‘Go with’ or go the other way?

Ian Pollick: Well, especially what’s interesting is that you had the OSFI data last week and what it showed is that loan growth is now picking up a bit. And so asset generation is improving relative to where it was. People forget, it’s not just mortgages, right? It’s business loans, it’s commercial loans. And that stuff is now going from low single digits to high single digits. All right, it is the Friday before the long weekend. The Canada bond market closes very shortly. And this is another episode of Curve Your Enthusiasm. I’m joined today by a very good friend of mine, Jonathan Guilford, from our Government of Canada bond trading desk. Johnny, how are you?

Jonathan Guilford: Not too bad, man. How are you?

Ian Pollick: I’m good. I’m glad that you’re here. And I’m glad that you’re here for three reasons. First reason is because I just, well, I enjoy your company. Number two is that as much as I enjoy your company, we actually very rarely agree on the market. And so I think there’s going to be some interesting discussion today. And number three, I think you have a very unique perspective because you are a cash trader, you are a swap trader, and so you do have a bit more dynamicism than most other people. And so let’s just kick off. Obviously, it’s been a crazy week. We’ve had a lot of data, we’ve had a lot of moves. From your perspective, when you think about what’s happened in the past week, the repricing, the underperformance, what is catching your eye the most?

Jonathan Guilford: It feels like a lot of themes that people had kind of in their mind on the back burner in terms of the fact that Canada had seemed as if we were underpricing the potential for re-engagement of the Bank of Canada in the hiking campaign, I think a lot of people had taken the kind of soft pause as more of an explicit end to the campaign than it was. And I think there are a lot of people that felt that that was a mistake and that it was mispriced, quite frankly, and that there was going to be a pretty good chance that we were going to at some point see a re-engagement of a more hawkish lean. And all of a sudden that’s kind of just exploded to the forefront now over the last week, really explosively, but it’s kind of been, we’ve kind of been seeing fissures of it for a few weeks now. And it kind of really started as more of a cross market story when we started to get a bit of a turn on the US side, obviously kind of with the whole US regional banking turmoil situation, that kind of put a big dent in pricing and anticipation that the Fed was going to be able to continue their hiking campaign as aggressively as a lot of people might have foreseen. It really stalled that out. And then it made Canada look as if, on a relative basis, we had the potential to underperform from a rate perspective a lot more significantly than people had probably been thinking about before.

Ian Pollick: For sure. And what’s interesting, though, is that, you know, just to interrupt you for a second, it’s very natural for Canada to underperform when the US rallies. Particularly, you had this very, very acute banking stress in the US, we have a very different banking system. We’ve talked about that a lot. But then what happened is you got this recovery in rates and then Canada turned into that high beta market as rates sold off. And I don’t think people expected that.

Jonathan Guilford: That’s true. Like it’s gone from being a US led story in terms of the Canada underperformance to now in the last week very clearly a Canada story. Yeah, initially started with kind of the banking turmoil thin, a bit of a turn in US data to kind of a string of kind of softer numbers. Obviously the CPI, PPI, in combination with that underlying kind of risk off backdrop there. And then all of a sudden with Canada, you get, obviously we had hotter employment numbers a few weeks ago and I think people were really, really watching carefully this CPI number and there was a lot of apprehension around it when it came in as hot as it did.

Ian Pollick: When it came in, I literally, like my breath just stopped for a second. I was like, is this now the new labour market report? Like that 0.7 was just so much bigger than we had thought.

Jonathan Guilford: So it’s like all the things that people were concerned about and apprehensive about and were thinking kind of like in the background, there’s this risk all of a sudden, like you have all these little fractures and then it’s like, okay, well, this is kind of a confirmation of the fact that, yes, we’ve been underpricing the possibility that the Bank of Canada may have been premature in kind of instituting that pause maybe before they needed to and-

Ian Pollick: Always explicitly, as they did.

