Enjoying the moment

Ian Pollick: Over the next two months, 10s, 30s Canada. Flat or steeper?

Nicholas Neary: Steeper. Low conviction.

Ian Pollick: Canada, U.S. 10s. Richer, cheaper over the next month?

Nicholas Neary: Canada richer.

Ian Pollick: Ontario five-year spreads. Wider, narrower over the next three weeks?

Nicholas Neary: Three weeks?

Ian Pollick: (laughs) Okay.

Nicholas Neary: (laughs)

Ian Pollick: Good morning, everyone. I hope you had a great weekend. We have a very busy week ahead with the Fed. We need to discuss a lot of things that happened last week. And so welcome to this episode of Curve Your Enthusiasm. This is a very special episode of Curve. I am joined by my good friend, a legend in the market and someone who’s been a mentor to me for many years. Nick Neary from DV Group. Nick, how are you, man?

Nicholas Neary: I’m great Ian, thank you for the kind introduction.

Ian Pollick: You were the first client on this podcast and I’m really happy that it’s you.

Nicholas Neary: It’s an honor. This joke’s not unique, but a long time listener, first time caller.

Ian Pollick: (laughs) That’s actually legitimately true. Okay, let’s kick into this. And I think the most obvious place that we should start our conversation today is what happened in Canada last week. We got the Bank of Canada, they finally delivered that rate cut that people were looking for. Whether or not it actually provides rate relief is another question, but I want to get your sense on it. You know, what did they do? What did they say that stood out to you? And then we can talk about the rate path going forward.

Nicholas Neary: Okay, perfect. First I’ll say what I say on the podcast today doesn’t necessarily reflect the views of my firm or my colleagues. The bank was largely what was expected by the market. Going in yesterday, we were pricing probably a 75 to 80% chance of them delivering a cut. and a lot of the market move that we saw afterwards was really just kind of taking out that probability. I think broadly speaking the bank delivered what was expected. They gave a little bit of guidance kind of saying that there’d be more cuts if things evolve the way they expect, but they definitely didn’t kind of over-deliver guidance. And I think on balance, the governor was measured, concise. In a way it was sort of a very normal meeting with very little unexpected.

Ian Pollick: I would agree with that. You know, it was like you said, it was simply just a mechanical adjustment because you had to reprice some of those probabilities and just stick them back into the front end. You know, I’m going to push you a little bit though on something you said. There’s only two things that kind of stood out to me. And I think number one was in the statement itself, it said that governing council now has more confidence that inflation will get back to the 2% target without policy being so restrictive. I think it takes a lot to explicitly say that you have confidence giving that you think about the past three years, you know, you misjudge inflation, the upside, you see what happened to the Federal Reserve in December, and then the pivot again in March. And so this to me, doesn’t sound like a one and done, it doesn’t sound like a one and quarter, and then we’ll wait and see. And the second thing that stood out to me, and this is where I want to get your opinion on as well, is in the presser, someone asked me about the rate divergence relative to the Fed and what it means for the currency. And he did not sound like he cared all that much. And in fact, he said that we’re nowhere close to the limitations of that divergence. So we’re 75 basis points through the US. That nowhere close to me indicates maybe you can even double this in their mind. How realistic do you think that is? Do you think that stands out as anything that we should think about?

Nicholas Neary: That’s a two part question. On the first part, maybe kind of as a market participant, we’re kind of in the weeds all the time. I think the market was pricing that this wasn’t going to be a one and done and that there was going to be divergence. It’s not entirely surprising that the bank thinks the same thing. I think they’re often willing to communicate more to the market when they don’t agree with market pricing. So the fact they’ve been fairly silent kind of suggests that they’re kind of broadly on side of what’s priced. On the U S divergence, this is a theme that’s been playing on the market for a while. My view is that we can still diverge more than what’s priced. And that kind of the dynamics between the two economies are set up for the divergence to be as wide as it’s ever been. Maybe it’s worth going through that.

IP: Yeah, let’s talk about that. How are you thinking about it?

