Market tides & waves

Keith Rofrano: Welcome to Markets in the Middle, a podcast series dedicated to delivering you insights into the current economic environment with specific focus on interest rates and foreign exchange and what it all means to the middle market 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.

Keith Rofrano: If you had the mic today and you could ask Paul any question you wanted, what would it be?

Ian Pollick: Listen, I think there’s a ton of questions I would ask him, but my question to him would be what metrics are you looking at to understand whether there is more equilibrium in the labour market?

Keith Rofrano: Boy, it is good to be back with you gentlemen.

Ian Pollick: Oh, it’s good to be here, buddy.

Keith Rofrano: It has been a bit. I was thinking about since our last conversation, which was toward the tail end of October, you know, what are the tides in the market versus some of the waves and trying to help our clients think through what are the best practices and things they should be paying attention to. And, you know, I recall we talked about higher rates, the threat of higher rates for longer. And then we talked a little bit about collars as a potential solution. And, you know, if those were the tides, those are all still true. So I think that’s a good sign. But there’s all these waves, all this noise, right? You know, maybe, Ian, if you can just dive right in. Our clients hear a lot about hard versus soft landing. And, you know, I get a lot of questions. Are we in a wily coyote economy or are we going to put our tray tables up and, you know, experience a soft landing And what’s it all mean sort of for the middle market? So why don’t we start there?

Ian Pollick: Sure. And I think, you know, this is one of those weird periods of time where people are using a lot of these words. Some of it’s hyperbole. So let’s just break it down. What people are actually trying to say, the whole landing idea. Right. This idea of landing somewhere is that you can bring down the inflation, you can raise the unemployment rate. And in that process, you’re either going to generate some type of Wile E Coyote moment, like you said, It either is very, very aggressive and it overshoots in terms of in both directions, and that’s the hard landing. Or you can get this soft landing. Now, to me, the soft landing is pretty interesting. And here’s what it really means right now. When you look at the imbalances in the labour market, you don’t have a lot of labour supply and you have a ton of labour demand. And that is what a tight labour market is. So what policymakers will look at is, you know, various surveys like the Jolt survey to show how many job openings there are in a world where the economy is generating jobs and the amount of open positions continues to stay at either a high level or continues to rise. That’s the biggest problem for the Fed, because that is an economy that’s overheating. It’s a labour market that’s very tight. And so the way that the Fed is trying to generate this slowdown is to raise interest rates enough such that either wages are too expensive and labour demand cools, or that the economy gets so slow because rates are high, people are saving money as opposed to as opposed to spending it, that labour demand also cools. Where do we sit on the whole soft, hard falling off a cliff? We don’t really know yet. I think when you look at our forecast, we do believe in the evidence that’s showing a soft landing. The problem is, Keith, is that since we’ve talked in October, even where we thought and we were, you know, pretty out of consensus viewing rates had to go even higher than what the market was pricing. They’re going even higher still. And so by the time that people hear what we’re recording today, I suspect that we would have gotten a couple more pieces of very critical data. We are leaning to adding yet another Fed hike to the profile, perhaps even two, and so right now we see the terminal interest rate resting around five and a half to 5.75%.

Keith Rofrano: That harkens the other buzz phrase we hear a lot is financial conditions, right? So what are financial conditions? How do we think of financial conditions? Pull that apart for us.

Ian Pollick: Sure. Again, this is nomenclature. And so what do people mean when they say financial conditions? It is a term used to describe how economists think People on the ground feel the average level of the overnight interest rate. And so it’s a way for us to understand that regardless of what the setting of monetary policy is, does it feel softer, Does it feel tighter? Does it feel looser to people actually in the economy? And so typically, the way that these financial condition indices are created is it looks at a few different things. It looks at asset valuations such as home prices, broader real estate prices, equity prices, bond prices. It looks at the level of the currency. You know, you have a strong dollar, you have a weak dollar. And remind me, what is a strong dollar is what in the US is that tighter or looser?

Bipan Rai: A strong dollar in the US would be equated to tighter policy.

Ian Pollick: So the dollar obviously matters for the export channel and then you have the level of credit spreads. So that is a proxy for can people access credit and if they are accessing credit, is it that tighter or looser levels justified by the overnight interest rate? Now you go back and you say, well, what is the evolution of this thing? Well, you’ve raised interest rates pretty aggressively. Financial conditions tighten very aggressively on the back of it, as one would expect. But then, you know, every time you had the good news is bad news and the equity market, financial conditions got looser, the lower interest rates have gone, conditions got looser. I would say, though, in the past three weeks, conditions are tightening yet again, and so it is moving in the right direction. And the reason this is important is that what the Fed is looking for is, are imbalances and those imbalances are what create vulnerabilities in the economy. It’s likened to a situation where the Fed is raising interest rates very quickly. Financial conditions, as we’ve just described them, are getting easier, emboldens the Fed to actually do more. So the fact that financial conditions are now responding in the appropriate. Way it’s good because it’s throwing in the same direction that the Fed is and therefore, at the margin, it means the Fed doesn’t have to do as much.