Jonathan Guilford: As explicitly as they needed to for sure. And that for them to maintain that stance is going to take a really, really high threshold now. It’s like all of the signs are pointing to the fact that that may have been wrong and it’s going to be difficult for them to not acknowledge that. And so they softly already are.

Ian Pollick: A little bit. But let’s talk about that a little bit. Before we do, you know, one of the things that was interesting is that obviously you had this Canadian induced move by the data, right? SPI was very strong. And it wasn’t just the headline number because arguably, I would say headline numbers don’t matter all that much. It was kind of the Frankenstein core measures that three month annualized X food, X energy X mortgage interest costs that the bank said, look at what, well we’re looking at it and it’s rising very aggressively. You know, three, four from 2, 1. Obviously very big. But what I think this has exposed wasn’t just that what people were underpricing the bank. They were underpricing the risk from the overall level of duration, right? Like duration is expensive. And I know you and I may not necessarily agree on that, but I think from a positioning perspective, people were long Canada and this is another classic Canadian flush out. But let’s just talk very specifically about the curve moves because we’re now in that sweet spot for the June 1st extension. And so you and I have been talking about it. Obviously the seasonality says, look, tens bonds should probably flatten. Arguably, I would say it’s flattened much more than I would have expected. On the duration move, on the actual extension itself. Talk to me about what you’re thinking about that. Does that surprise you that tens bonds went from kind of plus 7 to -2?

Jonathan Guilford: Yeah, I think that I agree with you. It’s a seasonal, obviously suggests that. I think it’s become, everyone knows that going into early June you have the extension, big coupon payments and rolling of bonds out of the long segment into the mid and that usually has a pretty material impact. And I think that over the years, a lot of accounts have tried to get ahead of that and it kind of makes it even more self-fulfilling than it otherwise would be. So there’s always going to be the expectation that there’s going to be some element of that. But I agree that the scale of what we’ve seen so far over the last couple of weeks has even overshot what you would have expected given the understanding that that behaviour exists.

Ian Pollick: Why do you think that is? Because obviously you have, the extension itself is very large, right? So you have this outsized move in the log index and it’s really larger than we’ve seen for a very, very long time. And I’m a very big believer that seasonality is largely in the eye of the beholder. I’ve written about this for a decade, and it’s not always real. This year feels very real to me. But then you have this added backdrop where you have the data that’s now supportive. You have the macro element that’s obviously supportive of a flatter curve. But from your perspective in your seat, were people just not long, long bonds, like what is this demand coming from?

Jonathan Guilford: You know what? I would think that, yes, certainly the broader economic backdrop kind of front end led sell off natural inclination for curves to grind at least marginally flatter here. I think that backdrop has really combined with the natural instinct that some accounts, particularly real large money accounts, would have to get ahead of the extension flows and accelerated that behaviour and accelerated the scale of interest that they would have to execute.

Ian Pollick: So fast forward it a little bit.

Jonathan Guilford: Yeah, fast forward it a little bit and also increase the scale of it. I think that the environment is conducive to that trade working and I think when people feel like the environment is conducive and they have a little bit of wind at their back, they say, you know what, push the chips in a little bit more than they otherwise would be. And I think that’s probably the biggest factor, I think going into this, just feeling that the environment is very conducive, it allows you to maybe start that trade a little bit earlier than you otherwise would, feeling that risk reward is in your favour.

Ian Pollick: You know what’s interesting though? You know, it’s very rare that you see a situation where Canada, let’s just talk about Ten’s bonds for a second. So tens bonds, Canada, US, you know, it’s moved like six, seven basis points this week. Yet at the same time, individual cross market levels, we are cheaper cross market and everything. Fives to 30s, we are plus ten to the US and yet we’re massively out flattening them. And so that’s actually a very rare combination. And so that underperformance, I guess the question I have for you is, back end rates in particular, tens and longs. Yes, they are dictated a lot by the macro environment, but they are not twos, they are not fives. And so are we too cheap cross market in level terms to the US, let’s say tens and 30s?

