Making sense of the market

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.

Ian Pollick: The Fed can very easily target aggregate demand. So I’m more optimistic on the idea that higher rates can now start to trigger a downturn or a targeted downturn.

Keith Rofrano: Here we are faced with enormous amounts of uncertainty in the market, be it supply chain, labour costs, interest rates, etc. and so many middle market companies, I’d say, in fact, all middle market companies face some level of uncertainty they’ve not seen before. So, Ian, what we’re hoping that we can start to do is make sense of this, where it matters, where it matters for clients that are servicing the middle market. So as we roll through what is most important and maybe the first headline to address is the question around recession. What are your thoughts about recession?

Ian Pollick: Ah, the recession question. We’ve gotten a lot of recession questions lately, Keith. So let’s just take a step back and talk about what a normal recession looks like. A normal recession is all triggered by something called the bullwhip effect. The bullwhip effect is a supply chain phenomenon. And what it does is it describes how very small fluctuations in demand, whether it’s at the retail level, sometimes at the wholesale level, are extrapolated by producers and manufacturers into this persistent demand. And then that expectation means that companies invest in more supply. And what ends up happening, regardless of where the trigger is coming from, at some point in the cycle, aggregate demand falls and then there’s too much supply. And that excess supply is what forces inflation lower and all of a sudden is what really triggers a slowdown in growth. So I think to frame the discussion, it’s first really relevant to say, well, what is a normal recession? And that normal recession is just you have not enough demand for the supply that you have out there. Now, we’re in almost the opposite of that situation. We have a lot of demand and we don’t have a lot of supply. And that’s for all the reasons we’re very well aware about related to the pandemic. When I think about a recession, I do get nervous that we are starting to see some indication of that bullwhip effect coming into play. When I look at some of the manufacturing surveys, though, that have been released over the past week, it is very clear to me that the the hard data, the activity data looks very good, but the sentiment data is starting to roll over. Now, sentiment is a funny thing, and you can recover sentiment if you have a decent enough backdrop. But, you know, the way that we look at it is to ask the question, are higher interest rates on the back of high inflation going to trigger a slowdown in growth? And unequivocally, the answer is yes, it will. When I think about a recession, though, I tend to think about what type of recession we’re going to get. And there’s really three types, Keith. The first one is the most benign, and that’s a business led recession, and that’s a direct consequence of the bullwhip effect where you overestimate demand or the persistence of demand. And you either have too many workers or you have too much inventory and you contract. And that’s a relatively easy recession to fix because businesses, of course, can respond very quickly. The harder recession to fix is the one that we saw really in 2008. What started off as a household recession and household balance sheets need to be repaired. There was leverage in the system that needed to be repaired, and that ended up morphing itself into a financial sector recession. Now that’s the worst type of recession. It takes a very long period of time to come out of it. When we think about the type of recession we’re likely to see, it’s almost like the recession that no one’s ever seen before. And that’s because when you look at where growth is slowing the most, it’s in the interest rate sensitive sectors of the economy and the interest rate sensitive sectors are housing, construction, certain parts of manufacturing. The interesting part about that is that there’s not a lot of employment actually attached to those sectors of the economy. So you could in an ideal situation, this is what the Fed refers to as a soft landing, is you see this deceleration in the really highly productive parts of the economy. Those are the sectors we just talked about. And you don’t really get a huge hit to the unemployment rate. That’s the type of scenario that the Fed would say, you know, mission accomplished. This is a soft landing. How easy is that? Well, it’s pretty darn hard to achieve. So given everything we know right now, I would say that we are looking for a somewhat benign recession. But obviously conditions can change relatively quickly.

Keith Rofrano: As the Fed thinks about the shift, the components of inflation, if you will, between demand versus supply versus other idiosyncratic. How does that fit into your view going forward? I mean, do we still expect that half the supply story coming from the demand side or do we see half staying on the supply side?

Ian Pollick: It’s interesting to look at where inflation is coming from. And if we were to decompose inflation, let’s say in core PCE, what we find is that a year ago, almost all the inflation was coming from supply side imbalances. Today, it’s a much more symmetric distribution where you end up having about 35% of it is now coming from actual demand. Some of it’s stuff that we just can’t explain. And about 40% is coming from supply. So the amount of supply chain disruption that’s hitting inflation is lower. But, more importantly is that there’s more demand hitting inflation. And it’s more important because the Fed can very easily target aggregate demand. So I’m more optimistic on the idea that higher rates can now start to trigger a downturn or a more targeted downturn in inflation because more inflation is coming from real demand. And that really wasn’t the case six months or a year ago. And that’s really important for the bond market and the swap market, because when you tell someone, I can’t control this type of inflation, my tools are just not the right tools. The only thing I can do is over tighten. So that narrative is becoming less genuine. And I think that’s really important for us to start calibrating our expectations.

