Forecasting vs. planning

Keith Rofrano: Welcome to Markets In The Middle, a podcast series dedicated to delivering you insights into the current economic environment, the specific focus on interest rates and foreign exchange and what it all means to the middle markets 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. So I guess I’ll ask you if you’re Jerome Powell, right, you’re going to a Halloween party. Is he going dressed as a pilot or is he going as a football player? Because things are going to get rocky.

Ian Pollick: I think he’s going dress as an anchor. Because he’s pulling everything down with him. (laughs)

Keith Rofrano: (Laughs) Boy, oh, boy. It is good to be back with you two. Holy smokes. What a difference this October versus last October. As we approach Halloween, I guess I’m thinking the markets have gotten a little spooky. Clients in the middle market are looking at all kinds of elevated costs. And here to help make sense of all that is my two colleagues and to pull the landscape back, we think about this year versus last year, right? We got really used to cheap money, cheap labour and relatively cheap energy. And now none of those things are true. And so as our clients think about planning into 2023, it’s very important that they think about the difference between what is a forecast and what is proper planning. And so forecasting is very important. It’s a good idea to have an opinion about what’s going on in the market. It’s a good idea to be informed about that opinion. And luckily we’ve got experts to help with that. But I’d say even more important than forecasting is planning. So how do we handle certain things, certain market environments? What kind of actions or behaviours do we take if we see certain market environments? And then what kind of behaviours are always just good behaviours, good tried and true best practices as it relates to hedging. So I’m going to ask my colleagues to kind of chime in and give us an update on the current market environment and then we’ll talk about what are some best practices along the way. So Ian, over to you.

Ian Pollick: Well, thanks very much, Keith. And you know, you’re absolutely right on two things. Number one is it is good to be back together. It’s a lot of stuff to talk about. So I’m glad we’re doing this. And the second thing you said, and you know, this is music to my ears, forecasting is an imprecise science right now. It’s a bit difficult. And obviously that reflects just a copious amount of various macro crosscurrents. And an unveiling of a lot of really important vulnerabilities that were in the system, that were likely there for a really long period of time. And they’re all kind of coming to a head right now. So I would say that getting on the idea of forecasting versus planning, you know, you need a framework and the framework is one where, what is the most likely economic path over the next 6 to 12 months? And so let’s just talk about what we think that path is, Keith. Number one is growth is slowing. Growth is slowing not just in the interest rate sensitive sectors like housing. It is slowing in some of the sectors that saw a huge amount of demand during the pandemic, particularly on some of the services. And as demand for services begins to wane, the question is will that demand go somewhere else? Is it going to go into goods? Is it going to go into another part of the service sector? And the truth is, we don’t know. But we do know that growth is slowing. And we know why growth is slowing, because financial conditions are tightening, interest rates are higher and we are taking less and less risk with our discretionary income towards discretionary spending. And so what I tend to look at is the industries that are very much stronger than their trend rated growth. Those are likely the ones that will be falling fastest. That’s a lot of the intermediate production companies in the manufacturing sector. On the service side, that’s not actually what you would think it is. It’s not hotels, it’s not food accommodation, it’s professional services. You know, people don’t like paying for accountants when they have less money in general, they’re going to do it themselves. And then we all think about what the path of interest rates is. We think that the Federal Reserve is closer to the end than the beginning. That’s very important because the last time that you and I spoke, it was the opposite. They were just getting off the runway. So right now, you know, let’s call it right before the end of October. Interest rates in the US are three and a quarter and we think they’re going to go to 4% relatively quickly. By the end of the year, they’ll be at four and one half percent. The question is, is when we look ahead to 2023, what is the probability of interest rate hikes continuing? Well, I’ll tell you, that financial markets right now expect the opposite to happen. They expect the Federal Reserve to kind of reach an almost 5% level very early on in 2023 and then actually see a lot of interest rate cuts by the end of next year and into 2024 as well. I’m not so sure that’s going to happen. And so for my economic base case, we see a situation where the Fed probably overshoots our expectation of four and one half, but within a reasonable 50 basis point range around there. So we’re getting very close to understanding the ultimate parameters and resting spot of policy. But I don’t expect the central bank to cut interest rates in 2023. And that’s really important because there’s still too much inflation built in the system. And therefore your normal reaction function would be for slowing growth to cause the Fed to pivot. And that pivot is from hiking to pausing to cutting. We think you’re going to get the pause. We don’t think you’re going to get the cuts.

