Subterranean steepening blues

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Ian Pollick: Good afternoon and welcome to Curve Your Enthusiasm, I’m your host, Ian Pollick, Executive Director and Global Head of Fixed Income, Currency and Commodities Strategy. Royce is on a well-deserved holiday this week, but fear not, we have a very special guest with us in the studio today. If you’ve ever traded FX derivatives in the early 2000s or any swaps in the past decade, you absolutely know my co-host for today, longtime friend, mentor and one of the sharpest central bank watchers I’ve ever known in my career, I’m happy to invite Craig Bell, Managing Director and Head of Canadian Interest Rate Swap Trading, to the show today. Craig, how are you?

Craig Bell: I’m wonderful, especially after that introduction. And thanks for having me in the studio. It’s beautiful in here.

Ian Pollick: Yeah, absolutely. It’s really nice, right? Listen, there hasn’t been much data in Canada this week, so we’re not really going to focus on the data today. But as you and I have discussed many times and, as my group has been writing a lot about, there’s a huge amount of developing themes in the periphery which are starting to bubble. And from my lens at all centers around the Bank of Canada’s reaction function as we begin to move into the final months of the year. So to start the show today, Craig, I just want to ask your opinion on a few things. And the first thing is when we think about the Bank of Canada, we know that monetary policy itself is inactive from a conventional perspective. But the bank did provide us with some forward guidance. Some have argued that this forward guidance to not raise interest rates until the output gap is closed and inflation is sustainably at or above target, may be a bit soft relative to the conditional commitment from the financial crisis. So the question is, how binding is this forward guidance and what does it mean for the market? Because if we’re in a situation in six months from now where CPI is above target, output gap is narrowing. Do markets see this guidance as non-binding and what happens? What are your thoughts on that?

Craig Bell: Terrific question. I mean, it’s definitely a softer, conditional commitment than what we saw coming out of the great financial crisis. And I think the market is right to perceive it that way. And don’t forget that conditional commitment also got lifted one month early and that was seen as a much harder commitment. I mean, the truth of the matter is, in the situation that we’re in, nobody really has a good handle on how it’s going to play out. It’s, you know, even the central banks would say there’s a greater uncertainty than ever before. I certainly believe that they’re sincere in their commitment. It wouldn’t surprise me if we do see them put more solid parameters around that. And another reason that an output gap based commitment out of the bank isn’t necessarily as binding is because they’re the ones who measure and dictate what the output gap is. And so if it’s conditional on something that you control almost entirely, then obviously it’s fairly flexible in its commitment.

Ian Pollick: And by that you mean because they control potential, they can tweak the estimate as they please, if they wanted to guide it in a certain direction?

Craig Bell: Correct, yes.

Ian Pollick: So when you think about that situation and, you know, what we have is a blanketed statement, that policy’s not going to move, we have unconventional policy, which is really dictating a lot of the moves in the market. When you think about how the forward curve reacts to changes in this guidance. Right now, would you agree that the hump in the forwards is that three year, one year, that four year point that stays perpetually high? How do you expect that to trade over the next couple of months as we get into some of the meatier discussions around QE, once we get to the October NPR?

Craig Bell: On the one hand, it does make sense because that’s when you’re looking at, you know, certainly from the bank’s point of view or what they’ve guided in terms of the lifting of the commitment. So if you are looking at potential future hikes, you’re looking at something in that part of the curve. My expectation, though, is as we go through time and as they, you know, either become firmer in that commitment or introduce new policy tools like YCC (Yield Curve Control) as an augmentation of their QE program or a change in their QE program, I think that is a part of the curve that can definitely flatten. We can see that hump come out of the curve at some point.

Ian Pollick: And when you think about some of the structural rigidities in the swap curve over the past few years, what we tend to notice and tell me if you agree with this, is that whenever you have these humps, they tend to linger for a very long time, they provide very good realized carry trades. Is it a trap in 2020 to assume that that is the same type of setup that we’re going to see over the next six months?

Craig Bell: I don’t think so at all. I mean, like you say, you get paid to stay in them from a carry point of view. And that’s, you know, either as a purview in Canada or as a cross market view. You know, it’s a trade, we like the trade we have on. You know, it just makes a lot of sense. Is it a trap? I mean, that hump can stay persistent, but you can still realize the carry. And so there’s a way to profit from it without necessarily a market moving exit strategy.

Ian Pollick: For sure. And, you know, that’s a good point. That’s a great sentence you just used. Exit strategy. Because obviously everything that is interesting in Canada centers around QE. What is the exit look like? What does the evolution look like? Just for identification of some of our listeners that may not be that involved in the swaps market, can you just walk us through very quickly pre QE in Canada versus today, how has the swap market changed or here’s a better question, what are the two or three biggest changes that you have seen in your market since QE was introduced in April?