Jonathan Guilford: I don’t think 30s are too cheap. I think that, I mean especially the moves that we’ve seen over the last couple of weeks where front end, basically twos through tens, have all dramatically, dramatically cheapened to the US where 30s are arguably marginally richer over that period. So I think that, even on like say a second degree of relative, relative basis, 30s are not too cheap. I think that they’re getting into a zone where they’re arguably too rich. I think that there are a lot of things that like on the fundamental side that justify a bit of relative richness on the 30 year differential relative to other terms, particularly with what we saw out of the debt management strategy.

Ian Pollick: So lower net supply.

Jonathan Guilford: Lower net supply. So I think that that is going to have to cause a recalibration of where we think kind of structurally tens bonds sits, where structurally 30 year differential sits. But I think that it’s gotten pushed a little bit too far, just kind of on a flow induced move here, which is primarily kind of this extension driven buying that we have been talking about and are getting to the point where even though we understand structurally, yes, there’s an element of richness that should exist there, I think we’re pushing the boundaries of that. I think we’ll probably talk about this a little bit later when we talk about some trades that we like. But I think that heading into the end of the month here and into very early June, potentially positioning to fade that richness a little bit, whether it just be on the outright differential or whether it be on a box is going to start to look like a decent risk reward opportunity.

Ian Pollick: For sure. So let’s just switch gears here. Let’s just talk about the bank, right? Because we had the financial system review yesterday. Usually this is not a big deal. Right? This is just talking about, is the Canadian banking system safe? Yes, it is. Where do you see the risk, the vulnerabilities that could trigger those risks? But the press conference was funny, right, because everybody wants to talk about the policy aspects and policy is not usually mentioned. And Governor Macklem did a really good job trying to kind of push people away a little bit. I think the market misinterpreted what he was trying to say. I have my own beliefs and my own belief here is that I think the June meeting is dead. And I think it’s dead because when I think about our own call, we haven’t changed our call. I acknowledge that the risks have increased a lot. But when I think about June and I think about the subset of data that we get, all we have is GDP ahead of the confab, and we know GDP is going to be relatively strong. And so outside of a huge miss to the upside, even then, I think what the bank is worried about is the labour market. And I think he hinted at that yesterday. Really what I want to see is I want to see another labour market report and I want to see stability in the unemployment rate, because what seems to be happening is, yes, you have this re acceleration of inflation. Yes. Base effects have not been abated. They are working. They will bring inflation lower. But the mechanics in my mind, if you maintain this relatively firm labour market, unemployment rate stays very, very low, you aren’t doing anything to rightsize demand relative to supply. And therefore it’s really hard to push down prices, particularly when wages are still relatively high given productivity trends. And so I think the mechanics that would force the bank to actually hike come the July MPR is that the labour market still looks relatively firm, wages are firm, and you end up in a situation where the higher starting point of inflation means that that convergence to the 2% target is pushed into 2025. That’s arguably a little bit longer than they’re comfortable with. And so I think those are the mechanics that we need to see for them to actually hike rates in July. I’m curious from your perspective and I’m going to put you on the spot here, do you think the bank hikes rates again?

Jonathan Guilford: I think it’s more likely than not that they do. But I would say I’m not as beared up as a lot of people are. And I don’t think that it’s a foregone conclusion that they will for sure. What I do think is that I think it’s far more likely that over the next, call it three meetings, that they will have to hike at some point than the market had been perceiving and I actually don’t think that that likelihood has changed. I think it was always far more likely than the market had priced in, like when the market had had marginal cuts priced in over the back part of the summer and early part of the fall. I always thought that that was wrong. I thought the base case by far was that the bank was probably going to just have rates at the current level for much longer than most people anticipated or maybe were comfortable with. I think that maybe now that’s kind of like 50/50 in terms of whether they do need to hike again or not, whereas a lot of people think that it’s almost a foregone conclusion. I’m not in that camp.

