New beginnings

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Nick Exarhos: That’s the part that confuses me, right, because without more quantitative tightening as, kind of, curves too flat. We need to bail ourselves out of that because whether or not a flat curve actually means anything for the economy doesn’t matter because we think it does. So investment will go down with an inverted yield curve. We know that.

Ian Pollick: So I was driving to work the other day and I was listening to the radio and I heard on one of the news stations that they’re remaking Fresh Prince of Bel Air. And I was thinking about that sounds like a kind of a weird re redo. But I was thinking about in Fresh Prince, I used to watch it as a kid because obviously, I love Carleton, love Fresh Prince. But I remember when from season two to season three where they just changed and Viv remember that the actress changed right away and they didn’t tell us anything. They just acted like things just continued absolutely unchanged. Anyways, Royce, what’s going on?

Nick Exarhos: How are you, man? I don’t know if I should laugh, or it should be like, extremely offended.

Ian Pollick: I’m just kidding. As most of you know, Royce is no longer with us. We are joined today by Nick ISRO’s, executive director on the Fixed Income Sales Group in Toronto. Most of you would have heard from Nick because Nick does all of the moderating for our sales and trading calls and research calls. Most recently, this past week we did a provincial update call. So if you didn’t hear that, check it out. But Nick, I’m really happy that you’re you’re joining us today. How’s it going, man?

Nick Exarhos: I’m very excited to be here. I’m happy to be replacing my nemesis, Roy. I dont know if you remember this, Ian, but I worked with Royce in Econ Group for for a little while. Let’s just say I think this is going to be the best podcast

Ian Pollick: Ever, the best podcast in the world. Well, let’s kick it off because obviously there’s been a lot going on. And you know, from your perspective, you speak to clients all day long. What’s the what’s the prevailing bias you’re hearing? What do people want to talk about?

Nick Exarhos: Okay, Start of the year everybody hated longs, and we reprice that pretty dramatically in the market very quickly. Now the shift is talking about quantitative tightening and talking with some of my accounts. It’s really getting a tough on what the economy is actually doing because this is kind of like the Schrodinger economy. We’re simultaneously booming or dead at the same time, and it’s hard to get a handle on it. I know everybody’s jumped on the bandwagon with for hikes in the U.S. this year that we noticed that the build back better plan is dead in the U.S., and there was a massive fiscal drag coming down the pike. So I think it’s a weird dynamic. We just had seven percent inflation, but that’s for twenty one, the December twenty one. What’s that going to look like in December twenty two? Because those end of year twenty two forecasts are going to be staring at us in a few months?

Ian Pollick: Well, it’s a good point, and I think I’ve been talking to a lot of people about this. But I think ultimately, you know, there’s one thing you need to get right to make money this year, and that’s it. You have to have a good understanding where inflation is ultimately going to settle in a year’s time. And I think there is a difference if we’re talking about a two to three percent resting range or three percent plus just in range because that has a big implication from terminal. But I think there’s something that you just said that we should tease out a little bit. And it’s this idea that I don’t think a lot of people recognise that build back better is dead. And the implication of that is pretty big because when we think about the fiscal drag, i.e. the year over year expansion of the balance sheet at the federal level, it’s declining quite rapidly and it’s worth, what, seven eight percent of GDP on an annualised basis. Yeah. So kind of the bias here, if you delve into most economists forecasts, they’ll tell you that yes, this fiscal drag is coming. But don’t worry about it because there’s so much excess savings in the economy and that excess savings will be enough to offset the decline in growth because all of a sudden you have this really big ramp up in consumption. And what I get nervous about is, you know, even if we’re talking about a deceleration in inflation, it’s one of those things where the rate of change may fall, but the price level is rising the entire time, and that could ultimately restrict consumption. And that’s why I’m a bit concerned about the length of the cycle. So it’s not clear to me. And when I look at what’s priced in the long end of the US terminal rate, that’s up two percent. That that’s necessarily wrong for we are right now. And I think, you know, that makes the idea that should you own longs or should you not mix it all that much more of an interesting topic?