Craig Bell: Going back to April, there’s been so much thrown at the market in terms of QE and special programs and sort of, you know, non-rate monetary policy developments from the Bank of Canada and market changes in general. It would, you know, I’d have a hard time isolating it as a QE phenomenon necessarily. And the market’s still figuring out to a certain extent the QE. How is that going to evolve? How is it going to change? I think there was a, you know, thinking on the headline of QE that it would be, that it would really suppress the five year part of the curve and flatten twos fives and keep fives tens curve steeper than what we’ve seen. And that hasn’t really played out because the bank has followed a, you know, an issuance based mirror kind of QE. So it’s across the curve and it hasn’t really led to maybe the opportunities that I would have expected just on seeing the headline.

Ian Pollick: I agree. I mean, we’ve had a lot of those headline fakes. You know, when the IMPP announcement came out, everyone wanted to sell spreads, myself included. When we started to do some of the details, understand the program. We recognized that it probably wasn’t as big a deal. And in turn, it proved out not to be. And I think you hit the nail on the head because if we’re to decompose QE, you know, there’s a few different layers of it, because on the one side, you have issuance. And that’s something that we’ve been talking about for a couple of months now, and particularly since we got the new updated debt management strategy in July. Issuance is just very, very high. And what we’ve seen recently is that the inclusion of a small upsize in the pace of 30 year buybacks isn’t enough over the balance of the current fiscal quarter / calendar Q3, to really prevent the curve from steepening. And I think that broad expectations at the very start of QE was, as we saw in many other markets, the curve should steepen. Your five year point should be your anchor. Thirty years should kind of move around. We haven’t really seen that with huge momentum in Canada, but I think that we’ve talked about, for the better part of the past week is, when we look at the risk profile of issuance and the risk profile of QE, it paints us a picture of net supply that is more advantageous for the belly and less advantageous for the long end. We’ve seen the long end trade very weak, not just in Canada but in most global markets, but in particular, the idea that issuance is coming back online as we move into the Canadian fall, should start to engender a steeper curve. Is this a narrative that you buy into or do you think this is one of those, you know, show me the proof before I’m going to put some risk behind it?

Craig Bell: When it comes to the long end, broadly speaking, yeah, I favour a steeper Canada curve, fives thirties, let’s say. I’m just not convinced that it’ll necessarily manifest itself in thirties. The long end of the Canada curve is very flow driven. I mean, Canada tends to be a flow driven and the swap market tends to be a flow driven market a lot of times. That can, you know, override fundamentals for longer periods than you might expect. And that is more true in the long end than anywhere else. I think fives tens is where we can see a lot more steepening than we have. The long end, I mean, to a certain extent, like you say, it could go, you know, anywhere. It doesn’t necessarily have to steepen. You know, with the fives tens curve, you know, it depends what, you know, LDI customers and that sort of account base does to a certain extent and this is specific to swaps. It’ll depend on relative performance to other global markets and primarily the US when I’m talking about that because, you know, the swap market tends to get a lot wider participation from global real money and fast money, and the impact of that is cross market trades become a lot more looked at in that account base. And so they’ll be involved in swaps on those cross market trades. So if you get a steepening or a cheapening and steepening 30 year US curve, that’ll translate into Canada via that channel and vice versa. So, you know, I think the flows will dominate that, but I think fundamentally there’s a certain inevitability in my mind that we’ll get a steeper fives tens curve, you know, going forward. I don’t think that’s a next week story, but I certainly think if we’re having this conversation six months from now or a year from now, we’ll be looking at a steeper fives tens curve.

Ian Pollick: Totally agree. And, you know, one of the things that we saw in the latter part of 2019 was the directionality spreads really wasn’t moving with the market. It was more a cross market story. And that’s pretty much what I think you just said, i.e., on days where Canada outperforms the market, spreads tend to widen and days when Canada underperforms, vice versa. Are you seeing that dynamic, too? Because you know, endemically that speaks to a very heavy participation of cross market trades. It’s not necessarily a Canada story. It’s well, let’s look at the G7 or G10. What’s the dollar bought periphery versus some of the larger markets? That’s really an interesting dynamic because we could see very quickly what was happening in terms of the minds of investors just by looking at the directionality of spreads across market bases. Do you think that still stands today or are we seeing something a bit different?

Craig Bell: No, I definitely think it still stands today. You know, the international flows, international cross market flows tend to be bigger in our market than the domestic flows in the long end specifically, I would say. So that’s generally a very good barometer, looking at swap spreads to see what cross market flows are in the long end.

