Spaghetti goal posts

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[Ian Pollick]: Good afternoon and welcome to another edition of Curb Your Enthusiasm. My name is Ian Pollick, executive director and head of Fixed Income, Currency and Commodities Strategy at CIBC Capital Markets. I’m joined today by a very special co-host as voices on vacation for the next two weeks in the studio. Today is a good friend of ours, the Vivek Beri, executive director in our structured rates trading business. Vivek, thank you so much for joining us today. How are you?

[Vivek Beri]: I’m doing well and thanks for having me. Quite a lot of interesting developments yesterday for sure.

[Ian Pollick]: Over the past 24 hours, we’ve seen a lot of discussion coming up from the Jackson Hole Symposium this year. I’ll be honest with you, I was not expecting what happened yesterday in the lead up to Jackson Hole. I was always thinking in the back of my mind, every year we get a situation where people think that you’re going to get some type of policy announcement, some type of new innovation announced by at least one global central banker. And usually that’s not the case. Fed Chairman Powell discussing about the longer run goals, which is the conclusion of the Fed’s framework that they’ve been working on for the past year and a half leading into Jackson Hole. Expectations were that the Fed was going to introduce some type of adjustment to the way that they have fought inflation in the past. Expectations were for a move to an average inflation targeting regime. And what we actually got out of the announcement was a very soft version of that expectation. So it’s a little surprising to me that we saw the market sell off rates steepen the curve. The dollar was relatively strong during the day, and I think that it’s actually a very complex process that the market was interpreting, and I don’t think that, at least superficially, many people understand what happened yesterday.

[Ian Pollick]: When I think about it and correct me if you have a different view of it. I think that what was told yesterday was, listen, we no longer have faith in NAIRU. We no longer have as much faith as we do to the Phillips curve, binding our view on the dual mandate. And in turn, we’re now going to run the economy hot over certain periods of time. And when I look at the reaction in the long end of the curve, I don’t think it’s a function of more inflation, meaning that the long and hard to get disproportionately hit because over many cycles average inflation is higher. I would actually argue that over the long run, what the Fed did yesterday was actually raise the nominal terminal rate because of our star is something that we can’t see and our star is assuming it is static over time. The only differential is what inflation is. So over time that the average inflation is higher, that means your average terminal rate is now higher. And I think really that is what the long and was speaking to yesterday. What are your thoughts about that?

[Vivek Beri]: Yeah, I would tend to agree with your previously mentioned points, I would add that I think it’s not just our star that’s being called into question and moving around. I think it’s also a used star and their definition of what unemployment is and what wage growth represents. In the previous FOMC palace started mentioning that low income earners have not really participated in the 10 year boom cycle we’ve had in employment gains. And so I think this is a big change to long in rates and front end rates going forward. Those things that we typically used to look at, like non-farm payrolls, private sector payrolls and wage gains in general, we’re going to have to start looking at more granular data points. And so when I say granular, I mean, we’re going to start looking at what underemployment rates look like, much as we did back in two thousand, nine and 10 post. The GFC will also have to be looking at what the distribution of wage gains look like. Are they also filtering down to low income workers or are they not? And I think that renewed focus from the Fed or, well, change in focus from the Fed should see generally curve steeper as this framework starts to play out. I would also add that I do think that they are very happy to have inflation run hot for a period of time and there may be a little bit more than you stated, I think, in expectations of inflation running hot for a longer period of time or taking hold in the long run. But let’s also not forget that given the backdrop of COVID, there’s been a huge amount of issuance increase both in private sector and public sector purses. And so that does generally lead to a steeper curve, even though there is doing that QE purchasing the distribution should be more front end. 

[Ian Pollick]: And that’s a good point. And, you know, one of the things that I was really interested in the price action yesterday was that it felt to me like the market was totally missing the symmetry in what just happened yesterday. And there’s two channels that we can think about this symmetry. The first one is if you really are in an environment like you are today where you’re years away from hiking rates anyways, does it matter if inflation overshoots or under shoots in the near term? Should you be pricing that? I think that’s an important thing we need to think about, because as you rightly say, you’re starting in a very strange environment. We’re starting from a COVID type of world where, you know, policy is going to be dormant for a very, very long time. But on the other end, if you if you draw this to its natural conclusion and whether you think dynamics in the long end are more nuanced because you have higher average inflation or because you have higher average terminal rates, at the end of the day, what we’ve seen time and time again is that steeper curves do not jive with the equity market every time you’ve had a steeper curve. Traditionally, it’s been a function of some type of shock hitting the economy, which makes policy move and stocks tend to have a big draw down. So I’m a bit concerned about the level of risk appetite in conjunction with what we’re seeing right now. And then if we take it a little bit further, what we know is that if this engendered a rate spike, does that rate spike begin to undermine equities? And is that the automatic stabilizer to ensure that we don’t have an environment where we have a near-term taper tantrum?