Keith Rofrano: Right. So first of all, I want to thank Bepin and congratulate him for answering correctly to the first pop quiz number one of the podcast. But I guess then the connection, if I’m hearing you right, is how do we connect financial conditions to the labour market? And so if you’re a middle market company and I’ll just share what we’ve heard time and time again from our clients in these past months is we’re not necessarily looking at cutting labour, we’re not hiring at the same pace. But our biggest risk is we don’t want to lose labour, right?  So they’re hanging on to the employee base that they have for fear of they don’t want to let people go and have to rehire them later, and so that that’s very real. And I guess the real answer is at what point and it’s tough to know at what point do financial conditions get tough enough where it does impact the labour market. Any thoughts there?

Ian Pollick: Yeah, I mean, look, I’m a very big believer that in many developed markets, particularly in the United States, you have a sicker labour force. And when you have a sicker labour force, just think about what that means for a second. It’s not just COVID. It is that as a result of the pandemic, you generally have less healthy people in the system. And whether by hook or by crook, what that means is that more hours worked are lost to people for worker absenteeism due to being ill. And therefore, if you’re a big company, a small company, a middle market company, you are not only paying for people to be on short term leave, you are hiring people to do that person’s job while they’re on that leave. And so your productivity is going down as your wage bill is going up. That is a way that tighter financial conditions are starting to feed into the labour market because at the end of the day, as inflation continues to fall and labour markets continue to stay tight, wages are the wild card. And if you need to hire someone to offset someone who’s not at your job, then you’re almost somewhat inelastic on that wage level. And so it has to get to a point where regardless of how healthy the labour market is, that there’s a real cost to hiring an additional person. So you have to crush demand a little bit.

Keith Rofrano: Got it. So you mentioned inflation a couple of times. Let’s talk about that a bit. So what’s what’s the outlook, your outlook on inflation and what we should be thinking about.

Ian Pollick: For all intents and purposes, and given everything that we know, it is heading in the right direction. And, you know, you can take a look at a whole different variety of measures. The measure that’s reported on the newspaper, there’s a lot of measures that take out this and take out that and remove shelter or remove food. They’re all pointing in the right direction. Now, the thing that worries me a little bit and what’s worrying the Fed is that with the exception of core services, we are seeing things move in the right direction. Services, as we’ve talked about before, is where most inflation is coming through right now. That is sticky inflation, that shelter inflation. And that’s really hard for a central bank to get rid of just raising interest rates 25 or 50 basis points at a time. That is a very sticky component. And so I think that is what’s worrying central bankers right now. It’s not just a US story. You’re seeing core services re-accelerate in Europe, in the UK, in Japan, in the United States, So it’s not idiosyncratic to the US. There’s something broadly happening globally.

Keith Rofrano: Bipan do you agree with that?

Bipan Rai: Yeah, absolutely. And I think one of the key things that Ian touched upon that’s extremely relevant for central banks globally is that, yes, while we are seeing inflation trend in the right direction, you know, what is the risk that the central banks will remain above their targeted levels for an extended period of time? And again, that really dovetails into what a lot of them are communicating, that rates will have to stay at a higher level for an extended period of time. And again, that’s why when we entered this year, we sort of looked at the way that the the markets are pricing in central banks and and rate cuts really didn’t make any sense, and we’ve seen that for most for the most part priced out, and it does feel like the market is getting that message albeit at different speeds in different economies.

Keith Rofrano: So let’s talk about the reaction function of the Fed, right? So we know that the Fed builds in some reactive function to their models. But I’m just curious from our perspective, and if you’re a company that’s either in the services sector or the goods production sector, how should they be thinking about the reaction function of rates to play through their industries?

Ian Pollick: Very simple. You know, this is a central bank. This is a Fed that is going to do more than they need to full stop. And, you know, if the right number was 25, 50 or even 75 basis points ago, it doesn’t matter. You know, they’re not going to stop. And so I think the other side of that is that when you’re thinking about broader liquidity, when you’re thinking about your hedges on the other side of this, just as the Fed is going to do more on the upside, they’re going to do less on the downside, meaning that when interest rates are eventually eased, they’re not going to be slashed back to zero. They’re not going down. What we were used to following the financial crisis in 2008. And so that has a very big impact on funding on the liquidity on how you think about layering or laddering your hedges too.