Nicholas Neary: Well, I guess maybe start with a little sidebar of kind of how we got here, right? So during the great financial crisis of 2008, 2009, we had the U S consumer massively de-levered and that didn’t really happen in Canada. We had a much more resilient financial system. Our consumers left the GFC with pretty stretched balance sheets whereas consumers in the US, their balance sheets needed to be repaired. And Canada spent the next kind of 12, 13 years adding even more household debt that was exacerbated by low rates, lack of housing supply, and especially recently increased immigration. When rates actually rose, not only did you have very bad Canadian household balance sheets, you had, because of the structure of the mortgage market, i.e. mortgages resetting every two to five years, you had an economy that was historically exposed to rates. Whereas in the US, both corporates and households, had locked in a lot of financing at very low rates for long terms in 2021, late 2020. and the U S just had much less rate sensitivity in their economy. And then, and then you add to that buynomics, right, which is the world reserve currency running wartime deficits and what’s arguably peacetime. Canada just hasn’t matched the fiscal spending that’s happening down in the US. So all the dynamics are in place for the divergence to be historically wide. On this podcast before you’ve used the term kind of long and variable lags. And you know, they really are variable. You know, Canada is going to respond to higher rates faster than the U S is. We have a cliff of mortgages resetting. And there’s a risk of the banks already behind the curve.

Ian Pollick: Oh for sure. And so if I had to kind of push you a little bit, when I think about what that divergence looks like in my head, and some of the research that we’ve looked at from the IMF, as well as the bank, you kind of get to this hundred, hundred and twenty five kind of basis point differential before the currency really cares. At 100 basis points, even the bank said that, you know, headline inflation moves between a tenth to four tenths. And that’s a discrete move. And so like that doesn’t sound like a huge deal given there’s a lot of slack in the economy potentially if you look at some of those ex shelter measures you’re undershooting by a pretty decent degree. Do you have a number in your head? If I could just pull it out of you.

Nicholas Neary: The number in my head is the Canadian short rate at neutral and US policy where it is.

Ian Pollick: Okay, so that’s a big spread, right? That could be 200 basis points.

Nicholas Neary: Yeah, but I don’t view that as being a permanent divergence, right? It’s sort of recognizing kind of the fiscal and structural dynamics as they exist now.

Ian Pollick: Okay, so let’s take that for a second. Let’s pivot with that because, you know, with that kind of anchoring, let’s talk about duration. We’ve obviously had a relatively large movement duration in a relatively short period of time. That reflects, I think, just some slow deterioration of the US data. And to me, this is super interesting because, you know, on a relative basis, US data has looked exceptional. However, when you kind of look at it by itself, what you’ve seen really, is a US economy that is slowing, but slowing in a very controlled way. Recently, some of that slowing seems a bit less controlled. You have obviously relatively large deltas in terms of the movement and some of these soft survey indicators, some of the hard data. And so walk me through how you kind of think about the catalyst that we’ve seen in weaker duration recently and whether or not you buy this idea that maybe you’re past the peak in yields and is this a trend lower over the balance of the year?

Nicholas Neary: This is a bit of a cop out answer, but this is sort of one of the things I’m thinking about and kind of broadly confused about. In the last two years, we’ve had several kind of false starts where the market thought a recession was coming or a U S cutting cycle or kind of materially weaker data. And it kind of has yet to follow through on it. Obviously forecasting got really difficult through the pandemic and the aftermath and you know, I’m sure forecasts are improving, but I’m much less confident in kind of survey data and leading indicators than I was in 2019. Your question is kind of very much what’s on my mind, but I don’t have a firm view kind of relative to what is priced in the market.

Ian Pollick: Okay, I mean, listen, that’s fair. That’s very fair. And I don’t think that’s a cop out. I mean, you know, whether or not this is a go with or fade, you know, it’s yet to be seen. But it does feel we’re at an inflection point in the level of rates. And, you know, you kind of saw this with the Bank of Canada last week, we had rallied so aggressively into it, whether that was the June extension, whether it was the coastal gas deal, what have you. But it got to the point where even a dovish bank had a minimal movement on the level of yields because you had run so far. And so that brings the bigger question. You know, we had talked, you and I have talked extensively about this. When is the start of this steepening cycle? When can we expect a sustainable steepener? And maybe not one that’s led by higher long-term yields per se, not one that’s led by shorter yields rallying, but in general, when is that sustainable steepener coming into the market? And so maybe walk me through, like, are we now, we’ve had two rate cuts in the past week. Is this the time that we should begin scaling into these steepeners or do you think there’s something that can interrupt it?