[Vivek Beri]: Yeah, I think that’s a fair question. I would say that from a fixed income trader’s point of view, insofar as credit spreads don’t materially widen and cost of funds are not increasingly increasing at a rapid pace, I’m not sure you get a huge equity follow through or i.e. sell off if long and rates do move another 25 or 30 bps higher. Now, if we move one to two percent higher, I think that could move the needle somewhat as buybacks become more expensive or already rich and quite a lot so. The cost of the cost of equity buybacks increase and that support from the market for the market has been invaluable for the past five years.

[Ian Pollick]: So that’s interesting because I think when you look at the parallels to Canada, there’s a lot of global macro perception that Canada is also going through a very similar exercise at the Federal Reserve just concluded. And what’s not well known outside of Canada is that, in fact, every five years the Bank of Canada does have to renew its inflation mandate with the federal government. That renewal does take place at the end of twenty, twenty one. And over the past 48 hours, we’ve heard from Deputy Governor Schembry, Senior Deputy Governor Wilkins, Governor McCollum, and they’re all talking about this renewal and what are the potential things that Canada can do. And very similar to the Fed, they’re talking about price level targeting, average inflation targeting. Do you add a secondary mandate to the singular mandate that Canada has? And I don’t know if Canada is supposed to be trading as high beta in the curve as it should be, because people are maybe incorrectly looking at Canada as changing the way that it does inflation. Targeting and I would argue that because Canada has some type of forward guidance, conditional commitment already in that conditional commitment period, implicitly you already move to an average inflation targeting regime, because if inflation heats up while you provide forward guidance that you’re not raising rates because the output gap may not be closed, you’re implicitly lagging a little bit in terms of your reaction function. So I guess the question I have is in your specific market, which is vol, are you seeing any type of pass through, whether it’s the shape of the curve, whether it’s changing inflation expectations, how is that impacting your market?

[Vivek Beri]: Yeah, so I think most of the impacts coming through from the US market. And so what you see in the US and that theme should continue is that shorter tails,so options on one year to seven year tails, for example, are really lagging the move in 10 year to 30 year tails.And as you have a steepening rate curve, it follows that that process should happen and continue. So in Canada, for example, we are seeing the upper left sector. So they an option on one year, one year rate, really lagging the moves in one year, 10 year rate. And that theme, I think, should continue and play out further. I actually think the entire short tail surface will continue to cheapen is relatively rich to the US right now, creating about 10 to 20 percent over US levels. And I think that’s unfair, to be honest with you. And for the reasons you mentioned, that we do have a implicit average inflation sort of target now with the bank being giving forward guidance that policy rates remain low for the foreseeable future. These themes, I think, haven’t really taken hold sufficiently well, and that’s why we are rich to the US. But I think over the fullness of time we’ll start to see that move significantly and demand will increase for protection on 20 or 30 year rates subsidized by selling at least half the distribution on one year to five year rates, i.e. higher rates.

[Ian Pollick]: Let’s turn the tables a little bit and let’s talk about Canada, because one of the things that we’ve been very vocal about is when you look at the Bank of Canada’s QE program, it’s it looks over the long run to be an unstable structure and by unstable. But I really mean is that the trajectory of QE is a bit too fast in Canada. And if you believe, like I do, that at some point potentially at the October Monetary Policy Report or even earlier in twenty twenty one, if you do get an adjustment to QE, it’s very clear what the moving cash would be, i.e. take support away from the long into the curve. It should allow swap spreads to narrow, it should allow the curve to steepen out and more broadly to allow Canadian duration to underperform regardless of what the market direction is. But how do I take that view, and I transplant that into volatility space? Because the dual question I have for you is number one is if you follow that line of thought, what do you think the impact is? And to your market and more broadly, for those on the call today, what is QE done to the vol surface? Has it done anything? And is that surprise you at all? Yeah, sure.