Keith Rofrano: And so obviously a big component of every middle market company, every company period, is labour. So what should clients be thinking about? What should they be looking at? What are good indicators that we can all stay abreast on to make sure that we understand what’s coming down the road?

Ian Pollick: Yeah, so there’s a few ways that we could look at it. And I think the most high frequency indicators is every Thursday we get the data for continuing claims, initial jobless claims. That’s a really good look into some of the more real time activity in the labour market. Obviously, once a month we get our labour market report. But there’s something else that’s pretty interesting. And if you were to look at the Atlanta Fed’s website, there’s a portion on that website that talks about how much of a wage gain people are receiving if they are entering the labour force or if they are switching jobs in the labour force. And what we’ve seen really over the past year has been that these job switchers are making up the most amount of incremental gains in wages, and that speaks to broader labour shortages in the economy. And so I tend to look at that website quite a bit just to understand what the run rate is. And that run rate is north of what we see in the official data. It’s close to 7%. So I think this idea of you not only have labour shortages, but you have labour skill mismatches too. What happened in the pandemic, was that a lot of self-employed ended up moving into larger companies. That meant that there’s a lot of vacancies to be filled for low skilled workers, and the skilled workers are the ones that are in the most amount of demand. And it’s those skilled workers who are non managers that are receiving the largest incremental wage gains. And that’s a theme that’s not going away, that’s structural. And you can kind of compare that to other markets. Let’s take Canada, for example. Now the difference between Canada and the US when it comes to wage growth is that Canada has a lot of immigration and that immigration generates a lot of population growth and you don’t necessarily see the same thing in the United States. Now it is generally a closed economy and therefore when we think about the G7, it’s very easy for us to see wage growth being more persistent in the US and other markets.

Keith Rofrano: So it’s interesting, right? So if you’re a company and you’re thinking about labour as a topic, what you hear is there’s a shortage of labour. It’s more expensive and it’s fairly transient, right? People are moving around a little quicker for different reasons than they were, say, three years and certainly five years ago. And so that’s difficult to hedge and hard to keep up with, as you think about the backdrop of higher inflation for other components to run a business and as I said, with a less than stable labour force, it just makes it even a bit more difficult. So while we empathize with that, I think one of the things that makes it even more important is to focus on the things that you can hedge. And so let’s shift the conversation to rates and how clients should be thinking about rates. And I know they’re near and dear to your heart, Ian. And so you are our true expert on rates. So tell us everything we need to know about the curve, where it’s going, and what we ought to be thinking.