Keith Rofrano: You just repeated what I think were the tides that we mentioned on the last call, which is rates are higher. We expect them to stay up here and if anything, stay up here for longer rather than shorter. They’re not going to come down as fast as they went up.

Ian Pollick: Listen, I don’t want to be a broken record, but I think this higher for longer theme is the new reality. And when you look at our own bond forecasts that looked even six weeks ago widely unattainable, i.e. the market was rallying, we still had a very negative view on global bond markets. We thought yields had to rise and even the rise in yield had surpassed our own very bearish forecasts. And so you’re starting from a higher level, that means you’re decelerating to a higher floor, and again, it gets back to this idea that you can’t just look at the stance of monetary policy as your decision rule to hedge or not to hedge, because there’s other important factors, such as what is the shape of the yield curve going to do? How fast are interest rates going to come down when they come down, How are different sectors of the yield curve going to behave independently or coexist with one another? This is not the type of cycle that we have seen before. And so having your old school playbooks may not actually be the most optimal environment.

Keith Rofrano: Agreed. Yeah, it’s interesting. We’ve got I guess I would call it 2/10 in in camp reluctance with with clients. One is we’ve got a hedge in place where you know a little bit reluctant to do a blend and extend because we don’t like what these higher rates and we don’t want to blend into a higher rate. Okay Then we have the second tent, which is we haven’t hedged yet and boy, we’re still sort of shocked by the sticker of these higher rates. And yet we’ve got these tides again, higher rates, higher rates for longer. And so what you’re left with in your hedge decision is really a combination of two things. The timing of it like when you lock into it and the duration of it, how long do I go for it? And so timing is, as we would say over and over again, is not the best strategy. I wouldn’t get too hung up on timing, particularly if you’re in a corporate and the whole goal is to have your business be an ongoing concern. Right. If you want to dig into timing, let’s let’s talk about timing, right? So I think it’s hard to argue that the timing doesn’t look good right now when you consider a spot start. Five year hedge is roughly 40 basis points better than spot and a ten year is roughly 80 basis points. So, you know, it’s hard to argue that now is not a good time when we’re still talking about rates going up, although I wouldn’t, you know, pin the tail to the donkey on that. It’s not a best practice, but it’s at least worth having that conversation. The second is the duration. And you mentioned the shape of the curve. Like as we know, you know, this inversion gives us an opportunity to kind of lower that blended rate in the back years. And so maybe you can make a comment on your thoughts of the shape of the curve going forward.

Ian Pollick: Absolutely. And just as we’re recording this, the differential between your ten year rate and your two year rate in the United States reached 100 basis points. That is a historically large level of inversion. And so at the end of the day, you know, when you transition out of hiking interest rates to eventually lowering interest rates, your yield curve will steepen. So the differential between your longer term rates and your short term rates gets larger. And in this case, that means less negative. The problem is, is that in a world where central bankers are more tolerant to slowing growth, that the delivery of this easing comes a little bit later. And like we said earlier, you’re not getting the same amount of easing as you normally would in a prior cycle, just given how much inflation is currently in the system. So we do expect a steeper curve. We do expect the yield curve to begin steepening in earnest in the at the end of the second quarter or the start of the third quarter of this year. That being said, we don’t actually see the curve inverting moving into positive territory until the end of the first quarter of 2024. And if anything, I’m inclined to push that back a little bit. You have a huge amount of wood to chop. And so I would agree with you that from a timing perspective, from a term structure perspective, you are paid to move forward in time, which is a very unusual situation.

Keith Rofrano: Like if you’re going to get the gift, take it right. And that’s our message to clients. So if you if you had the mic today and you could ask Paul any question you wanted, what would it be?

Ian Pollick: Listen, I think there’s a ton of questions I would ask him, but my question to him would be, what metrics are you looking at to understand whether there is more equilibrium in the labour market? Because he’s kind of given us a little bit of guidance. He hasn’t given us a huge amount of specifics and rightly so. So I want to know what exactly are you looking at that tells you that the labour market is no longer tight. And it’s not just the unemployment rate, it’s not just one metric. So I suspect if he was in this room, he would tell us that there’s a dashboard of metrics that he would look at.

Keith Rofrano: So to sum it up, what I hear from our rate perspective is, again, the tides that we discussed at the end of October are still in play. Right? And the thoughts around hedging the timing is is pretty opportune at the moment. Right, again, that’s not the strategy that you you lay your hat on, but it certainly does make a compelling argument to do something about your unhedged rate risk in this environment.

Ian Pollick: Yeah, I would agree with that. I would also just say that this is a very fluid environment. So if you ever need anything, please reach out to myself, anyone on my team and we’d be very happy to walk you through our latest updated thoughts.

Keith Rofrano: Absolutely. So, Bipan, let’s shift over to FX a bit and maybe you can help us with this dance between the Fed, the Bank of Canada and the ECB.