[Vivek Beri]: Yeah, sure. So we really haven’t seen too much impact from QE outside of just cheapening of general five year tail. So I would say that’s more a forward guidance impact than it is a QE impact.But through the combined tools, we have seen a relative cheapening of vols in general, especially in the one month to one year sort of space. To your earlier point, sorry, about The Bank of Canada’s current QE trajectory being maybe a bit too aggressive, I do believe that it’s a very fluid and dynamic situation right now and they were relatively reactionary through the April, May, June periods as we were having significant issuance through the provinces and through the government. It is logical that that is curtailed. And I do agree that you should see a steepening. Now, the knock on effects for the surface for me would be increased appetite for for shorter duration structured products. So something like a five year non-call one year or a five year cap floored structure, I think those are attractive given how low belly and front-end rates will remain. So any little pick up from volatility is of help to investors. Now the converse is really true on longer tails, right? As you have a steep learning curve, your incentive really to move into structured product or yield enhancement type trades is greatly reduced. And so I would expect the issuance that we’ve seen in 20 year and 10 year type structures should start moving towards the front end of the curve. And more likely you see those investors moving to straight GOCs or into credit product.

[Ian Pollick]: That’s a very good point. Thank you for that. That’s interesting because I think one of the things that we don’t often see is what those attendant moves are doing from the cash market to the swap market to the vol market. And in turn, that does trickle down into various parts of investors portfolios. But they do have these structured notes or these yield enhancement products. And to me, when I look at the market right now, it’s very evident this is not an asset allocation market. This is very much a trading market. And one of the things that we’ve seen is that all these innovations coming from the central banks, whether it’s the Bank of Canada or the Fed or the ECB, has in theory reduced the attractiveness of owning rates as a core holding in your portfolio. The diversification isn’t there, geographical diversification isn’t there. So if you think about some of the potential dampening effects of all this QE, one of the ones that we know is going to be potentially painful is some type of future introduction of yield curve control, yield caps. How do we think about Vol that we’ve seen react in other markets like Japan or Australia when they have implemented yield curve control yield curve caps? If that indeed is coming to North America, which we could argue that it’s a non zero chance, I would argue it’s probably a higher probability in Canada. How does that affect your market?

[Vivek Beri]: Yes. So I mean, it’s a volatility killer, really. You’ve seen it in Japan. JJB vols have done nothing but decline since then. Investors do believe that central banks are able to implement those caps, as has been seen by BOJ purchases. And so I think that that it will lead to an effective cap and hence a real drop in volatility. You’re effectively truncating distribution to one side or not even to one side, but just to an equivalent strangle. So you do start seeing things cheap quite aggressively and you do start seeing the level of the general level of also decrease. Now, on the flip side, you do have people looking at much more wing based hedges. So they’ll look at things that are like five or 10 delta going forward, whereas protection strikes were twenty or twenty five deltas historically. So if they do see a move, they want to see a very large move and get paid multiples for doing it.

[Ian Pollick]: So if we do move into that type of environment, do we see a resurgence of the activity we saw pre-COVID where you did have those very large programmatic sellers of all I know that went away a little bit. Can you comment on the types of flows that you’re seeing in your market right now?

[Vivek Beri]: Yeah, the programmatic selling has actually been relatively absent, which is why falls in Canada specifically are significantly above US levels. There’s not really great rhyme or reason other than a lack of supply. And I think part of it is, for one, Canada is a relative peripheral currency for most alpha asset managers. And so it’s not a natural place to look for. It’s after you’ve exhausted all possible, after you’ve exhausted a significant amount of bullets to spend in Euro, Sterling, US and to a lesser extent, Australia. So it really is a lack of selling. I don’t know that we have them come back in earnest until actual outright rate levels drop significantly. So one of the rationales levels have been relatively elevated is that our swap spreads are significantly wider in the US and hence the all in rates look much more attractive and they have further room to drop potentially if the bank comes in with further measures. Whereas in the US you’re already at the zero bound in policy and swap spreads are significant, are pretty tight. So LIBOR levels, for example, are twenty four, twenty five basis points, whereas CIDOR levels are still up in the fifties.