Nick Exarhos: Well also, Ian, talked on Terminal a little bit last business cycle. I felt like we overshot and we didn’t. We didn’t get much above two percent when we overshot. So what are the things in the economy post COVID that we think all of a sudden we unlock this massive productivity boom? It doesn’t feel that way. So there are a few things that leave me a little bit more. Ok, hold on. Let’s not get over our skis. I think we need to see the Fed actually hike. I think they want to get off of zero. I’m on board with that. I just think, you know, pricing in a hike a quarter for a lot of quarters in the future is a little bit premature, especially when we just said there’s a few things and what we’re talking, what we haven’t mentioned yet. I don’t think anybody would talk about it. China hasn’t gone through their Omicron wave right. They have the Olympics coming up. Omnicron going everywhere. They’re going to have to go through it. They’ve been more draconian. And their responses to it. You can’t tell me that’s not going to have an impact on the global growth profile through the middle of this year.

Ian Pollick: Well, I think, when I think about China and I think about what does it mean for my day to day life, I think this idea of having COVID zero just further compounds the supply issues, right? And I think that just builds back into this inflationary forecast that has such wide confidence bands around it that it’s again, you have to get inflation right by the end of the year in order to make money. But you know, one of the things that you talked about was interesting, and maybe you can just walk me through it. You know, you cover a lot of structural investors in Canada, and you do look at a lot of the long ends, both on that right basis asset swap basis are we seeing any kind of line in the sand where it counts, let’s say a two percent long bonds, there’s a lot of interest. One eighty, there’s not. Are there any lines in the sand that we should

Nick Exarhos: Be aware of? Two percent, for whatever reason? That’s the number where everybody kind of gravitates where it’s like, Oh, that looks about right. I think longs can settle in that two to 20 range for a little while as we see what the normalisation looks like in both the economy, inflation and policy. And I want to push you a little bit because we talk about inflation, where is inflation going to be in six months? What’s headline inflation Canada US? 

Ian Pollick: So if you look at our internal forecasts and I’ll say that that forecast is changing rapidly, just given the move in energy prices and thus gasoline prices, I think in six months from now, by June, we are still north of three percent, but barely so. And then you kind of go through this somewhat rapid undershoot where we’re actually going to be seeing transitory disinflation just due to the base effect numbers. And I think we actually trough out or around one seven at the start of Q3. And then we finished the year closer again to like two, four to five.

Nick Exarhos: So I think you’re right. I think it’s like it’s the second derivative for price pressures that matter more for the long end than what the actual headline is right now.

Ian Pollick: So let me ask you this. I mean, the new idea that’s been so socialised really in the past two weeks has been this idea of quantitative tightening. And you know, in theory, quantitative tightening helps to add more term premia to the yield curve. Therefore, it helps to steepen the curve out. And I think that’s somewhat of a palatable academic design if you believe that you want to avoid inversion relatively early on in the cycle. Do you believe that in practise that you can get a steeper curve if you’re getting the delivery of a hike a quarter just because the balance sheet is being utilised?

Nick Exarhos: That’s that’s the part that confuses me because quantitative tightening as kind of curves too flat, we need to bail ourselves out of that because whether or not a flat curve actually means anything for the economy doesn’t matter because we think it does. So investment will go down with an inverted yield curve. We know that. But if quantitative tightening is net restrictive to the economy, the yield curve kind of has to flatten a little bit. So I’m not so sure about the stock argument on the yield curve like the slogan matter, but I think that’s going to be swamped by the fiscal picture.

Ian Pollick: Well, it’s a good point because I think if you read any of the academic literature, there’s a ton of academic literature on QE and there’s just not a ton on because it’s so relatively new. And you know, the idea is that QE obviously suppresses term premia works to the portfolio diversification channel, but QT it’s not clear to me that you have that symmetry, and I would argue quite vigorously that it’s it’s asymmetric where you don’t get the same type of move on the way out as you do on the way in. And I guess the question is, is the stock is generally believed to be more important for QE to suppress yields. But I think you’re right. I think the flow is what ultimately matters for QT. So it could be more than just a signalling mechanism. But I do have a hard time stomaching this idea that quantitative tightening in of itself is a steepener. I will say that I think there’s some very large differences in Canada, in the U.S., and we’re kind of working through our heads right now what it would mean for Canada, what it would look like. And just to kind of put a little spoiler alert out there. I don’t think quantitative tightening in Canada is exotic at all, i.e., I don’t think there’s any curve caps. I think it’s a very straightforward approach. I don’t think there’s any discrimination across various parts of the curve. I think once they hike rates, you will already have a communication hand with the sequencing looks like and the hike rates. And then very shortly thereafter, they just stop their secondary market purchases. I think it could be just as simple as that. So do you think people are interested in in Canada in General or no?

Nick Exarhos: We’re getting tons of questions.