Ian Pollick: Interesting. And, you know, I want to take this a step further by taking it a step back. And when you think about Canada, you know, Canada has a very defined market where we tend to be higher inflation in general than many other economies. And that means that the beta of our market tends to move quite dramatically depending on the inflation regime. But what also happens is that because historically, Canada has had a very small budgetary deficit or surplus, which has led to very slow and stable issuance, swap spreads are generally much higher in Canada than most other jurisdictions in the world. Now, one of the impacts that we’re seeing in 2020 is that all of a sudden, Canada grown up into a real market in the sense that you have such a huge amount of auction issuance that all of a sudden auctions matte, the setup matters, tails matter. You have to understand where your net supply lives on the curve. Eventually that should, in theory, lower swap spreads. And I’ve had a lot of conversations with domestic and global investors over the past couple of months, and it all centers around the idea of are swap spreads too high in Canada, is it structural, is it something that’s been lingering from the past, is it an antiquated view? How do you think going forward, given what we know about QE, given what we know about issuance, are spreads in the wrong postal code?

Craig Bell: That wouldn’t be my starting point, necessarily, to be honest with you. I mean, there is a structural difference. You know, a swap at the end of the day is just future expectations of CDORs over the period of time. So a 10 year swap would be 40 CDORs stacked one on top of the other. And CDOR tends to set higher in Canada than some of the other IBORs. If you look at the US specifically, you know, you’ve had settings in the high to mid-20s on an overnight rate that’s in a range a little bit below that, whereas in Canada we’ve had settings in the, you know, low to mid 50s, let’s say. So that difference alone has, you know, a reasonable impact on how high spread should be won relative to the other. You know, there are parts of the Canada curve that I think, going along with my fives tens steepening theme, I think the 10 year spreads would be too high looking at that type of curve move, so while I don’t share the view that swap spreads are wildly too high, or certainly not in the wrong postal code. You know, I can buy the argument that they’re a little bit too high and that they will come in through time. You know, we’re seeing a situation now where the supply in the front end of the US is not being absorbed and it’s leading to a higher LIBOR setting. And we’re seeing the inverse in Canada with the shrinking of the bill options. There’s just less supply in Canada and it’s grinding CDOR a bit lower. I have no insight as to whether those two trends are going to continue. But, you know, it’s something on the radar and we could see a bit of a narrowing of the spread gap in between.

Ian Pollick: Let’s talk about that a bit more, because one of the really interesting dynamics that’s played out since the crisis has been the lack of new bankers accepting supply. You know, you had a period where people were expecting credit facilities to be drawn down because the issuance markets are generally closed. And yet, if you look at the early months of the crisis, you know, March, April, even May, you didn’t see a lot of new BAs being created. And I think that was the risk for a lot of people, where CDOR could underperform even though the cash market was rallying. When you think about the end users of swaps in Canada and the net suppliers of swap spreads, which is something that you often talk about, how do you see that changing, if at all, as we move into the next phase of the recuperation of the economy?

Craig Bell: Well, I mean, there’s you know, it’s a very good question, we, you know, to a certain extent, it’s a little bit too early to tell a lot of these questions. We just don’t know how, you know, behaviour is going to play out. Real estate market in Canada, big driver of swap spreads. In the past, we’ve seen seasonality in the spring where five year spreads are supported and that’s generally thought to be hedging from the bank treasuries, making five year mortgage loans and hedging that in the swap market. You know, we had a late start, obviously an interrupted spring, but is the real estate market going to continue turning over? We’ve seen some surprising real estate numbers in terms of turnover, in terms of buying, you know, and if that continues, it’s going to change the behaviour of the bank treasuries if the real estate market starts to slow down and not turn over as much, you know, maybe and I’m talking residential real estate, you know, maybe there’s less activity, less hedging needs from the banks. You know, then there’s issuance flows, you know, that matter, whether it’s you know, are we going to have issuance in the Canadian market? Are people who issue bonds going to be hedging those bonds at these yield levels? Maybe they’re happy to be short the market at the current yields.