[Ian Pollick]: What we’ve seen, that’s a very good point. And let’s lead into a discussion on some of the IBORs around the world, because what we’ve seen correctly is in the U.S., you’re right, you’re kind of at that lower bound. And when you take that into the context of Canada, we’ve seen CIDOR being very stubborn to move. It’s slowly been grinding lower. If you look at some of the competing assets in the short term, bills are very expensive to OAS. BP is relatively contained. BAs are effectively flat to OAS right now. And what that’s done is it’s only pushed CIDORs in. And we will look at, for example, the BAs or CIDOR basis, which is just a proxy measure of the bid offer. Between your primary and secondary markets. It’s still relatively wide. I think that makes sense. In a world where credit concern is still paramount in banking institutions, it’s not clear to me that can come down any time soon. So if you believe that, do you think there’s a natural floor to CIDOR where it is around fiftyish? You think we’re going to go materially lower? And the reason I ask Vivek is because Canadian  swap spreads, as you rightly said, have traditionally always been higher than most other markets. Part of that reflected what our IBOR was and part of it reflected very low levels of issuance. But that’s been flipped on its head. And if you do believe you are moving into an environment where the marginal buyer, which is the Bank of Canada, will be moving away, does that reorient swap spreads in Canada to be more closely aligned with their global counterparts?

[Vivek Beri]: Yeah, I would I would agree that there is probably a floor on CIDOR rates not too far away from here. We’ve just had bank earnings and commentary about NIMS being compressed has been significant. And so I don’t think that the bank would want to encourage any instability in bank earnings or banks, robustness of capital, let’s say. And so any erosion of NIMS further, I think, eats away at those sorts of capital buffers and earnings potentials and so on, so forth. Now, I am no bank expert or bank analyst, but that is my general feeling that you don’t necessarily want to see any further compression in NIMS, given we are a small banking where smaller banking economy than the US, for example.

[Ian Pollick]: So does that leave any potential move lower in spreads is purely a function of the cash market in your mind?

[Vivek Beri]: Yeah, I would expect so. I would say it should just counter directionally to the cash market in general.

[Ian Pollick]: And do you think I mean, when you think about the tail risk in Canada, I know that we always make very big concerns about potential moves in the BOC and many times it doesn’t prove to be as dramatic as we think it is. I just happen to think that people are underestimating how large of a move this could be, because for a central bank that’s never done QE before, I think they’ve done a very good job. I think it’s very evident they have to tweak the program a little bit. But I think the risks around implementation or even communication about doing it are very, very high. And I’m not suggesting we get a temper tantrum like we did in 2013, but I do think there is a material risk where you can have Canada diverge from the rest of the G-7 when you have this adjustment period happening.

[Vivek Beri]: Just to that point, I think we have seen that the bank has been very responsive to market reaction to their QE announcements and to the size of their purchases versus what issuance is coming in the pipeline. So I would expect that we may see a very localized move higher and potentially a taper tantrum, but I think that might be a bit excessive, but that will be controlled by the bank.

[Ian Pollick]: So we’re going into the balance of the year. Everyone’s coming back to work relatively soon. Issuance should be increasing quite a bit going forward, given the outright level of rates. Maybe that lets issuers take short a little bit. Are you seeing any activity that would suggest that some of the rate locking activity by issuers is moving into the volatility space? Or does it still very much remain a swap driven business?

[Vivek Beri]: Yeah, I think there is. Given the swap spreads represent roughly 50 percent of the level of rate currently, we have seen increased demand from issuers to buy volatility based hedges, specifically in bond option space. And so for issuers, that historically would issue versus a bond spread. They would look to the swaption market as a relatively good alternative in that liquidity was better and better offers, generally tighter. They’re now looking at bond options because it’s unclear that the swaps spread level will be stable and provide them with an effective hedge if they bought a payer instead of buying a put on a bond option.

[Ian Pollick]: Interesting. I think that’s a very important development and we should talk about that going forward, because I think it’s interesting because one of the things that’s happened to the Canadian market this year is, you know, I hate to say it has become a real market and a real market in the sense that issuance is so high, auctions start to matter, setup start to matter, understanding QE starts to matter. And as you have these trends in the very esoteric parts of the bond market, it does create new opportunities like we were just talking about issuers hedging rates. The way they do so changes the products changed a little bit. So I think it’s a very evolving market. It’s actually a very exciting time in Canada. And with that said, what are your favourite trades right now?