Keith Rofrano: So, Ian, is that another way of saying that 2% is the new zero bound?

Ian Pollick: I think so, because I think implicit in kind of what we’re talking about right now is this idea that’s a mirror image of what we saw after the financial crisis in 2008, which was lower for longer. And now we’re talking about higher for longer. And the higher for longer is just you have a resting spot that exceeds what we’ve seen over the past decade and stays there and chills out for a very long period of time.

Keith Rofrano: And so as I think about what you’re saying and I can appreciate, the market is expressing the sort of peak in rates next year, it’s concurrent with your forecast as well as perhaps even pulling back. And so as a company trying to plan ahead, and we think about and I hear this an awful lot, is there sticker shock as I start to look at or can hedge three year risk or five year risk? And there’s a bit of where I saw it last year, call it one and a quarter, one and one half. Now it’s four and one half, four and three quarters. It’s a hard number to look at for the first time. And so what we encourage our clients to do is to think about hedging as it’s not binary. In other words, it doesn’t have to be all or nothing, right? One of the things that plays very well, particularly in these environments, is a concept of simple. It’s very simple. It’s layering, right? Taking certain chunks over time and also attaching that to kind of your destination hedge ratio, which really is answering the question what is comfortable for the company? Very different than trying to predict the market and tops and bottoms, which as we all know, is practically an impossible thing to do and certainly not recommended for companies that are trying to manage through that. The other thing, it’s very popular, is a very simple structure, but the use of callers has come back in vogue now.

Ian Pollick: Yeah, absolutely.

Keith Rofrano: Yeah. So conceptually what our clients are looking at with the caller is yes, rates can go a little bit higher and I’m not too comfortable at pinning these higher rates and I want the ability to maybe drift down over the period of my three five year hedge. And so a caller is very opportune for that. And so we’re having lots of basic conversations about layering, about making sure that we have a plan around targeting your hedge ratio and the use of fairly simple structures such as a caller. So thank you for that, Ian. And so I guess I’ll ask you if you’re Jerome Powell, right, you’re going to a Halloween party. Is he going dressed as a pilot or is he going as a football player? Because things are going to get rocky.

Ian Pollick: I think he’s going dress as an anchor because he’s pulling everything down with him. (laughs)

Keith Rofrano: (Laughs)

Ian Pollick: But I just want to say, I just want to extend on something you just said. And I think this idea, when you’re in an environment where you have a huge amount of volatility that we’ve seen in the interest rate market particularly, and recognizing that hedging your interest rate exposures is not about timing the market, it’s about creating certainty. Then when we think about the distribution of outcomes, right, the tails are a little bit more removed than they have been for a long time. And so by truncating some of the distribution around extremely high rates and extremely low rates on this idea that you’re close to the top and the monetary policy tightening cycle, but at the same time that 0% interest rates aren’t likely in the coming months. So let’s say two is a new zero, recognizing that distribution and trading around it, that is a framework I would use for thinking about how I set my caller hedges and I think it’s a tremendous idea.

Keith Rofrano: Excellent. Excellent. Well, speaking of volatility, there certainly is no shortage of that in the FX market as well. And so, Bipan, walk us through kind of the force behind King Dollar, the likelihood of its persistence and maybe let’s pull apart a bit between importers and exporters and what that might mean for the middle market.

Bipan Rai: Yeah, thanks, Keith. And I think one of the things that’s going to be important for everybody on this call to understand is the fact that going forward we’re expecting realized volatility in the foreign exchange market to pick up. Quite simply, we’re undergoing a structural shift, several structural shifts, I should add, which requires more active engagement in terms of your exposures when it comes to whether or not you’re importing or you’re exporting your wares outside of North America. Now, you know, from that lens, it’s important to understand why these structural shifts have arisen. You know, Ian spoke a little bit about what we’re expecting in terms of monetary policy. And, of course, you know, we’ve got a wider array of views with respect to what’s going to happen in the interest rate markets as opposed to what we saw over the last decade or so. I mean, that migrates over to the FX market as well because don’t forget that a lot of the times we in the FX market when we’re looking at, say, valuation models and calibrating where exchange rates are going to go, we need to have a full and comprehensive outlook for what the macro looks like. And with this degree of uncertainty priced in, and especially as we’re in an environment now where central banks are now sort of removing or reducing their footprint in the macro space, this introduces an additional round of uncertainty, an additional round of or at least premium for realized volatility going forward. So that’s one thing. And I can also talk a little bit about the trade barriers that we’re seeing, you know, a rise around the world. I mean, that was something that kind of predated the pandemic. But nonetheless, this isn’t something that we’re expecting to go away anytime soon. And again, what this does is it does introduce an additional layer of uncertainty with respect to the FX markets and especially the way that the US dollar moves going forward.

