‘Go with’ or go the other way?

Jonathan Guilford: Just fundamentally, I think the backdrop just makes a ton of sense there.

Ian Pollick: And you like it in the belly?

Jonathan Guilford: Yeah, I like it in the belly. You like it in the five year sector in particular, just because of some supply dynamics there domestically, what we’re seeing the relative data, a little bit of divergence and relative hawkishness of the two central banks.

Ian Pollick: All right. We are at the tail end of a short, long. It’s a short week that feels long. And there hasn’t been a huge amount of data this week. I’m joined today by Jonathan Guilford, who works on our Government of Canada trading desk. Johnny, how are you?

Jonathan Guilford: Not too bad, man. How are you? Good to be on.

Ian Pollick: I am very glad you’re here. And I’m glad you’re here for three reasons. Number one is I just, I like spending time with you. I enjoy your company. Number two is, you know, you and I rarely agree on market direction. And so I think we’ll have a good discussion today. And number three is that you were a swap trader in your old capacity. And so you bring some added dimensionality into some of the flows that we’re seeing. And so glad to have you here. Let’s jump into it. The past week and a half has been a big one, right? We went through a huge week last week. Canadian CPI comes in hot. Bank of Canada repricing. Macklem speaks, doesn’t say anything. We unpriced some of that repricing. And now we’re left in an environment where some of the debt ceiling talks are looking somewhat more constructive. All that said, my first question to you to kick off the episode is, you know, what stands out to you the most after the past week and a half of price action?

Jonathan Guilford: Yeah, I mean. Certainly, as you said last week and a half has been one of the wilder ones in recent memory here. Obviously, I think one of the biggest themes has been kind of the re acceleration of the Canada versus US rate cheapening theme on the back of kind of a few factors. Obviously, we’ve been getting a bit more mixed data out of the US for the last little while and a bit more balanced Fed speak and then that’s kind of been contrasted with just this string of hotter than anticipated data that we continue to get out of Canada. And obviously the most topical recent number being that extremely hot CPI print from early last week. And that was really the big trigger that really started pretty material back up in CAD rates, particularly in the front end and belly on an outright basis, but also on a cross market basis as well, especially in the early part of last week, I would kind of say like three themes kind of stick out to me a bit. I can briefly touch on those if it makes sense.

Ian Pollick: I’ll allow it. I’ll allow it. (laughs)

Jonathan Guilford: First of all, I would say that one thing that has been really interested in this, this most recent little sell off has been the fact that tens bonds has been leading the flattening that we’ve seen across the yield curve. I mean, we’ve seen both fives tens and tens bonds flattened pretty decently. And I mean, that directionality is logical given the nature of the selloff.

Ian Pollick: But the magnitude is a bit larger.

Jonathan Guilford: The magnitude, especially on the tens bonds, like the violence with which that snapped flatter, especially right at the beginning of this sell off, has been pretty surprising and mostly chalking that up to some real money buying that we’ve seen in long bonds over the last little while.

Ian Pollick: I mean the extension this year is very big. Yeah, right? Absolute basis biggest, you know, really since pre pandemic. Relatively too if you look at it versus the mid index, it’s almost two and one half times as large. And so when we wrote a piece about this, we kind of said, look, I don’t put a lot of stock in seasonality, generally. It’s in the eye of the beholder. But this year there was enough backdrop to me that it was going to be impactful. And then, as you said, we had the hot CPI report last week and you had this massive, massive move. Okay. So that’s theme number one. What’s the second theme?

Jonathan Guilford: Second one I thought was interesting was just the fact, the scale of which fives underperformed and in particular, in fact, that twos fives actually showed some steepening. And I think that surprised a few people because this is theoretically a front end led selloff driven by a bit of repricing for near term hiking possibilities and the fact that twos fives would actually marginally steepen into that when the rest of the yield curve flattened pretty hard was a bit interesting. I don’t find it quite as unreasonable as I think some others might, just because I think that the shape of our curve, like how flat twos fives has been for a long time relative to fives tens, I think already expresses quite a bit of pricing expectation of the bank potentially needing to re-engage the hiking cycle and also pricing in a lot of expectation of higher rates for longer over the life cycle of a two year bond.