[Vivek Beri]: Yeah, so we quite like being short on the left side of the surface here. So specifically for vol, so being short caps and floors being short one year to five year tails, I think those are all excellent trades, very simple things for yield enhancement, for things like a three month, five year strangles 15 basis point, each side strangle still a 15 percent premium to the US. And I really do think that the Bank of Canada, while it may have some hairiness around long end purchases as they change their QE program, I do believe that five year and in will be relatively range bound. Additionally, I think the steepener in general does make sense. So on a Delta one basis, I think five 10 steepeners in general and five, 30 steepeners in general are attractive and should remain so until the narrative really materially changes from the wage growth side in the US.

[Ian Pollick]: I agree, and that’s pretty consistent with some of the trades we have on in the research book right now. We generally like any type of variant of five 10 steepening in cash that really speaks to the issuance profile. It speaks to the potential of a tension building beneath the surface. We’ve expressed it in the five 10 spread of spreads. Flattener hasn’t been working too well, but it hasn’t been working against us yet. I do think you need a bit of a catalyst to get that to flatten out. What about in the short end, when I look at the back strip, I look at what’s priced in the curve again. We have our first high priced kind of mid twenty twenty three. When you look at the Reds in Canada, they do look a little bit steep within the recent ranges. Do you fight that? What’s your thoughts on the curve right now in baxes?

[Vivek Beri]: Yeah, so actually I haven’t been playing any of the red baxes. They have been cheap but I think they’ve returned up to a reasonably fair level and I don’t think there’s that much room for them to rally from here, maybe six or seven basis points. What I do also like, though, against a shortfall or steepening position is received one year later. It feels like a bit of a free option here. If you look at what the US forward curves have done through the past three months, we have priced in potential for negative rates. Now, we don’t need to have that necessarily in Canada, but I do. From a 24 basis point, mid-level right now, I think you could see it trade down to 15 as and when stimulus from the federal government starts to recede and potentially some consumer defaults or an increase in delinquencies starts to rear its head, I think the immediate market reaction will be to price some of that. And so against those types of trades, i.e. steepness or outright shorts and long and rates, I think having a received in the very, very front end is quite attractive.

[Ian Pollick]: I would agree. And I think when you look at one-year, one-year OIS, vs. one-year, it has moderated from the worst, it’s about 10 right now. But to me, that still looks relatively steep to other parts of the G-7, particularly as we get into the thick of the election setup. So with that said, I guess my question to you is, in CAD, even though we don’t have the same politics in the U.S., is the U.S. election impact in the bull market trickling into Canada? And does that make that delivered ratio seem even more erratic in your mind?

[Vivek Beri]: It has. So if you look at the US market, the elections worth about another an extra 10 to 11 business days. In Canada, it’s about six to eight. It seems like it’s about fair. If you look at what happened during the Trump election in 2016, the markets were similar on ratio. And if you look at what happened in eventuated the following that that night and the following morning, those seem like fare levels. It’s not a made in Canada story, be it Trump or Biden. And so it’s not logical that Canada should under outperform either way, depending on the outcome.

[Ian Pollick]: So you think it’s just a normal amount of spillover that it’s not going to go away? Don’t hedge against that and it’s going to be what it is until you’re through the event?

[Vivek Beri]: Yes, I do think so. I do think so. You know, it typically, though, these events do start cheapening up as you approach the event. The danger really is if it’s a coin toss into the event and then they respond very quickly.

[Ian Pollick]: Listen, I think that we’ve covered a huge amount of ground today. And I think if we have to summarize what we talked about, number one, is that I think the move that we saw yesterday was a bit complicated in nature. Maybe it means a bit more than just curve is steepening because inflation is going to run hotter over time. I think it reflects either some type of balance of a higher terminal rate over time and potentially the fact that rates in the front end are going to stay low for a very long time. Because implicit in that relationship is the fact that the Fed has now allowed themselves a bit more room to stay dovish throughout this period. Number two is that when you look at Canada, some of the surface that you said doesn’t really make too much sense. Some of it is a function of the natural spillover just given the time of the year, proximity to the election. But general nuances that we need to be aware of because you have some idiosyncratic developments coming from the Bank of Canada. Finally, if you had to leave all of our listeners with some lasting words, what would they be?

[Vivek Beri]: Be safe and enjoy back to school.

[Ian Pollick]: I hope everyone has a great weekend. I hope everyone safe. Thank you very much for taking the time to be with us today. And remember, no bonds were harmed in the making of this podcast.

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