Ian Pollick: Are you OK?

Nick Exarhos: We talked about a lot in terms of the U.S., and I was in the minutes that was really what came out of the U.S. and I think people’s attention rapidly turns towards Canada because we were the first to taper basically, right? So we’re wondering what that looks like. Do you want to talk a little bit about the BOC now or do you want to leave that? Because I’m I am curious. There was that bold call that was in the market this week about Jan. It doesn’t seem likely to me. I’m wondering from your perspective. One, what odds you place on a hike and then to what or they talk about at this confab? It’s an NPR meeting. You’re saying it’s going to be a vanilla QT when they do it? Do we hear about it now?

Ian Pollick: The meeting’s in two weeks time. I would say that what I’m thinking kind of on the top of my head, my expectations are, I don’t think that we get the delivery of a rate hike at this meeting. Not that it feels early. It’s more that given the communication disaster that was October and given, we’ve had very little indication of what’s happening in the next two weeks. We’re entering Blackout as of Tuesday. It’s not clear to me that they would want to surprise the market and they were not priced for it. To be very clear, I think what we’re going to hear from this meeting is two things. Number one is we did have a mandate change at the end of last year. It now includes the labour market and what we know about the labour market. Pre January data is that the market is very tight. The labour market is ripping in Canada. We are at full employment and when you’re at full employment, wage gains follow shortly thereafter. And I think the statement is going to have to change such that the forward guidance is almost removed, saying something to the extent that, you know, judging by the pace of GDP growth as proxy by the unemployment rate being so close to pre-pandemic level, it’s very likely that the new range of output gap is, call it, minus half to plus one type of thing. And I think that in of itself is not a hawkish innovation, but I think it does open the door for a hike as early as March. And I’m starting to feel less emboldened about this idea that the first hike has to occur in the MPR. So, you know, officially, the house call is an April hike. I don’t know if it has to be April. I think if they do it properly, they could set it up in January for a March move. Obviously, we’re priced like that, but I do think we’re going to hear more about the sequencing, for sure.

Nick Exarhos: Yeah, I don’t. I don’t think that whole hike has to be a positive thing. Is that the real thing, like you’re saying, it’s in the market already. So I don’t think that will surprise anybody. I think more for the BOC as a restricted factor, given you’re saying that communication snafu in October was just figuring out what was going on in our kind of group has a one percent drop for GDP. That’s a lot.

Ian Pollick: It’s a big number. But the move in February, I think we have plus half a percent in March. We have a full percent. So, you know, it doesn’t do much for the quarter as a whole. But the handoff to Q2 is very strong. And I think one of the things we’ve seen from the Bank of Canada is that they tend to look through some of these output distortions. That’s been the reaction function thus far over the pandemic. So there’s nothing that tells me that that’s going to change anytime soon.

Nick Exarhos: Yeah. So you’re thinking like March Hike, how many deliver and twenty two total now? In your mind?

Ian Pollick: So I still think it’s a three hike year, given everything that I know of right now. Like, it’s not clear to me that we’re not going to have a different Omicron Delta Cron, whatever cron further and the impact of a rate hike today is just very different than it was even in twenty seventeen because it works through the system much faster and if you are going to utilise the balance sheet. The big question is is does the market see quantitative tightening in Canada as a substitution for rate hikes? Or does they look at it as a complementary policy tool? I think the bank believes it’s a complementary tool, but it’s not clear yet how the market’s going to trade it. So I still think it’s going to be a three hike year.

Nick Exarhos: I mean, that’s how I’m thinking about it. Three hikes this year with a vanilla quantitative tightening. That’s an effective four five maybe hikes. That’s where I’m thinking about again. Maybe it’s a little bit too punchy. And then what does that look for? Twenty two growth. But also, what does that look for? Twenty three?

Ian Pollick: Well, listen, I think it’s a good point, right? Because I think what’s very different this cycle compared to prior cycles is that in the past, if you were hiking rates to try and tame inflation, you would do it by widening slack in the economy by slowing growth. But I think this time around, they’re trying because of the nature of the pandemic and the nature of where inflation is coming from. I think they just want to rapidly tighten financial conditions any way they can, and that means a few things. It means you go a little bit faster early on and the delivery of rate hikes. You also try to tighten up the balance sheet. So you’re targeting really two different sectors of the curve, and you allow real rates to rise in a bit of a faster rate than you’re used to, and you largely ignore a drawdown or risk assets. And I think that’s something that’s very different than we’ve seen in prior cycles.