Ian Pollick: That’s a very good point, right? Because, you know, and it fits nicely into the next thing I want to talk about, because one of the big implications of having so much issuance in the very long end of the curve is that traditionally this is a part of the market where the government has on purpose stepped away from. It’s allowed some sovereign issuers and corporate issuers to come and fill in that gap. But now that everyone’s kind of drinking from the same pond, so to speak, it does create this crowding out impact. And, you know, indeed, we look at the news from Ontario yesterday that the budgetary deficit was worse than expected, which in turn meant that issuance levels are going to be higher than expected. And proportionately, what we’ve seen is from many provinces where you have these outsized needs that were unexpected for issuance, they can go abroad. They have that flexibility to go abroad. And if that happens and there’s clearly an implication to the BA LIBOR channel, but there’s also an implication for spreads too, because that’s the natural follow through if all this stuff gets swapped back into Canada. So can you see a situation where mortgage activity, whether it’s refinancing or new originations, begin to slow as some of the fiscal programs that are offering income support begin to expire? That, in theory, should take five year spreads lower. But if you have this international issuance and you have issuers that don’t need those foreign currencies that’s coming back into Canada, that could keep five year spreads, relatively anchored, can’t it?

Craig Bell: Oh, it definitely could in that respect. You know, the truth of the matter is, it’s like I say, a little bit too early to tell. I mean, definitely, you know, I agree with the thesis around the mortgage borrowers. I would expect that to slow down at some point, you know, taking some support away from five year spreads. Is that necessarily going to be replaced by international issuance swapping back? I’m not sure. There’s going to be a flood of issuance, not just from Canadian issuers into foreign markets, but those foreign markets will have domestic issuers that need money. This was a very synchronized global event. You know, what is the appetite going to be from the investor base on this issuance is, to me, still a very open question. And, you know, it’s encouraging to think there’s going to be international markets, huge international markets that pick up the slack for our domestic issuers and bring them abroad. But, you know, it remains to be seen how long that support lasts. You know, and we’ll be figuring this out as we go. So, yeah, I think that’s still too early for us to tell. You know, I would assume people would be looking at, issuers would be looking at keeping their same proportions of domestic issuance versus non domestic issuance that they’ve done. So if they did 20% abroad in the past, I would think they’d still be looking at that, you know. But, you know, ultimately they’re going to raise money where there’s investors willing to buy those bonds. And we’ll just see how that pattern plays out. I’m not sure how it will.

Ian Pollick: For sure. And I think that’s really a good narrative, right? It’s that we know there’s a lot of these really important themes that are coming down the pipeline. We just don’t know yet how they are going to play out. And there’s two in particular that are bothering me just from the perspective of, it matters so much for our market but it’s still a little bit ways away. The first one obviously is the size of Canada’s QE program. I’ve been very vocal, as you know, in suggesting that I think the quantitative easing program in Canada is too large for our market and there has to be a course correction at some point because, left unchecked, by the end of the fiscal year in March 2021, the Bank of Canada is going to own a hugely disproportionate amount of the bond market. I have to suspect that the idea of neutrality and not wanting to have too much of a footprint on the market would prevent them from getting to these outsized levels of ownership. You know, for example, left unchecked, we’re talking about twos, threes, fives as sectors being more than 60% owned by the Bank of Canada, not even including the fact that they’re now buying benchmarks. So the biggest tai risk in my mind is that the permanence of QE is not that permanent. That’s going to have super important implications for everything that we just talked about. But if you take it to its root, the second thing that I want to ask your opinion on, because as many of you know or may not know, Craig has been instrumental in the Canadian IBOR reform. He sits on a bunch of different boards and represents CIBC in particular in discussing what some of the future iterations of IBORs look like in Canada. So we know that the MX has some new CORRA futures and CORRA typically is not a huge part of the market that people think about. And when I think about the balance sheet and I think about its evolution, we know that when the Bank of Canada first started buying assets at the start of the crisis because the money markets were so frozen and because of the way that the Canadian financing system works, a disproportionate amount of assets on the balance sheet are very short dated in nature. That means that the maturity distribution is very truncated over the next six to eight months. As the balance sheet starts to decline, which it did last week for the first time, we have seen upward pressure in very short term interest rates. The day that the balance sheet shrunk nearly 8%, we saw CORRA move higher by almost two basis points. So if you think that you’re going to be in a situation early 2021 where the balance sheet starts to show more deterioration in terms of narrowing, that’s how long the term repos begin to mature. That should, in theory, begin to drain settlement balances from the large value transfer system that could put upward pressure on CORRA. How do we use CORRA futures to play that type of dynamic?

Craig Bell: Wow, there’s a lot to unpack there.

Ian Pollick: There’s a lot there.