Ian Pollick: I mean, I don’t know, like, you know what, like aside from what we’re seeing in the data, you know, I’ve been doing a lot of travelling, hence why this is the first Curve in a while. And I’ll tell you, you know, every flight that I’m on is full. Every restaurant that I go to is full. Nice ones, not nice ones, you know, big destinations, small destinations. And so it’s very true that the economy is always the tightest before a recession. But I want to ask your opinion, in your own personal life, do you see higher rates impacting the economy the way that we talk about it on the desk?

Jonathan Guilford: Yeah. So I’ll just go back for one second to your last question, just to give a more just more explicit answer. I would say that I feel far more comfortable saying that I think that the chance that the bank will cut this year is almost zero. I feel far more comfortable saying that than I do, that they’re going to hike for sure. I feel it probably 50/50 that they hike at some point this year, but I feel like the chance that they cut is almost zero.

Ian Pollick: Okay. So in your personal life, are you feeling the tightness in the economy?

Jonathan Guilford: I would say that I certainly don’t see it in my day to day life and the kind of the places that I walk around and grocery stores that I go to, restaurants that I go to, I don’t see it like with that kind of with the eye test. I mean-

Ian Pollick: But do you feel the inflation? Do you feel it?

Jonathan Guilford: Inflation, for sure. It’s noticeable. I mean, it’s noticeable when you go in.

Ian Pollick: Yeah, anywhere, anywhere.

Jonathan Guilford: It’s noticeable. What I don’t notice is that I don’t notice the impact in terms of patronage of places. You go to a restaurant, every restaurant, the prices are sky high, but they’re full.

Ian Pollick: Yeah, but the same people. People aren’t saying no yet right? And there’s always a point where people say no and I don’t think we’re there. And so this is a good kind of segue to the next part of the conversation is, give me your outlook on bond yields, right? So you and I have, I think it was late last year, you were rates lower. I was rates higher. We were kind of both right for the wrong reasons. So let’s talk about the next three months. Ten years right now, pin them. Where are we? Higher or lower? And tell me why.

Jonathan Guilford: Say a ten year yields right now, say around 315? I kind of look at that as kind of being like tens kind of being relatively the most anchored part of the curve right now. And so say we fast forward three months with a lot of noise around where we are right now. I don’t see tens that much different than, say, 315. What I do see is potentially in the very near term, because of all of the, obviously the recalibration now, of the potential for near-term hikes, the front end, call it twos and fives, having a fairly material backup, which we’ve already seen quite a bit of in the last week we’ve seen twos and fives back of 40 beeps. I can see us backing up marginally more on a push here. But three months from now, even if we do get a realized hike, I think at most we probably get a 25 basis point hike if anything, over that three month period. And then I think the market starts to recalibrate and look forward again, especially if things continue in the way that they have been in the US. If rates compress there, Canada is going to get dragged along. You’ll still get the cross market differentials cheapening but we would get dragged along. So I actually see us three months from now, I would say even in a scenario where we get a hike, I think that’s out of the way and I see yields compressing in the front end.

Ian Pollick: I actually, and this is shocking for me to say, I do not disagree.

Jonathan Guilford: So I’ll say like two year bond yield right now is kind of somewhere between four and a half and four and 410. I could easily see us three months from now, two your yields being 390. So call it a 15 to 20 basis point compression there. I could see fives compressing maybe 5 to 10.

Ian Pollick: Yeah. Okay. So similar story, right? Like you have this seesaw pattern. I think we have a lot of risks around and you know, we get through this debt ceiling, you have a huge amount of net supply coming online in the US, huge amount of net supply coming on in Europe. That’s going to hit Canada. We probably sell off a little bit, but regardless of the hike, I agree with you. I do think that the peak in yields is very close. Yields to me still look relatively expensive. And so I am still bearish, but I’d say that fast forward and we’re talking in September, October yields either look the same or they’re marginally lower.

Jonathan Guilford: And I definitely see steeper curves by then.