Nicholas Neary: Assuming we have a short rate divergence between a few advanced economies and the US, I think you could easily see relative steepening in economies like Canada relative to the US. But I’m not sure that steepening is enough to kind of justify the costs of being in the trade. If I want a steepener in the portfolio, I want to sort of see the odds for a probability of a big move. To me, that’s when we have kind of a big macro regime change. What causes that? That’s sort of caused by a kind of coordinated global recession, a geopolitical event, a pandemic, a financial crisis. Those are all sort of things that would kind of bring short rates lower globally quickly. And then the flip side, you could see the long end selling off a lot if kind of the US fiscal story, kind of gains traction again and then follows through.

Ian Pollick: Let’s talk about that for a sec. And and you absolutely nailed it, right, like the cyclically adjusted primary balance in the US is 8 % of GDP. By all measures, this is not a sustainable figure. You had a brief hint of this in Q3 last year where we had that really big bear steepening, but then you kind of had Treasury walk back their issuance, and so they didn’t increase the delta, but the level increased. In a world where you have this concern about fiscal dominance in the US, this is a two part question for you, Nick. Number one is, does that spill over pretty aggressively into other smaller DM markets? And number two, let’s just talk about the timeline around this because it may not be instantaneous.

Nicholas Neary: Your point on the timeline is very valid. The US government, the Treasury and the regulatory authorities have a lot of levers they can pull to sort of stabilize the Treasury market if it appears like it’s unraveling or weakening quickly. The kind of timing of when the U S fiscal situation is forced to be resolved by the market. This is something that could take five to 10 years and knowing the timing of it is impossible. I’m personally a little worried about that specific risk around the transition to a Trump administration. Although that discussion is probably outside the scope of this podcast. That’s an unorderly transition in the US kind of spilling over to the long bond market is definitely something that’s worth at least having an eye on.

Ian Pollick: Oh for sure. Like that is real. Unequivocally with some of the unfunded tax cuts that he’s going to make permanent if you do have a change of POTUS in November.

Nicholas Neary: For other DM currencies, I think it absolutely spills over. And I think that it should be very important for other DM governments to have their fiscal situations look good relative to the US. Because we will all get painted with the same brush. And it’s definitely in our interest to be materially superior if that risk materializes.

Ian Pollick: Well, you have to be the not just the cleanest dirty shirt, you got to be clean or else you risk some type of accident in the long end. And for a market like Canada, we’ve talked about this. This is an LDI heavy market. There’s a lot of levered overlays, like a lot of nonlinear things can happen in a very disruptive long end situation.

Nicholas Neary: So you’re absolutely right, Ian. I agree with that. But in Canada, we have a tendency to exaggerate how good our fiscal situation is, especially if we lay household debt on top of it. I like to think about Canadian government debt on a kind of consolidated basis. So take the federal debt, take the debt of the provinces. Remember that Canada is a strange, strange market, where a lot of our government spending happens at the sub sovereign level. Another thing that could move Canada US a fair bit with Canada outperforming is a change in government. We don’t know how ambitious fiscal changes will be under the next government, but they may be very significant. 

Ian Pollick: That’s a good point. Very good point.

Nicholas Neary: When we think about the overall fiscal picture, you can’t Ontario’s 38 % of Canada’s GDP. You can’t just ignore the $430 billion of debt in Ontario. Quebec is half the economy of Ontario, but three quarters of the debt if you include hydro Quebec. The other thing that we do in Canada is we include the CPP assets in when we report net debt. 

Ian Pollick: Yeah, absolutely.

Nicholas Neary: And we also include some CMBs, which I actually do disagree with. So CPP and CDQ have about $700 billion in assets, which are subtracted from our net debt. And then kind of the $250 billion CMBs are added back. Are our debt numbers really 450 billion higher than kind of then we report and then if you add the provinces you know that’s another 1 .3 trillion.