Bipan Rai: Yeah, just piggybacking off of what Ian said earlier, it really does make sense to be more active with your hedges instead of being passive. I mean, I think, you know, given the fact that we’re seeing the sort of the surprising strength in US data and what that’s meant for calibrating Fed terminal and of course that’s being the main channel for which the dollar has strengthened. I mean, it really behoves everyone, especially market participants that have exposures outside of the country to pay a little bit more attention they might have done before the pandemic.

Keith Rofrano: How do you think that plays into rate differentials and the driving of the currency pairs?

Bipan Rai: What we’ve noticed of late is that this sort of recalibration of Fed terminal hire has been in direct response, you know, of course, to the stronger US data of late. But, you know, we’re also at a different point in the in the cycle for other central banks, including, you know, say, the Bank of Canada or the or the Reserve Bank of Australia, where they’re either at a conditional pause or they’re looking or getting closer to that conditional pause. And again, you know, if you look at the if you compare those central banks to where the Federal Reserve is today, obviously the release mechanism is going to come via the exchange rate. And, you know, there are pressures there that could lead to a stronger dollar, at least in the here and now then. And that is going to, you know, could lead to a lot of pain if you do have revenues coming from outside of the United States. And something that you do need to be a little bit more mindful of now relative to before when most central banks were working or at least moving in conjunction with each other. So, you know, that’s the one thing that we’re watching. We are expecting, at least at this point, given the fact that we are seeing greater divergence between the different central banks that, you know, this divergence story is going to be a key driver for for markets in general.

Keith Rofrano: So do you think that you we see a sideways to weaker dollar in 23 or do you think we see something else?

Bipan Rai: So for that to happen, Keith, I mean, we need to have greater certainty that we’re getting closer to Fed terminal, and unfortunately, right now we just don’t have that sense given how strong the data has been. Now, Ian spoke a little bit about, you know, what to watch for in terms of in terms of jolts, watching to see if those job openings continue to to rise as employment continues to grow. I mean, that tells us a lot about the how tight the labour market is and how much further the Fed might have to go. And at this point, it’s really too early to say that, You know, we’re getting closer and closer to to to being at Fed terminal with any sense of great conviction. I mean, our House Call does suggest that we’re going to have to change things up and accommodate another Fed hike, maybe two hikes. But beyond there, we’re still paying attention to the data. Now, once that’s out of the way, we look at the more medium to long term trends that are playing out. I mean, it’s they still point to a weaker dollar on balance for the for the rest of 2023. It’s just that we have to be a little bit more patient with that call at this point.

Keith Rofrano: So in terms of currency, just straight up currency volatility, are we looking at a pickup in that as this data comes out or do we think we’re sort of steady state involved?

Bipan Rai: No, I think in the near term, we do have to look for potentially a vol profile that’s a little bit higher in the near term. And that, again, is a function of the uncertainty and potentially the demand for protection if we continue to see Fed terminal move higher. And really a sense from the Fed chair that they might be a little bit behind the curve, a little bit more behind the curve than they might have envisioned heading into this year. So again, if that is the case, that uncertainty should migrate into foreign exchange via higher vol profile in the near term as well.

Keith Rofrano: Okay. So if I were to translate that into a middle market view, if I’m an importer, it sounds like I should start thinking about getting a little bit more aggressive in my hedge ratios. If we are getting close to sort of peak dollar or even a sideways dollar for a period. And conversely, if I’m an exporter, I might want to build some flexibility into my hedges to allow the dollar to breathe differently and so that I’m not kind of locked into the the strongest points of that.

Bipan Rai: Yeah. Yeah, I would say that. And especially if you are importing from a place like the eurozone where potentially they might have more to go with respect to their interest rates. And they, you know, they’re sort of in a similar position where we’re not quite sure where where terminal could be for that central bank. I would say. Yeah. I mean, it does make sense to potentially look to layer into hedges if you are importing from a place like Germany or Italy. 

Keith Rofrano: Guys, great. So this hopefully has been useful to clients. I know that it’s always interesting to talk to you and just as Ian had mentioned earlier, if there are any questions, I don’t think there’s there’s anything more important than having a best practice strategy. Right, and so everything around how you form your policy high, determine your hedge ratios, the exercises and disciplines you go through as a company to make these decisions shouldn’t be done just on the whim of an article or shouldn’t be done on the whim of one conversation. So I strongly would encourage anyone who’s who’s got the time or inclination to please reach out to your banker, to myself, to Bipan or Ian, we are here to help. So thank you, guys.

Ian Pollick: Thanks very much, Keith. We’ll speak soon, buddy. Right on.

Bipan Rai: Cheers.

Keith Rofrano: Thank you again, Ian and Bippen 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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