Craig Bell: Yeah, well, you know, my thoughts are, OK with respect to CORRA, the setting in general, I think you have to look at it as the bank definitely thinks that this is the market manifestation of its overnight rate and it will intervene in the market to tilt CORRA, you know, higher if it’s setting low, lower if it’s setting high. You know, it’s not going to do it for a tenth of a beep or a beep here and there or for a short term basis. But, you know, it will get involved. And given the number and scale of the non-rate monetary policy tools that the bank is using now, you know, they’ve really opened the toolbox on this. I think and given our current central banker being Tiff Macklem, who was definitely around and very involved in the plumbing back in the great financial crisis, the bank is going to be more active than usual in trying to keep that setting a particular stable or that market that leads to that setting as stable as they can be. And so, you know, you might get,and it is an overnight setting, so the, you know, the individual deltas or the amount of risk you have to any one setting is not something that, you know is going to be anything that should change your day. So when I look at CORRA futures, they’re all forward starting, basically one month or three month gaps, you know, at some point in the future. And my assumption is the bank is going to have the repo market working sufficiently well that the setting has to be assumed to be whatever the bank’s target overnight is in the time at that time. So I’m not too worried or I’m not looking at opportunities to play individual settings. I just don’t have that type of knowledge or insight of what the flows are in repo or money market, other than to say I expect the bank to be very active in, especially if it sits on the high side to keep the setting tending towards overnight. So if you, you know, looking at the forward gaps, you know, it gives you a sort of an elegant way to play the overnight rate. It’s a bit of a shame for the MX that they launch these contracts in the middle of a time when the bank is probably going to be on hold from a rate point of view for an extended period of time. So, you know, we use them as, you know, interest rate hedges and rate management tools. But ultimately, I don’t think there’s much of a trade there in OIS, you know, itself or OIS futures, other than I like taking or hedging risk in forward space and OIS to try to minimize the individual settings that you might be exposed to.

Ian Pollick: Right now you see it more as stub management than anything else.

Craig Bell: Yes, stub management. I mean, when the time comes, I think there’ll be curve opportunities there. I just don’t think we’re in a space where the overnight rate’s going to be moving in the near term.

Ian Pollick: I agree. Listen, we’re going to wind down the show a little bit, but one of the things that I love talking to you about, and anyone that knows you, knows that you do have very strong opinions on politics. We’ve seen a lot of variability in Canadian politics recently and whether that is concerns about deficits, whether it’s the trajectory of whether or not we’re going to get an election this year or next. How do you think some of the increased noise around Canadian politics will start to filter into our market? Because traditionally, Canada is not a market that tends to be overly impacted by politics coming out of Ottawa. I’ve always saw it as politics in almost any region as an FX market reaction. Do you agree with that? Do you think that Canada continues to look through some of the noise that we’re hearing right now? Do you think we’re going to get an election this year and ultimately what markets are going to be impacted by that?

Craig Bell: I think you’re right. The main, you know, potential source of impact would be through the FX channels. I really don’t think there’s, I mean, listen, I have no opinion on whether or not there’ll be an election this year in the near future. I don’t think there will if I have a leaning. But, you know, there’s certainly some saber rattling going on. And, you know, the opposition parties in the middle of its leadership convention. But at the end of the day, the issues that the country is facing in terms of the recovery are going to be the same no matter who the government is. And there’s not really a tremendous amount of daylight at this point in terms of what the policy responses are going to be. There’s going to be, you know, stimulus. There’s going to be money spent. There’s going to be deficits and increased debt and so on and so forth. That’s just inevitable no matter who’s actually governing, you know. So, you know, we’re just quibbling on details after that. And so I don’t think they impact the big picture. It was funny. I was in a conversation with a political science professor just a few weeks ago, but their observation on Canadian politics impacting the market. But it was not the market. It was just in people’s engagement. And his observation was, you know, people in Canada are much more passionate about US politics than they are in Canadian politics. And that’s probably something that would be good to change.

Ian Pollick: Yes. And, you know, before we finish the show, I got to ask you, top two favourite trades. What’s the timeline? What’s the conviction level? Go.

Craig Bell: Well, fives tens steeper, I mentioned that a few times, Time-frame, let’s say, you know, start to look to that in October, into the bank’s NPR in October would be the place to look in my mind in terms of catalyst. And that’s really the big one. You know, on the back of that, we do have some spare flatteners. We like being received Canada versus US and just received Canada in the front end in general here. We think it’s fairly cheap when yields start getting above 30 and twos and above 40 and threes, those look like opportunities that will play out over the next six months.

Ian Pollick: Awesome. Well, listen, I know you’re a busy guy. I know you have a lot of risk to manage. So we really do appreciate you taking the time to fill in for Royce today. It was a great conversation. For everyone on the other end of this and listening to us, we hope you have a great weekend ahead. Remember that next week we do have a pretty busy data calendar. We have some wholesale trade data. CPI is going to be the big one, particularly given the upside surprise that we saw in the US this week. And thank you very much for listening and remember as always, there was no bonds harmed in the making of this podcast.

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