Ian Pollick: Yeah. And that five year point is your neutral point, right? And so, you know, I look at like 2 or 2 year OAS, it’s still below the top end of the bank’s neutral rate. So there’s room. That’s 290. We kind of saw it trade above 320 for most part of 2020, latter part of 2022, early part of 2023. But it’s interesting because on the cross market basis that twos fives box has kept going. And you know, we’ve talked a lot about that before. But you know, twos five steepening is everybody’s dream. It rarely ever happens. So it’s right to look at it as an oddity. But I do agree with you. I think the market is now interpreting not only the potential move from the bank, but there’s pre-existing supply concerns that were never fully priced correctly.

Jonathan Guilford: And so it’s not unreasonable to me that if we get another central bank induced driven wave of selling here, that relatively some more pricing impact at the incremental level starts to focus more on, especially if we’re looking at higher rates for an even longer extended period of time, that that doesn’t start to have more incremental impact on considerations of over the five year bonds life cycle relative to the two year bond. And starts driving maybe a bit of more sustained underperformance of the five year.

Ian Pollick: For sure. And so third theme is?

Jonathan Guilford: Third theme is, it was just interesting, so to close out last week we had a pretty decent reversal of Canada US. Canada re-richened pretty sharply and obviously earlier in the week we had had a pretty material cheapening of Canada which made a lot of fundamental sense. And the re-richening thing that we got on Friday actually occurred on a day when we got retail sales, ex Auto, which was a pretty hot number again. So it didn’t make a ton of sense. And I think what happened there was we had a holiday shortened session. Oftentimes in those days you get thin liquidity, you can get some erratic moves.

Ian Pollick: People don’t necessarily want to be short going into a weekend with all the headline risks.

Jonathan Guilford: I think you got a little bit of people kind of coming in to try to take profits, quick profits on some of the Canada US cheapening and the market just couldn’t support it. But we’ve already seen that move reverse pretty good this week. So I think just the thing that stood out to me about that was maybe suggesting that positioning in that trade is getting a touch crowded.

Ian Pollick: Yeah. So the week over week I was looking before we recorded today and so, you know, you did have a net richening in Canada across the curve except for the back end. The back end, you know 30 year Canada US cheapened five basis points end of day Wednesday. Let’s dissect this a little bit and let’s just talk about the positive risks of further underperformance. Okay? So number one is, as you said, you have this policy induced cheapening that’s obviously twos and fives. And the risk here is that, you know, you don’t get data that tells the market the Bank of Canada is not in play. You know, the bank is in play whether you want to believe it or not, whether you think June is dead or not. I personally believe June is a dead meeting, but July is very much alive. The second thing is that you have this unwinding of some of the flight to quality flows that we saw really build up since mid-March. That’s largely on the back of the fact that we have not seen ongoing headlines of new stress in the US banking system. There’s just too many longs in the market and we can see it in the futures data that we produce. So I think those are the positive risks. Am I missing anything?

Jonathan Guilford: No, I mean, I broadly in line with those themes, I think those are kind of the most topical things of note and the big risk factors. And I’m in league with you there.

Ian Pollick: So let’s talk about the negatives. Right? I think on the negatives, number one is you do have the extension, right? And you have the first, you have the second. They’re relatively big. Obviously that’s a made in Canada kind of dynamic that could kind of push away some of the trend to cheapening. Number two is that you have the debt ceiling. And so one of the things that I looked at, I went back over time and I wrote about it in this morning’s morning curve. I looked at how Canada traded into the 2011 and 2013 debt ceiling into the ex-dates. Remember that in both those years there was an estimated ex-date and a deal was done basically at the 11th hour. But Canada richened pretty substantially going into both of those, which didn’t make a lot of intuitive sense at first because it’s a US led move. Right? Why would Canada richen. Well I kind of look back. Number one is Canada’s data deteriorated on a relative basis to the US. So you think about the comparable macro indexes, the surprises, Canada’s had worse surprises. And so I get a little bit nervous right now because we’re starting at a point where the relative surprise index, as you said, is very much in favour of Canada. Number two is that you did have legitimate needs back then for collateral. So the cross market collateral transfer that existed back then, maybe it doesn’t exist so much today because you have the RP facility, you have other facilities that didn’t exist back then. So I think if I remove that from the equation, what I think I’m worried about the most is that forecasters maybe are turning a bit optimistic in Canada. So coming out of the extension, I don’t mind being long Canada versus the US, but maybe the more elegant way to play it is through a box trade. What do you think about that? Like Canada steepening, for example?