Ian Pollick: But yeah, because all the assets are at the provincial level, right? And so, you know, I take that and well, let’s just talk about this for a second. I mean, you know, you’re in an environment right now where you keep hearing the soft landing from, you heard from Lagarde, you heard it from Governor Macklem that Pavlovian signal is, to me, is an environment where I want to harvest carry. And so let’s just talk about government spread product. Obviously we’ve had some decent mentioning over the balance of the fiscal year. But I think the real story here is just how much issuance has gone abroad. And so I guess my first question to you would be, do you see a real relationship, a real relationship between the proportion of provincial bonds that have been issued abroad, stabilizing the domestic market? Do you think this is a real impact?

Nicholas Neary: I think it’s absolutely a real impact. And I think it’s also decreased the volatility of spreads.

Ian Pollick: So, I mean, but is this sustainable is the question, you know, I think the large offshore issuance is a function of the size of the program this year. And so either you have to believe that these programs say around this 140, 150 billion aggregate level for the next few years, otherwise this is a stopgap type of strategy. And therefore, aren’t we just opening up spreads to more vol when this starts to abate?

Nicholas Neary: We would definitely be opening spreads up to more of all if the foreign markets weren’t open to us.

Ian Pollick: But they are.

Nicholas Neary: and the way to make sure they’re open is to run a good fiscal house. It’s almost circular, right? If you run your house irresponsibly, eventually the markets might not be open to you and that’s a risk. But that’s already true. Certainly, it exposes the Canada to kind of broader weakness globally for spread assets. But remember, with the government buying half the C &B program. A lot of foreign capital has kind of left that part of the spread market. So it’s not totally crazy that it would come in elsewhere. The people running, the provincial, issuance programs, especially Ontario and Quebec are, they’re sophisticated actors who know what they’re doing. Andthey’ve identified this as a way to diversify and limit the volatility of their product, at least in the short term.

Ian Pollick: Well, I mean, it seems to be working and yet at the same token, you look at some of the shape of these credit boxes, you know, the 1030s credit box in government spread product space, it is not moved. You have any ideas why? Is this just market recognizing that there’s a certain limitation of the proportion of what you can do abroad? And once you reach that level, you have to come back domestically and that is the saturation point. Like is that, is it just as simple as that?

Nicholas Neary: So I’ve thought about this a lot and I kind of think it’s just that. 

Ian Pollick: Okay.

Nicholas Neary: Yeah

Ian Pollick: There you go. But like, lastly, like, you know, in a world where you’re repricing your dominant asset, and you think of the parent child relationship in government spread product space, you know, you’ve had this this very big structural change in issuance pattern of provincials this year, as we talked about, managed exceptionally well. Can we talk really quickly, Nick, about some of the value in other HQLA? You know, let’s talk about CMBs as a starting point. And then maybe we can talk about, you know, CPP or some of the other asset managers.

Nicholas Neary: Okay, I would say kind of broadly speaking, I’m positive CPP relative to CMB. 

Ian Pollick: Okay

Nicholas Neary: So,my view on the CMB purchase program are well known, but it’s not at all clear to me that the CMB program continues to be bought at a 50 % level when the government changes.

Ian Pollick: That’s a very good point, actually.

Nicholas Neary: It’s also not clear to me that there should be a CMB limit kind of imposed by finance because the real risk is in the underwriting of the NHA products, not in the securitization of NHA into CMB. If you didn’t limit that securitization, you would have many more CMBs, especially in a world where the government wasn’t buying them. and then on the flip side, with CPP, you insist on including CPP in the government net debt, which I could rant about again, then the liabilities related to those assets should actually be government guaranteed assets. In a sense, the government’s buying the wrong bonds. They should be buying CPP, which is actually their debt, not the CMBs, which aren’t. Why should that spread be as wide as it is? They’re kind of 35 basis points in 10s.

Ian Pollick: Listen, it’s a fair point. Part of that’s somewhat existential, but I, in theory, hear what you’re saying. Let’s pivot. Thoughts on the Fed this week? What do we have to be mindful of, and how are you setting up for it? And maybe just let’s conclude with some of your favorite positions right now.