Ian Pollick: So this is interesting. This is interesting because, you know, Canada has a problem. We have hikes priced for September, a very small amount of cuts. Yet the forward curve has this very aggressive pace of steepening that really starts now over the next year and a half. And so there needs to be a resolution. And so it’s a pretty simple thing to say, but the bank doesn’t hike. I get concerned that people start to say, okay, the bank has said we care more about growth than inflation or protecting growth. Inflation is sticky. That hits long end rates. That is how your curve starts to steepen out. When you think about the steeper curve, what are the mechanics? How do you see the curve steepening?

Jonathan Guilford: Like I alluded to before, I see kind of like backend rates, relatively anchored, like looking three months forward from now. And I see that steepening coming from lower yields in the front end. Correct.

Ian Pollick: See? Life finds a way. We’re disagreeing again, I actually think the curve can bear steepen a little bit. And I think that’s the big concern if you have any Bank of Canada policy and activity. A really big question for you. In your seat, what is the biggest concentration of risks? Is it twos, fives? Is it fives tens? Is it some micro RV? Where do you see the big pockets of risk right now?

Jonathan Guilford: Yeah. So I mean, I would say, first of all, I don’t think that there is a massive amount of crowded positioning in the marketplace at this point in time. I think that that last wave of kind of US regional banking sector turmoil shook a lot of positions out of the market, particularly on the speculative side. We saw a lot of players kind of disengage from Canada, especially a lot of accounts for whom Canada is not core market. And a lot of the speculative players tend to be international accounts. So when you get periods like that, you get a lot of de-risking generally from those accounts. And we saw that and even domestic accounts that can be some of the primary drivers of big fundamental risk flows here. We saw even those types of accounts remove a lot of risk from the table and only really starting to kind of tepidly re-engage a bit over the last couple of weeks. So I would say we’re starting from a point where positioning is not massively crowded. I would say over the last couple of weeks, the things that we’ve started to see that I would highlight maybe some concentration risk is building up in potential for knee jerk big reactions if these positions had to be unwound, would be some cross market trades. I think a lot of people had started to layer into fading Canada over the last few weeks.

Ian Pollick: Tale as old as time.

Jonathan Guilford: Especially as the cheapening has accelerated. I think that you’ve had a few people kind of in larger scale come in and not want to feel like they’ve missed the boat. And when you look at some of these differentials, like you look at the five year and ten year differentials, there’s still a lot of people would look at kind of flat level of the differentials as kind of like a steady state. So even though they’ve moved a lot, they’re still theoretically 30, 40 basis points in those trades. And I think a lot of people have, okay, well, I want to participate in that last 30 or 40 basis points. So if we were to get a situation where all of a sudden, for some reason, the data in Canada starts to turn sharply or you get some big risk off event, that significantly reduces the likelihood that the Bank of Canada could do anything or say for some reason, all of a sudden you start to see data in the housing market start to turn a little bit or you start to hear a bit more about refinancing on mortgages that are refined.

Ian Pollick: Resetting at higher rates becomes a problem.

Jonathan Guilford: A bigger factor. And then that Canada US differential story starts to turn a bit. That would be probably the thing that I would say potentially is there for the most concentration where there could be a bit of a problem if all of a sudden these positions need to get unwound. But aside from that, I don’t see.

Ian Pollick: It’s not a huge amount of crowding.

Jonathan Guilford: I think a lot of people have already started to lighten up on flatteners over the last little while. So that would have been an area. But I think that it’s less of that now and I think we’ve never really started to see a really material layering on of steepening. I think a lot of people have been, they’ve just been really reticent.

Ian Pollick: They’ve been waiting for it, but they haven’t actually pulled the trigger, right?

Jonathan Guilford: Exactly. So that that risk is not really there because people, even though they’ve been waiting to pull the trigger, not a lot of people have.