Jonathan Guilford: Yeah, I mean, I think the box trade in particular is one that kind of is also on our radar on the bond desk. I think prior to the debt management strategy coming out in the spring and the announcement of, you know, pretty significantly reduced long bond issuance, that box had kind of, like the tens thirties cross market box had a broad range of kind of like 0 to -15. And we kind of thought that, okay, fundamentally now obviously with the supply of long bonds reducing dramatically, that the natural state of that box has to move lower. Yeah, we kind of broadly were thinking maybe that range becomes something more like -25 to a -15 kind of a thing.

Ian Pollick: We kind of breached that last week. Yeah?

Jonathan Guilford: But yeah, so we breached that last week and we’re still kind of bumping up towards the bottom part of that range. But we basically had touched very close to -30. So from our perspective, as we head into the end of June, if that box is still hovering around, you know, the high negative twenties, or can manage to approach even -30, again, we think it would be great risk reward from my perspective, to come into the beginning of June with that cross market steepening Canada.

Ian Pollick: I agree with you. But I also think it makes, there’s tactical sense in the sense of, there’s seasonality in Canada that doesn’t last for very long. It goes away. But then you do have what we were just talking about. If you did have this concentration of risk in Canada underperforming and that turned and you have that taken back, which is so classic Canada, that is going to be a ten year led move. And so I generally like that box as well. Let me ask you this. Let’s just turn the table a little bit. You know, we’ve talked a lot about some of the front end moves, five year weakness. Do you think the Bank of Canada is going to hike again?

Jonathan Guilford: You know, I would say I’m not quite as convicted as a lot of people in the marketplace seem to be, that it’s a done deal that the Bank of Canada will certainly hike again over the next couple of meetings or even by the end of the year. I think the market was underpriced for a long time, like when there were actually cuts priced in for kind of mid 2023 or early fall of 2023. I thought that was clearly wrong, especially with the data that we’re seeing continuing to come in hot like it, just the threshold for that data in terms of CPI, wage pressures that we’re starting to see little signs that the housing market is starting to turn. The threshold for how much those would have had to turn around for the Bank of Canada to actually perceive cuts being reasonable. I thought it just didn’t line up with market pricing. And now in this most recent sell off, kind of where the market’s gotten to now I think we’re around 60% for a hike by July, fully priced by October. I think that’s fair.

Ian Pollick: That’s fair.

Jonathan Guilford: So like, do I think more likely than not, the Bank of Canada hikes once before, call it early fall? I think it’s more likely than not, but I wouldn’t say that I think that it’s a done deal.

Ian Pollick: But it is more likely.

Jonathan Guilford: It’s certainly, I think it’s definitely more likely than cuts. I think the thing I’m very convicted about is that it makes cuts make no sense in 2023 unless you get an absolute Armageddon type of situation.