Keith Rofrano: So we’ve gotten a just a ton of recent in the last several months, like strong lessons from the UK, strong lessons from China. And I think one of the things we encourage clients every year, particularly in FX, right, which it can be a little bit more complicated in terms of different currency pairs, different directions. How do you set your budget rates and planning again, What are best practices along planning? And you know, I like to think of it as not all vol is created equal, right? So you both just express that the vol environment is very, very different than it was this planning season versus last planning season. And so what we really need to do and what we ask clients to think about is how do we pull that apart and look at what is the current volatility environment, what could it mean for the business and the exact same process, not trying to pick the highs, not trying to pick the lows, but trying to figure out what is the worst case scenario that we can live with, right? And everything else, right, we can live with but the worst case and beyond, we need to hedge, right? And so our best practice advice to clients, as always, is figure out the worst case scenario. And the best way to look at that is really to take an inward look at the business first and then we ask, we solve for what market outcome, right, would be harmful to your business that gets in the way of you doing business fundamentally. And then the selection of what structure do we use, what solution when you use, that actually becomes pretty easy. But the hard part is doing the work upfront. And so I’d encourage you to think through with your banker, with any of the three of us into how you can pull apart the risk and really analyze where it can get you and create the most harm. And we take that off the table so that you can go on and do your business. Another thing that I often see, I guess I’ll point out the biggest mistake that I see clients make, and that is they take a forecast and they make that forecast the budget rate for their fiscal year. And again, while I think the world of forecasters, right, and my colleagues here on the line, forecasting is not a great way to plan the business. And so a very typical way, a best practice way to plan an FX budget is to take a look at the current forward curve, right, Because that’s what you can actually hedge today, right? So you’ve had a choice as a CFO, as a treasurer to hedge what you can actually enforce today, which is the forward curve. And then if you choose not to, that’s a risk decision, right? And so that’s why it’s important to kind of marry the two. Let’s figure out what the risk is. Let’s see what you can achieve today. And if you decide to not take action today, then let’s have a plan for when you will take action. And that’s planning as opposed to pure forecasting. So just a couple more questions for you, Bipan. So did we learn any lessons from the UK? Should the US be thinking about anything that we’ve observed in that bit of chaos for the last 60 days?

Bipan Rai: You know, I don’t want to say that there’s nothing to be learned from an FX perspective, but I think there was a lot learned about the importance of ensuring that, you know, whatever exposures that you have from an external front and the UK has had a massive imbalance with respect to its external deficits, I mean, you have to make sure that your fiscal policy reflects those risks. And I think that was something that was a little bit underestimated with prior administration now in the mini budget. And that, you know, if you do have irresponsible fiscal policy, I mean, those imbalances could become exposed. And that’s you know, that’s largely the story of why we saw that reaction in gilt yields and also by extension, in the cable itself as well. And, you know, I mean, there’s been some chatter about the illiquidity in the Treasury market. And of course, Ian can speak to a little bit better to that. But I will say that the US dollar is a little bit better insulated, I should say a lot more insulated given the fact that it is a reserve currency and there’s always going to be that residual bid there that typically isn’t there for the cable in times like these.

Keith Rofrano: All right. So let’s boil it down, right. Obviously, I continue to bring up best practice, best practice, best practice. But we still do want to know what is the forecast? How do you see CAD? How do you see euro? How do you see sterling?