Ian Pollick: So there’s not stop outs there. Okay. So listen, we are at 25 minutes. It’s a pretty long episode. It’s a beautiful day. Long weekend ahead. Give me your top three trades.

Jonathan Guilford: Yeah, for sure. So, I mean, as much as we’ve talked about it, I’m definitely still in the CAD cheapening versus the US camp, particularly in the five year sector, because some of the supply dynamics there kind of around the DMS with the issuance profile this year being heavily, heavily skewed to a bigger proportion of five year sector issuance, that with the backdrop of the data starting to turn relatively with Canada starting to kind of come in here with a sequence of numbers that have all kind of been hotter at the same time that the US is kind of softening a bit of a change in rhetoric from the Fed in terms of being a bit more cautious relative to the Bank of Canada here and now likely having to.

Ian Pollick: Some belly weakness.

Jonathan Guilford: Yeah, be a bit more hawkish. Okay. So I like that trade. I think there’s probably at least another 10 to 15 basis points there in near term, just tactically. And over a longer term horizon, probably something more like 20 to 25. Generically, just like for a lot of the same reasons, just five year weakness on the domestic curve as well.

Ian Pollick: So is that like twos, fives, tens?

Jonathan Guilford: Twos, fives, tens. For a lot of the same reasons and also much more just domestically focused, I think that there’s a lot of the five year sector richness I think was driven by a lot of acute needs out of the bank Treasury community here needing to replace duration gaps that they were short in the belly of the curve. And I think that the need for that is going to exist a lot less as we go forward here.

Ian Pollick: Well, especially what’s interesting is that you had the OSFI data last week and what it showed is that loan growth is now picking up a bit. And so asset generation is improving relative to where it was. And people forget it’s not just mortgages, right? It’s business loans, it’s commercial loans. And that stuff is now going from low single digits to high single digits. So you don’t, this twos, fives, tens trade isn’t just predicated on people paying five year rate, it is just the general demand to replace an asset is coming from other parts of the bank. Banks are big places.

Jonathan Guilford: Yeah. And also probably some liabilities are leaving the banking sector in terms of like a big part of some of that need to receive last year was a huge uptick in fixed rate liabilities on bank balance sheets just from all the cash that was sitting around, all the deposit cash, a lot of it from pandemic stimulus, like that’s going to slowly start draining out of the system a bit more. So yeah, short fives on the curve. And then also we talked a little bit earlier about kind of setting up to be a bit short 30 years, whether it’s just cross market differential or whether it’s on the box.

Ian Pollick: I love the box.

Jonathan Guilford: Coming out of the extension.

Ian Pollick: Out of the extension. I agree. I think, you know, you cannot do better than, number one, putting on that tens, 30s box or you see CAN, Us and it’s great for three reasons. The first reason is if this is all a head fake, right, And the bank just kind of laughs at the market says, well, yeah, it’s hot, but let’s say you got a really bad employment report the day after the June meeting, for example, which is June 7th, All of a sudden, you know, you have to steepen this curve quite a bit. Number two is that on a relative basis to the US, you are very close potentially to a debt ceiling resolution. Rates are still too low. Sell off is going to flatten tens bonds in the US at a faster pace, just given that relative starting point. And typically what we see in the seasonals is that you get kind of between the second and the 15th of the extension and it just peters out. And so love that trade as well. We talked about it a little bit in the morning curve yesterday. I think that the risk here is that you have some assets in Canada that have not repriced BAS in particular. There’s just not a lot of supply right now. Come end of month, I think BAs and CDOR can actually move a little bit and so I don’t mind being long kind of SEP orders. I know this is your old life, but I know you keep an eye on it. Do you have any views on funding spreads?

Jonathan Guilford: Not anything acute, I would say. I mean I’ve been quite focused on the new job for the last little while, so I’ll defer on that for the time being.

Ian Pollick: Okay. So we’re going to call it, Johnny. Thank you very much for coming on the show. I hope everyone has a great long weekend. And remember, there are no bonds harmed in the making of this podcast.

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