Ian Pollick: Barring a cataclysmic tail event being delivered, I would agree with you. And I think, you know, we are from a house perspective, we haven’t changed our call yet and we haven’t changed our call because I would like to see another labour market report. I don’t want to put a ton of focus on one data point. That being said, the one data point that we’re focusing on is a big one. You know, you look at the persistence of core inflation and the measure the Bank of Canada’s supposed to look at was, you know, ex food, ex energy ex mortgage interest costs on a three month annualized basis. It rose so aggressively, you know, you went from something a bit above 2% to something just under 4%. And it’s hard to ignore that. I would like to see some stability in the unemployment rate because to me that would indicate the labour market still remains way too tight and therefore demand isn’t falling fast enough for them to realize their 2% inflation target in the time that they’ve told us they want to realize it, i.e. the end of 2024. And so mechanically, if I see a situation where the labour market is still too tight, that suggests they have to push the convergence to 2% into 2025, given what I know about the Bank of Canada, that to me would suggest they will hike rates. And I think in conjunction, what we’ve seen over the past really 48 hours is a huge amount of Fed speakers coming out saying, you know what, maybe we haven’t done enough. And this is mostly on the hawks to be granted. But there was a couple of centrists that sounded more hawkish than I had heard of them. And when I think about the differential Canada US, if the Fed goes to 25 in June or July, we’re talking about 100 basis point differential. You are pushing up against traditionally pretty elevated levels. And you know, the currency right now, if you do a fair value regression, the Canadian dollar is probably $0.04 too expensive given that rate differential. And so I do worry about trade being impacted. The Canadian dollar has to weaken up a bit more and then all of a sudden, whether it’s right or wrong, you are going to start talking about, is that the right level, that you start importing more inflation. So I agree with you. You know, I think that the probability is more likely than not. But the question is on the back of that, let’s say they go 25. 25 doesn’t do all that much. Are we really talking about a resurgence of the cycle or are we talking about an insurance hike? And then more of the same for really what we saw January to March? And if you believe that to be the case, what does that mean for the level of yields?

Jonathan Guilford: Yeah, I believe that to be the case. I don’t perceive it would be a situation where it’s a re-engagement of another round of a hiking campaign. I would see it more akin to that kind of like an insurance type of a situation. I think the bank’s preference is to keep rates at higher levels for longer, but with higher being more or less where we are already, rather than having to take them sharply higher and then quickly be in a situation where they have to cut sharply and more steeply than they otherwise would, and the volatility that that potentially introduces into kind of the economic growth cycle. If it was only just the incoming data, that was the only consideration, I think, yes, it’s obvious that the bank, it makes sense for them to hike. But I think that in the background, I think that they’re very concerned about a potential mortgage refinancing crisis in a medium term horizon.

Ian Pollick: And they talked about it in the Financial Stability Review.

Jonathan Guilford: And I really think that’s the only thing that’s holding them back.

Ian Pollick: Yeah, for sure. These are big numbers, right? And like ultimately, at the end of the day here, you know, you heard it here first. The laws of supply and demand have not been repealed. Monetary policy does work and it works maybe with longer lags than we had appreciated. So with that said, and you think about the level of yields and talk to me as if right now we’re recording in the fall, we’re about to put on our jackets. It’s cold outside. I’ll buy you a pumpkin spice latte. Where are the level of yields? Are they higher or lower from right now?

Jonathan Guilford: I would start off with kind of talking about back end yields because I think that I see those being relatively anchored around where they are right now, like in terms of a, call it a four month look forward, just static point, say the end of September or something like that, with the caveat that there could potentially be a lot of volatility in between then.

Ian Pollick: But your point estimate is they’re probably around where they are right now.

Jonathan Guilford: And I think that volatility in the fluctuation probably ends up being a path of higher rates first and then coming back. But yeah, kind of static around where they are. So say ten year yield right now. 325 roughly end of September, I think that is a reasonable estimate and I think most of the variability in rates comes in the front end and I actually potentially see those front end rates marginally lower than they are right now. And I think that could potentially come about one of two paths. Okay. Say we do get this insurance type hike, say it does manifest at some point here over the summer or early fall. Obviously, you reset base level of rates at a bit higher of a level. But I think then at that point you start to get some people start thinking about and considering whether that’s a policy mistake and you start getting the pivot towards, okay, now thinking about when the reversal and the cuts that need to come to correct that policy error will need to occur. And I think that that potentially induces a pretty material rally, albeit obviously from a bit higher level of rates.

Ian Pollick: And that’s in the front end you’re talking about?