Bipan Rai: Yeah, absolutely. I mean, at least over the coming quarters, we still think that the path of least resistance is for a stronger US dollar. And I’m comfortable saying that right now because if we are talking about this higher for longer message that Ian spoke to earlier, I mean, I think it’s very salient to understand that the longer that interest rates remain at these levels, the more and more that imbalances that have been building up, especially in these smaller markets, smaller developed markets like Canada, in terms of elevated household debt levels, I mean, those come into sharper relief as risks for central banks to manage. You know, if you look at things from the United States perspective and from the Federal Reserve’s lens, you know, those risks aren’t as acute because the US did go through a deleveraging episode after the last financial crisis in the household sector. So that to me tells me that the Fed terminal is going to be a little bit maybe even meaningfully higher than, say, where the Bank of Canada’s terminal rate is. And I think that will migrate into the exchange rate. And potentially we’re looking at dollar CAD to strengthen further going from here, potentially reaching above the 140 mark over the coming quarters. With respect to the euro and the sterling, I’m a little bit more constructive on the euro going forward, and that’s primarily tied to the fact that at least in the near term, the natural gas storage issue has been addressed to an extent. And of course, in the summer months there was a lot of concern as to whether or not the larger economies there could secure those supplies. Now, it’s all about whether or not demand is going to strengthen beyond what they have in storage right now. And I don’t think we can forecast that here, because that’s contingent on how cold the winters are going to be in places like Germany and Italy. So at least into December and January, I do think that the euro will appreciate as investors exit some of these short positions that have been built up over the last couple of months. Beyond there, I mean, we’re banking on potentially the macro backdrop looking a little bit more constructive. And if you do get that sort of ex US growth narrative come to the fore, I do think that there will be some upside into the middle of next year potentially for a more supportive Europe backdrop. Having said that, we’re not expecting a complete reversal of what we’ve seen over the past year. We do think we are in a new trading regime with respect to euro dollar, sterling dollar and some of the other major currencies out there. So again, next year should see the US dollar come under a bit of pressure, but that’s contingent on a more constructive backdrop outside the United States.

Keith Rofrano: That’s excellent cover on some majors. Let’s talk a little bit about emerging markets, Bipan, because we do have some clients that have exposure there, mostly on the import side. So as you think about elevated fear and perhaps there’s been some talk about maybe a bit of a lack of liquidity, some emerging countries not being able to access dollar swap lines like they had in the past. Do you see that as a risk going forward? And if so, to what extent would it impact our clients?

Bipan Rai: At this point of the cycle, it’s a risk, but I don’t think it’s something that really should result in weakness in emerging market currencies at this point. And I’m comfortable saying that because of the fact that there’s really no signs of stress in the funding space, which we tend to look at as sort of a leading indicator for what will happen in spot FX for some of these emerging markets. I’ll use the example of the Mexican peso. If I were to look at funding spreads there, there’s no indications of stress at this point, which is kind of curious, given the fact that we’ve seen interest rates rising, you would imagine that there would be some degree of some stress in those larger emerging market economies. But what is less appreciated is the structural change that we’re going through in terms of French shoring and the fact that we do have these new geopolitical blocs that are being built up. I mean, that’s, you know, a country like Mexico stands to benefit in that sort of environment. So there is an increased demand for pesos that we’ve noticed. Something else that is less appreciated is the fact that remittances are still very much a very strong driver of emerging market currency strength. And that’s what we’re seeing by large in the Mexican peso as well. So at this point of the cycle is really, you know, there are sort of signs of worry emanating in terms of a narrative perspective. But in practice, we’re not seeing it actually play out in the EMF space either. So and that’s not something that we’re going to be thinking about, at least until the Q1 part of next year, and then whether or not, once we start to see the real economies, especially the United States, tip into a recession, that’s when we need to start thinking about potentially what that means as a pass through to the Mexican economy and maybe some of the LatAm economies as well. And then maybe we need to start looking at whether or not there’s going to be increased demand for dollar liquidity from some of the central banks there.

Keith Rofrano: One of the things that’s, I’ll call it more common than not is in the US anyway, middle market companies, they prefer to do their business in dollars, right? And so King Dollar, particularly when you’re an importer, has got a sweet ringtone to it, right? And at the same time what we often will see when we go into a planning discussion with a client, we ask things like, have you had a recent price spike on your imports that you’re spending dollars, for example, sending dollars to China or to Hong Kong? And often the answer is no. Or sometimes we find out that the price break is more like two or 3% when it should be six, eight or 10%. So one of the things I encourage people to do this time of year is to really examine, particularly if you’re importing and you’re spending dollars. Well I would say you shouldn’t be using dollars, you should be using the foreign currency. But if you’re not, we ought to be asking for an appropriate price break. And there are ways to have that conversation. You know, just sort of acknowledging that first and foremost, neither counterparty really is in the business to generate FX income or losses. They prefer it not be there. But we do generally find that when we coach clients through having that conversation, the vendor is looking for an equitable conversation and a resolution as well. So appropriate price breaks is something that should also be part of the planning discussion. So one of the bigger cost components or the biggest cost component for most companies, for sure in the middle market is what’s going to happen with labour costs, what our labour costs are going up. We’ve got job vacancies all over the place. So Ian, help us understand the labour market a bit in the US and what our expectations are for 23.

