In terms of stuff you look at, oh, there’s plenty liquidity in the RRP, for instance, that’s not really usable. So the dollar side is still going to remain quite constrained. And I think that will be more of a driver than the Canadian dynamics themselves.

Ian Pollick: So that’s a good point, right? Because the dollar is more important.

Brenden Donaher: And it’s not just that it’s more important. I think it’s the euro outlay globally will take time. You still have plenty of liquidity in the eurozone. You still have kind of relatively high levels of liquidity in Canada, in the US. So as those things start to transpire, you’ll start to see that movement globally, I think take more of a hold. But all those things will take time. And I think that’s the biggest thing is, I’m not expecting an immediate dynamic change with real time rail and things like that. I’m expecting the dollar side to really drive the equation more than anything else.

Ian Pollick: Okay. So the domestic factors are only marginal at this point in your mind?

Brenden Donaher: I think so.

Ian Pollick: So let’s just talk about a really home-grown fact that’s happening next year. We know June of next year your excess settlement balances at the Bank of Canada’s balance sheet, those get re included in your LCR. And so we also know against that there’s two things. Number one is there’s been a huge amount of bail in debt. You’ve had just an enormous amount of financial issuance this year. That’s the denominator. That takes care of a lot of it. But one of the theories that’s floating around and let me run it by you. So one of the theories is, look, you have proximity to CORRA first. You have BAs that are very close to be going away. There’s a gap that’s opening up in terms of supply in the money market. At the same time, you have these reserves that are going to flow back to the bank’s balance sheets being included in their leverage calculation. And the third point is that, as you were saying earlier, there’s a general shortage of dollars relative to what you would think there would be just given the size of the RP program. And so you marry those together. And the theory is that you have a collateral shortage that’s developing in Canada. You may have some HQLA rotation around that. You have a situation where because of the shortage of dollars, you’re less incentivized to bring dollars back into CAD and you still have ongoing funding needs from the bank. And so the way that plays out is that you have much more negative cross currency in the front end, but then you have bank issuance that gets brought back, which kind of keeps that two or two year, five year kind of spot level relatively high. So do you believe in this idea, number one, that you have a very steep cross-currency curve as you look into 23? And do you believe in this idea of collateral shortage or is this too premature?

Brenden Donaher: I think the collateral side is a little premature. The one thing, however, I’d say and it’s been a fairly popular trade and I think it still has decent legs, but to your point about more negative cross currency, we really like still being short or received forward starting cross currency pass the year end turn. I think the year end turn will be somewhat of its own event. It should be relatively well behaved. There’s going to be some dollar expenses, but as we get towards the end of the year, you should see that ARB kind of collapsed upon itself. However, I think that dollar demand will stay sustained. So something like an H31 year M31 year cross currency position, I think those make a lot of sense is that you’re kind of playing for a sustained dollar move or sustained dollar premium as well as just a relatively slow liquidity kind of position, if that makes sense, or liquidity drop.

Ian Pollick: No, that does make sense.

Brenden Donaher: I think it just takes time.

Ian Pollick: So what I’m hearing from you, though, is that you have these kind of mini themes that are developing in Canada. You know, we love to think that our short end matters for our short end, but in reality, it’s just a derivative of the US, right? And so you believe that the US is still more important and that these little mini teams in CAD are only incremental?

Brenden Donaher: Yes.

Ian Pollick: Yeah. Okay, that’s interesting. But let me ask you this, right? One of the things that you have done exceptionally well this year, other than get very, very good breakfasts on Fridays, is you’ve called the inversion between spot for OIS and kind of the IMMs very well. We did it in March, we did it in September, December to a lesser extent. So you take a pause and you say, okay, well spot is in that 55, 56 level. We missed the setting this morning, so I don’t know what it was, but you know, Dec looks about okay, but then you get into March and June, they still look very inverted. What are you supposed to do with that? Is this a continuation of the theme that we saw this year?

Brenden Donaher: Yes, so but I think to a lesser extent. March, I’m still a fan of I think the roll still looks good around ten basis points or so. To Dec, I still think there’s some opportunity there. What I do think happens, though, is you have a bit of a law of diminishing returns. In the event the BoC pivots harder than expected, does start realizing cuts or does start pricing in cuts, those bases wideners work out really well. OAS will fall fairly rapidly.

Ian Pollick: Faster than CDOR.

Brenden Donaher: And CDOR will be relatively slow moving. I think what we’ve seen a lot of this cycle and what we’ll continue to see is money market investors broadly have been very defensive and they haven’t been looking to extend or to really put themselves in duration positions past, you know, one month or three month type paper. So one of the big drivers of the initial funding spread move in the widening move was a real buyer strike in cash. Until the bank says for sure we’re done or we’re going to start cutting, I don’t think you’re going to see people come in and scoop up scores of BAs. So that to me is where the widening really works from a material standpoint. But it’s past H3 kind of thing. I’m talking more like M3, kind of U3, where I think the potential for a greater recession or things could transpire.