Jonathan Guilford: The front end.

Ian Pollick: So you are a big believer, if I’m taking this all in, of the bull steepening move?

Jonathan Guilford: Yes. So say we got two year yields right now at 415. I could see four months from now an estimate maybe they’re call it 4%. So say 15 beeps lower and five year yield is call it 345. So maybe that’s ten beeps lower, maybe that’s a 335 or something.

Ian Pollick: So that’s really interesting because, I’m going to cut you off for one second, because we have done a lot of work trying to understand curve cycles, you know, and one of the things that we found is that when you build a transition matrix that basically says, if I am in one stage of the cycle of the curve, how do I transition to the other stage of the cycle? Now, no one at home can see this, but I’m writing a paper on it. But what I’m showing Johnny right now is right now we’ve been in a bear flattening move. The probability of transitioning from a bear flattening environment to a bull steepening environment is now 35% versus historically only 14%. And that’s just because the level of base rates are higher. You have more yield in the front end so it can actually account for the curve to moving. And that’s where our forecast is. Like, wait, we’re agreeing. (laughs) It doesn’t happen too often, go buy a lotto ticket. But I agree with you. We do see the curve steepening really after the summer. Okay.

Jonathan Guilford: So that was kind of the first path that I could see getting to that, like you get a hike, but if you don’t get a hike, I see kind of things manifesting in a similar fashion. If you don’t get a hike, then I think, okay, then the market starts to perceive, okay, well, the Bank of Canada has decided that this is not required and I don’t think it would be in a situation where, okay, people just keep pushing out, okay, maybe they’ll hike in late fall then or in the winter or early in 2024. I think if we don’t get a hike in the next few months here that it’s just over. It’s the end of the campaign and that you still get that beginning to pivot and focus and look at-

Ian Pollick: So it’s a game of attrition at that point, right?

Jonathan Guilford: You won’t be starting from as high of a base rate level, but then also the steepness and the pace of the cuts when they come doesn’t need to be as aggressive.

Ian Pollick: So and that’s true, right

Jonathan Guilford: And neither of those scenarios I can see like getting to those same kind of yield point estimates.

Ian Pollick: So if I think about, let’s just talk about the very tactical term because we’re getting a bit long in the tooth on this episode. When we think about your top three trades or top two trades or your top trades, what are they?

Jonathan Guilford: The thing that I have the most conviction about is that crowded trade that we were talking about with Canada, US. Just fundamentally, I think the backdrop just makes a ton of sense there.

Jonathan Guilford: And you like it in the belly?

Ian Pollick: Yeah, I like it in the belly. I like it in the five year sector in particular, just because of some supply dynamics there domestically. What we’re seeing the relative data, a little bit of divergence in relative hawkishness of the two central banks. And also I think just like this kind of overhang of the US regional banking situation, if it were to reignite, it’s a potential kicker for that trade as well. So that would be the number one conviction one. Also, just in general, I like being short fives on the curve domestically.

Ian Pollick: So twos fives tens?

Jonathan Guilford: Yeah. And that’s primarily a supply story kind of thing with the DMS coming out, the proportion of fives

Ian Pollick: Just that net DV01 is larger.

Jonathan Guilford: The proportion of all coupon issuance dramatically increasing the potential overhang of the CMB program potentially being ceased. And if that were to occur, that obviously theoretically is some incremental five year issuance, at least at the margin. And I think a little bit of flow dynamics, I just think that Bank Treasury receiving needs in that part of the curve, which were really, really significant last year and helped us get to kind of the levels that we are right now. I think that they’re abating heavily. If anything, there’s a chance that they may be marginal payers.

Ian Pollick: And what’s interesting too, is that twos, fives, tens, it has legs, right, because you will cheapen into the end of the cycle. When you start to turn, that’s when you get your legitimate twos fives move right? And so I can see that trade having a bit of a longer run investment horizon, especially given the starting point, right, as you said. Okay, look, we’re out of time here. We hope everyone had a great time listening to Johnny and myself. And remember, there are no bonds harmed in the making of this podcast.

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