Ian Pollick: Well, thanks for that. It’s been challenging, to say the least, because you are wrestling with this very odd situation in financial markets where your, like I said earlier, your hard activity data remains very good and your forward looking sentiment data is starting to roll over. And against that you have inflation that continues to rise, commodity prices that remain elevated, and therefore you have central banks that are very nervous about inflation expectations becoming unanchored. Now, I do believe inflation expectations are unanchored. I look at the basket in my life and the CPI, my personal CPI, my personal CPI is above what the official rate would be. I think a lot of people would suggest it is too. And bond yields get the joke and bond yields have sold off dramatically this year. It’s been the worst returning year for fixed income, well ever. And so the question is, what do you do from here? It’s our expectation that we’ve already seen the peak in yields for 2022, Keith, and very likely for the cycle. And that really reflects this idea that we are almost perfectly priced for the Fed to achieve a level of overnight rates close to three and one half percent that gets achieved later this year. And if the market has perfect foresight, then you end up getting some type of interest rate cuts from the Federal Reserve in 2023. Just a course correct the economy a little bit. And then you end up in this very long period of inertia. And markets are never perfect and markets don’t have perfect foresight. But I’d say that the way that we view the world isn’t terribly different. Where we differ bit is we do see the Fed getting to three and a quarter. Let’s say three and one half by the end of this year, but then staying there for a very long period of time. Because remember, why do central bankers lower interest rates? Well, to promote higher inflation. But I think you’re going to be in one of those situations, Keith, where you get interest rates that are moved into restrictive territory, growth begins to slow and inflation does moderate, but stays very well anchored above that 2% inflation target. And so to me, that argues in favour of a very, very flat yield curve. And actually, when you look at our own interest rate forecasts, we expect peak inversion of the yield curve to occur in the first half of 2023. And that’s simply because it’s very hard for this market to credibly price in more cuts than what it has right now. Really, there’s only about 40 basis points of cut price into 2023, and that just means that any excess premium in the bond forwards really have to be harvested through a much flatter yield curve. And so what does that mean for the actual level of rates? Let’s put some meat on the bones here. We see ten year yields finishing this year, around 325, a little bit lower than where they are today. When I look ahead to the end of 2023, now, my crystal ball, which by the way, has been in the shop for most of this year, sees rates closer about two and one half percent. And that’s a big move relative to where we are today, right? And so the question is, what do you do with that if you need to hedge? I think there’s two ways I’ve been thinking about it from a middle market perspective. And on the one hand, you know, we often talk about rising interest rates and the need to hedge and a lot of that ship has sailed. And so don’t be scared to monetize some of the good hedges that you have on that does help to create a very important narrative when it comes to rehedging again. You know, hedging works both ways. The other thing I would say, though, is that for those type of investors or those type of clients that need to hedge that currently do not have anything on, I would say that being very realistic, the confidence intervals around my central forecast are very wide and it’s a weird situation that needs resolution because I can make a very strong case 12 months forward that we’re either in a much worse situation or in a much better situation. And either the path of rates is as we expect or it’s much higher than we think. I cannot say with all that much conviction that I know which way I’m leaning with a huge proportional difference. So to me, that’s just that, you know, you’re supposed to deploy some of your risk that you’re looking to hedge now, whether it’s through a vanilla hedge or a hedge with more optionality. But you have to start thinking of wider these confidence intervals are, it should not preclude you from entering into a hedge, even though we think interest rates will fall.

Keith Rofrano: So let me put myself in a middle market shoes. So my experience in the past may be that I’ve done some swaps in the past 12 years and maybe weren’t so happy with the outcome of that. And then I walk in one day and I see this rapid rise in interest rates, and then I hear experts like Ian telling me that, yes, rates are probably going to go a little higher from here. I believe that. And then the confidence level, which I understand is very difficult to predict going forward. So the question is, what do I do about it? Well, there’s a few levers that are available and should always be available to a middle market company. One is think about your hedge ratio. And the way that you determine the hedge ratio is really take a look at a shock analysis of what happens if rates do X or rates do Y. What does it mean for my business? Pretty simple to go through that exercise. The other thing is to consider your duration of the hedge, right? And so where there is flatness in the curve, which we are seeing beyond years through seven and ten, I would argue that getting a little bit more aggressive with duration makes a lot of sense because it’s fairly cheap to do so. The third thing is getting creative in your solution. So one of the things that we’re getting a lot of sort of traction and use from is this concept called the cap mark to market. So in the past of those 12 years where clients were experiencing negative marks that seemingly had no end, we can change that this time. So if rates were to go down and you did receive your hedge protection and rates did go down from here, there are structures that can cap and limit, like with 100% certainty, the extent of those mark to market losses. So I’d encourage you to make sure that you’re thinking through something other than binary, all or none type thinking with your hedges. Because remember, the three levers: hedge ratio, duration and the creativity around your structure are always important. Anyway, so we talked a lot about rates. Let’s talk about FX for a little bit. So, Bipan, tell us what you’re thinking about the general direction of the US dollar and what our clients should be thinking about.