Nicholas Neary: I have kind of two trades to talk about. One’s macro and one’s micro. The micro trade is the Canadian $25 preferred share market. The second trade is more macro, more speculative. My conviction is only medium on it. But I like being long the Canadian dollar. 

Ian Pollick: Okay, okay. I concur. Like not a lot. No real new innovations are expected this week.

Nicholas Neary: Correct. And you know, therefore I don’t have a big setup for it. On kind of favorite positions, we’re a big fan right now of the $25 Canadian preferred share market. 

Ian Pollick: Okay, let’s talk about that.

Nicholas Neary: Yeah. So, the markets already kind of realized this mostly, but there’s still some alpha left, where it’s more efficient now for banks to raise kind of tier two capital away from the $25 dollar pref market. You’ve seen some issues being called. And our broad view is that the bank $25 dollar pref market’s going away.

Ian Pollick: Yeah, and let’s just remind people that the market you’re talking about is not the institutional market, it’s the retail.

Nicholas Neary: It’s broadly retail driven, although there is significant institutional participation. These securities are tax advantaged for Canadian individuals because they’re dividend income A big chunk of the market is going away because the bank issues are going away. So these are tax advantaged floating rate reset every five year instruments, that look very good relative to the carry you can get in other risk assets anywhere else. We particularly like the issues that have kind of reset recently where you’ve got kind of great carry for the next five years and then a solid floating rate asset beyond that. There’s a lot of hedge funds short positioning in CAD.

Ian Pollick: Massive, it is actually huge.

Nicholas Neary: Obviously, you know, the currency to some extent will move with short term rate differentials. But I think the market hasn’t yet woken up to how much Canada could potentially change when the government changes. We may move from a government that’s kind of unfriendly to capital and business investments to one that’s kind of actively trying to promote the resource sector. To me, it’s an open question how ambitious the next government will be to that end. But there’s a chance that if the main data is big and the ambition is there, that the Canadian dollar could have a massive move. If you’re short it now, I think you’re kind of blind to that oncoming risk.

Ian Pollick: I mean, listen, that’s a very good point. And I would say that, you know, I wouldn’t tell you my two favorite trades because it is my podcast. I think you’re at the point right now where, you know, two’s, five’s, 10’s is probably the best cyclical trade going forward. And that is to be short the five -year part of the curve. You know, any steepening adjustment that has to happen in Canada, just given where neutral is priced now below the top end of the Bank of Canada’s estimated range, you know, neutral in Canada, that three or one-year point is around 280, 285. That seems really expensive. And so I kind of like the two to five steepening trade to what we were saying earlier to help mitigate some of that carry. I think you have to have a 10 year around it and that speaks to potential repricing of global growth. The other trade that I really like and I’m putting out a paper this week on it is just to be received 10 year course SOFR. There’s a lot of reasons why we’ve had these imbalances largely reflecting a very slow accumulation of foreign reserves from the Government of Canada and a very fast pace of foreign issuance from the provinces. Check that piece out. Look for it, it’s in your inboxes.Okay, cool. I’m going to do something that I’ve done with other guests on the show before. And so this is going to be a quick pop quiz. It’s either rich or cheaper, flat or steeper, up or down. Okay, we’re just going to do three questions, okay? Over the next two months, 10s, 30s Canada. Flat or steeper?

Nicholas Neary: Steeper. Low conviction.

Ian Pollick: Canada, U.S. 10s. Richer, cheaper over the next month?

Nicholas Neary: Canada richer.

Ian Pollick: Ontario five-year spreads. Wider, narrower over the next three weeks?

Nicholas Neary: Three weeks?

Ian Pollick: (laughs) Okay, okay. The next two months, next two months, next two months.

Nicholas Neary: Tighter.

Ian Pollick: Okay, I’m going to leave it there. Nick, thank you very much for being the inaugural guest on the show. I hope you have a great week ahead. Good luck with everything. Thank you everyone for listening and remember there are no bonds harmed in the making of this podcast.

Nicholas Neary: Thanks again. Glad to be here.

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