Ian Pollick: So you’re still biased to try and fade this inversion, right? Because you have a different governing force here and that is that you end up transitioning to an easing cycle faster than people had expected. And that’s kind of everywhere and always FRA OIS widener.

Brenden Donaher: I think so, yeah.

Ian Pollick: That’s interesting.

Brenden Donaher: But I think things are broadly fair. You know, you’ve seen decent year end pressure build in the US unsecured markets, Europe to similar extents, but broadly speaking, I think a lot of the dynamics in Canada that made FRA OIS widen aggressively will start to kind of tap out a bit and you should see some normality return to the money markets overall and things should kind of just stay stable. So I like these near-term roles, but past that, I think things are kind of fair.

Ian Pollick: Okay. Now that makes sense. And so listen, a couple of things I want to talk to you about just before we leave. Number one is when you think about very short term assets, short term swap spreads, do you have a view directionally?

Brenden Donaher: Broadly, yes. I still think there is a bias for collateral to remain constrained, and I think things will still be difficult. So I think spreads at these levels don’t seem like a huge sell to me. Broadly speaking, you know, there are some interesting things that look good on cross currency. I think going back to the point about year-end stuff, I think there’s some decent opportunity to pick up some short end CAD stuff on a cross market basis, kind of swapping it back from dollars and whatnot. And there are some decent picks there. But I still think broadly spreads are too low, at least in the kind of very, very front end. But outside of that. I mean, I think the bigger story is really going to be how the momentum plays. If you see momentum receiving, it’s not going to matter what cash is doing. I think that will take over.

Ian Pollick: So it’s direction at that point, right?

Brenden Donaher: Exactly. So I think in terms of asset swaps and spreads, that’s going to be really the driving force. I think it’s going to be less of a cash story than a directional story.

Ian Pollick: Okay. And then finally, when we think about just the utilization of general repo, right, and we go to this kind of T plus one settlement environment next year as well, does that change your world at all? Do you see any problems with repo that just makes funding in general a bit more expensive?

Brenden Donaher: Not largely. I think the one thing that would be interesting is if Canada decides to institute any kind of a fail fee or-

Ian Pollick: Which they talked about.

Brenden Donaher: Exactly, right? So that’s something that I think is more pressing. The Canadian repo markets as a whole have a lot of nuances like that that are, I think, optically more important than the settlement leg. So I think the T plus one is a very manageable transition. I think we’re one of the few markets that operates the way we do in terms of settlements and things like that nature. So I think a bigger issue would be something like a fail fee that actually constrains your ability to deliver something or charges you deliver.

Ian Pollick: So I hear you. I mean, I think it’s more operational more than anything else. And I think the SRO has done a good job despite not owning all these benchmarks, right? And so a lot of the concerns we had about asset swaps for the benchmarks outperforming hasn’t really happened. So you haven’t really had that pressure. But the fail fee is interesting. Remember, there’s a whitepaper that’s making the rounds right now. It’s consultations coming up very soon. And one of the last things I want to talk about was this idea of term funding getting more expensive in Canada, right? Because let’s think about what happened in the U.K. Obviously, we’ve done this many times. Canada is not the U.K., even though we’re a very big pension market. But what is consistent is the potential risk of owning very, very long dated assets using very, very short dated repo. You have this imbalance where you, just you’re funding 30 year securities with maybe one month repo. What happens in a situation where you have a more conservative risk profile? The probability is that you probably utilize more term funding. And so the question is, number one, is there enough term funding to go around from balance sheets in Canada at the current cost? And I’d say no. So prices go up. And so if you have this general, let’s say, steepening of your kind of spot term repo curve, how does that play back into, I guess, your world when you’re thinking about just FX OIS or FRA OIS more generally?

Brenden Donaher: I think broadly what it does is it just it locks up dollars more. I think it just creates CAD more expensive broadly speaking. The term repo market in Canada is tricky because it is kind of like an agency market. There’s really not a lot of depth to it, so to speak. But what I think it does happen is you start to see overall funding costs go higher. And I think you just see capital locked up for a longer time. Balance sheet gets more expensive and that will ultimately get passed through to funding costs and fundings for that.

Ian Pollick: And so that is a secondary reason that’s not really macro related when you think about just fading the inversion that you’re seeing in 2023, you know, that’s a that’s a good story for wideners. Okay look, I think we’ve covered a lot of very, very short end ground. I hope everyone has a great week ahead. Brenden, thank you very much for being on the show. And remember, there are no bonds harmed in the making of this podcast.

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