Nick Exarhos: The irony is they will actually succeed in taming inflation, but it won’t be because of base effects and they might actually crush growth growth over twenty three. And will that be a win? That will be the interesting dynamic that I’ll have. I’ll have to judge a little bit, right?

Ian Pollick: So let’s let’s shift gears here a little bit because again, you know, I want to get back to your specific count base. And obviously, they spend a lot of time looking at asset swap levels, general level of swap spreads. Give us a quick update. What are you hearing from accounts and what are you thinking on spreads right now?

Nick Exarhos: We have that government spread conference call yesterday where all three of you GG, Soreti, yourself, were pretty defensive on scrum and I have to say I’m a little bit not on the same side, I think, I think there’s a big outlet for spreads and I still think it’s the treasure channel. I think a lot of the banks are doing great assets are growing, and I think the primary driver will be what a swap spreads do in the next year, like 10 year swaps. Because if those state reasonably depressed, then there will be a bid in those types of assets. So there will be an outlet for provinces to issue in a sector that will be kind of tucked away. There won’t be much pressure on long end spreads, and they’ll have foreign markets to top as well. So I’m not so sure that it’s doom and gloom for Proby spreads at all. 

Ian Pollick: Well, I guess it’s a good point. When I think about probably spreads really quickly, and we kind of touched upon this in our call this week. But you know, you hear first and making the call right now, I think we’ve given where we are today in Ontario, 10s in Quebec, longs in Manitoba, fives, whatever it is. I think that we have seen the tights of the year in provincial spreads.

Nick Exarhos: Yeah, I’m totally I totally disagree with you, but I always continue. So what are you? Ok, how about this 10 year swap spreads higher or lower?

Ian Pollick: Over what timeframe?

Nick Exarhos: Like next six months?

Nick Exarhos: Oh, I think lower. I think at the end of the day, this is very much a market that has largely ignored a lot of the trends in net supply. And, you know, as net supply grows, swap spreads should narrow. Even in an environment where rates are rising and we see what’s happening with cedar and cedar has to rise half a tick a day just to meet the H2 contract implied level. But but I do think that spreads are going lower, and I think there’s two wild cards here. Number one is is how quickly the banks can allow the balance sheet to roll off. The second thing, and again, that just adds more net supply to the market. We haven’t yet seen what the new budgetary deficits are going to look like for the year ahead. It’s it’s a pretty big number. And you know, there’s been a bit more of stimulus announced since the fall economic update last year. So, you know, I think we’re talking about gross issuance this year that could be very similar to this past year, really. That like to twenty to two hundred and forty billion range. That’s a big number and at some point acts as a trigger to converge that supply to gross supply, right?

Nick Exarhos: But but Ian, I’m telling you, if swap spreads continue drifting lower over the next few months, I will not struggle to sell 10 year quotes like our firm. Like we will be like the market will be able to absorb a lot of potential supply. So I don’t think you’re going to have this. I think the asymmetric nature of what you’re talking about in terms of profit spreads, I don’t think is there.

Ian Pollick: Do you mean asymmetric? But look, I also think the other wild card, because I said there was two wild cards. I think the other wild card here is IFRS 17. It’s one of those regulatory impacts we’ve been talking about for many years. It’s finally coming into light. I think it mostly affects the very long end of the swap spread curve, and definitely that could be a situation that takes, you know, 10 30 spread of spread curve to very, very different levels. And what we’re seeing right now quite inverted. But I also think it could take the level of 30 year spreads to zero. You know, that’s a gigantic trade if you have that right. But I just don’t think we have enough visibility yet. There’s not an industry standard on whether or not there’s going to be a swap curve, discount curve convention or whether or not it’s a Double-A curve. And that also has a really big implication that could blow up my provincial spread story as well if people have to own spreads. But that’s that’s a that’s a bit dynamic. We’ll have more more on that going forward. But look, we’ve talked for 20 minutes, Nick. Are there any last thoughts you have and anything that you want to talk about that we didn’t really talk about today?

Nick Exarhos: This is extremely painful, and I’ll consider whether or not I’ll do that.

Ian Pollick: Well, listen, we’re going to do a little bit of a Jeopardy style co-host finding surge. We’ll have a few different people on over the next few weeks. Feel free to reach out to myself. For people that you love, people that you love a little bit less. And remember, there are no bonds harmed in the making of this podcast.

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