Bipan Rai: Sure. I mean, when I look at foreign exchange from the perspective of the target audience for this podcast, I mean, I try to think about why FX matters. And again, you tend to see more and more headlines popping up in the media about us shifting into this deglobalized world, which is obviously implications for global trade. But I think the important thing to stress, especially for our listeners, is that, yes, we are moving towards a deglobalized world, but not completely. We’re moving towards more regional blocs. And if you do have trade relationships and partnerships with firms outside of the country, say, in Canada or Mexico, it still does matter in terms of which way the US dollar is heading. And in our view we still think that despite the move that we’ve had over the last several months for the US dollar, we still see further upside for the dollar against currencies like the Canadian dollar and the Mexican peso. And if there are listeners there that are exporters and adversely impacted by the fact that the US dollar is going to be appreciating, you know, we’d encourage them to look at potential dollar buying strategies to really participate in some of that dollar strength instead of being adversely impacted by the potentially compromised export picture. And for our listeners that are more geared towards imports, I mean, it might be a good idea to potentially look at reducing hedges that you already have in place. Now, why are we so constructive on the US dollar? And a lot of this dovetails with what Ian said with respect to the fact that the Fed does need to continue to tighten monetary policy conditions which are still way too loose relative to where they should be. And consider that most indicators still point to a reasonably tight labour market in the United States and healthy activity in the real economy. And of course, that differs a little bit with what we’re seeing in terms of forward looking sentiment data. But nonetheless, there is still a need for the Federal Reserve to tighten policy going forward, and that’s going to be incredibly supportive for the US dollar, especially when we consider what’s priced into the market relative to, say, other central banks. And indeed, if we listen to some of the rhetoric that’s been coming out from several Fed speakers of late, the messaging is also changed by an appreciable degree. Before it’s all about getting administer rates back to neutral settings. Now it’s shifted towards getting them to restrictive settings by the end of this year. That’s still a little bit different than what we’re hearing from other central banks. And of course, that matters for the foreign exchange market because we are detailing the relative messaging from the Fed versus other central banks. And of course, if the Fed is more hawkish than other central banks, it stands to reason that the US dollar should continue to appreciate. So another reason why we have the US dollar outperforming is that the Fed, put simply, has fewer imbalances to deal with the further along this rate hike cycle goes. Now considering Canada, we’ve got somewhat of an imbalance when it comes to our household sector. And Ian mentioned earlier that a recession that’s tied or led by the household sector is probably the most serious recession to overcome. In Canada, that’s a particularly acute problem because unlike the United States following the global financial crisis, households in Canada didn’t deleverage. And what that means is that as the Federal Reserve and the Bank of Canada continue to tighten policy rates going forward, you know, a rate hike in Canada is potentially worth more in terms of curbing real activity relative to what it is in the United States. And of course, that to us suggests that the terminal rate for the Bank of Canada is somewhat lower than where it is for the Federal Reserve. And of course, in equilibrium that should lead to a higher US dollar over time given what markets are currently pricing in. And finally, the third reason why we think that the US dollar is going to be supported is that it’s a haven asset, especially when we’re looking at things from a foreign exchange perspective and we continue to see risk markets, risk meaning, say equity or potentially other assets remaining on the defensive that should continue to support the US dollar going forward as well.

Keith Rofrano: So what I hear you saying is if I’m an importer, I should be thinking about aggressiveness in my hedging, maybe aggressiveness in my duration as well.

Bipan Rai: Exactly.

Keith Rofrano: If I’m an exporter, I need to think about, one stopping it from getting worse. So put a boundary around it from this point onward and maybe have some optionality in my hedge solutions so that if the market does come back, I can be a bit more opportunistic in fits and starts.

Bipan Rai: Yeah, I absolutely agree with what you’re saying there, Keith. I think that is the messaging that I think we should send to our listeners out there with respect for the US dollar strength and what it would mean for their bottom lines.

Keith Rofrano: Another thing we hear a lot about, Bipan, is this deglobalization, reglobalization, and I know for a fact that a lot of our middle market clients have have begun to at least think about, and some of them mobilize. And I wouldn’t say it’s reshoring, but I would say reglobalization is probably more appropriate and a lot of the feedback that we get is moving perhaps out of China into other areas of Southeast Asia or even some into Mexico. And I’m just curious your thoughts. What’s the currency backdrop of that? And again, how should our clients be thinking about getting away from one risk and into another?

Bipan Rai: Certainly. I mean, if we look at the way that the Mexican peso and other emerging market currencies, for that matter, have performed so far this year, they’ve held up relatively well against the US dollar strength. And one of the reasons for that is because central banks in the emerging world have been far more responsive to this inflationary shock than some of the developed market central banks. But going forward if we’ve got a more aggressive profile from the Fed and of course, they are moving in larger increments than they were relative to before. It stands to reason that some of those emerging market currencies might be exposed. And again, you know, I talked to our resident expert here on all things Latin America, including the Mexican peso. And he still sees the Mexican peso weakening by an appreciable degree going forward against the US dollar. Part of that is predicated towards further dollar strength, tied to an aggressive Fed backdrop, but also because we’re closer to the end of the Central Bank of Mexico or Banxico’s rate hike cycle as well. So over the coming quarters, we’re maintaining our forecasts for Q3 and Q4 for dollar MEX close to the 21 to 21 and one half range.

Keith Rofrano: Excellent. Thank you, Bipan. So I guess, again, the takeaway from there is you rotate risks. You have to kind of reanalyze your materiality and think about not just your forecast and volume, right? But also the volatility of that currency you might be getting into because it could have a different impact on how you run your business.

Keith Rofrano: 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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