Ian Pollick: Yeah, absolutely. I mean I think up to date what we’ve seen is a labour market that by all measures looks very tight and what we mean by tight is people are not staying in their positions for very long. You know, we’ve heard anecdotal stories of people having to be paid just to show up for an interview. And so the job levers in the economy are running very high. That’s left a lot of vacancies. Open vacancies in the system. At the same time, those job stairs look around them and they recognize that their real wage growth is now negative. And so they want, they want the money. Show me the money, Keith. All this has led to a situation where in general the pie of wages has gone up, incomes going up. And the question is, when you look at recent data, what’s been happening is that there’s a tremendous amount of job vacancies around. And it’s interesting because talking to a lot of CEOs up, particularly in the Northeast, one of the messages we’re getting from them is, you know what? Yeah, we do have these jobs, but we’re not willing to pay the wages people are demanding. So you’re starting to get a little bit of wage pushback from some employers. And so I think there’s the labour market probably is overstated in terms of how tight it is. And that’s a risk, right? That’s a risk because everything that we talked about earlier on in the show, slowing growth, rising interest rates, tightening of financial conditions and really the Federal Reserve trying to shrink demand to right size it, to supply that just all means that the unemployment rate is vulnerable, right? And so this whole notion of a soft landing, you’ll notice no one’s talking about it anymore in monetary policy circles because they realize it’s just a landing, like literally just a landing. And so you have to get that unemployment rate higher. And so I do expect some of these firms that cannot survive in higher interest rates whose appeal to some people over the past couple of years isn’t what it will be going forward. We’ll all start to suffer. And so we do expect the unemployment rate to rise.

Keith Rofrano: I really like what you said about survival and higher interest rates. And so I get back to kind of that initial sticker shock we talked a little bit about earlier is rates are high, rates are elevated. But as we do, as we look out the curve, right, the three, five, seven, ten years, it looks a little cheaper. And so also you had mentioned that the market is looking at a bit of a, wouldn’t call it necessary, a rollover, but at least a slight flattening slash pause that can take some time. And so for clients who are thinking about hedging, I’d encourage you to look beyond the sticker shock and think about extended duration of your head. So, for example, moving from a three year to a ten year, you can pick up 40, 45 basis points in savings in your hedge rates. And so that’s something to really think about as well.

Ian Pollick: And I would say that, just in that point before I turn it back over to Bipan, you know, one of the consequences, Keith, of this higher for longer kind of thesis is that you have yield curve inversion that lingers for a very long period of time. You know, historically yield curves don’t invert for very long, let’s call it six months and then they steepen back out. But this is not the past. And for all the reasons we talked about on this episode. And so I expect that whether it’s the differential between a ten year rate and a two year rate, seven year and a five year, even a five year and a three year will be inverted for a very long period of time. And so you get this natural buffer from extending duration and you actually get paid to have the hedge on, which is not usual.

Keith Rofrano: Right. Right. So here’s what I heard today. Vol is a multiple higher than it was last year, right? Both in rates and FX. Forecasting, it’s always difficult. It’s really difficult right now. Planning trumps forecasting but forecasting as we’re talking about here, is it’s good. It’s how we set our base case, it’s how we have conversations with clients around what is important to them, what could impact them. And so as I think about kind of the best practices in this environment, as you go into a 23 budgeting, think layering, right? Don’t think it’s a binary decision hedge all or nothing. Think targeting a hedge ratio, right? Thinking about what interest costs could get so punitive that it starts to hurt, for example your coverage ratios with the bank, right. Those are the proper planning discussions to have. On the FX side, as I said, all vol is not created equal. So really take a look at the current environment. Think about the direction of your exposure and how that might look over time. And to the extent that you should be getting price breaks, you importers out there where you’re doing it in dollars, please have that conversation. But as always, what I encourage people to do is to think about not just the markets, right, but the markets as they apply to their business. And so we’re here to help you with that. Our ears and our lines are always open. 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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