The multiverse of credit & rates

Disclaimer: The materials disclosed on this podcast are deemed to be sales desk literature and subject to our client communication policy and code of conduct as well as IIROC rules.

Ian Pollick: Im An alien, I come down, travelled a long time, I land on Earth and I say, OK, I look at this inflation, I look at the level of employment and unemployment, and the first thing I would think is, wow, we just went through a massive productivity shock. Interest rates are probably closer to four percent. Everybody, including myself, likes a good origin story. Indiana Jones Last Crusade. Great Origin Story. Star Wars Attack of the Clones. Great Origin Story. My favourite Batman Begins. Best Origin Story of All Time. So I’m going to draw up a little origin story right now about this podcast. Rewind two years ago. Pandemic starting. We’re nervous about connectivity. We knew we weren’t going to see clients for a while. Me and he, who shall not be named, came up with this idea to do a podcast. So step one decide to do a podcast. Step two Trying to figure out a name. So the backstory here is that one day I was talking to Josh Kay, who’s on the show today, who heads up our distribution team, and I mentioned to him that me and what’s his face? We’re about to do a podcast now, Josh, I’m going to put you on the spot here, but do you remember any of this and do you remember any of the names that you suggested to me?

Josh Kay: I do remember Ian, and I do remember suggesting to you, Curve Your Enthusiasm, there may have been a few other ideas in there, but I don’t recall what they were.

Ian Pollick: Oh, there were a few other ideas and they they were they were gems. Let me tell you, the first one was called read with interest. The second one was first rate perspectives and the third one straight answers on the curve. And again, like, you know, you kind of said you had that light bulb moment and you’re like, Well, what about Curve Your Enthusiasm? And the rest is history. So that’s the back story of Curve Your Enthusiasm in terms of how we got our name. Josh, welcome to the show. How was your long weekend, man?

Josh Kay: I’m great. And I’m honoured to be on the show, man. I haven’t missed a single episode of the show. I’m a big fan of yours, and I’m looking forward to talking to you here over the next half an hour.

Ian Pollick: Oh, well, flattery will get you everywhere. So listen, I’m excited to have you on the show today. Obviously, we’re friends, but the reason why I think our listeners are going to benefit from you on the show today is that you have a very unique perspective. You cover rates clients. You cover credit clients. And given where we are in the cycle, I think it’s it’ll be interesting to pick your brain on stuff. So let me start off picking your brain on, you know, what’s what’s the elephant in the room? And the elephant in the room is the Bank of Canada. So give me your opinion on the bank right now.

Josh Kay: Right? Ok, bank. Ok. Good question to start, Ian. I think this helps to contextualise our whole discussion. My thought about the bank and what they should do in March is probably not consensus, and it’s probably a little bit controversial. So in order to contextualise what I think about the bank from Arch, I’m going to tell you a little bit about what I was thinking last December and into the beginning of this year. So last December, Ian, I felt like the bank should probably set up for a 25 basis point move in January. I felt like the market was kind of coming our way. I felt like clients were sort of starting to agree. And then Omicron hit the scene and the discussion shifted to what’s the impact of Omicron? Maybe the bank should wait to see how this whole al-Muqrin thing plays out. And I sort of thought that American felt like a movie I’d seen before. We’d seen lots of different coronavirus waves. So to me, it almost felt like a sequel of police academy. Like, you don’t need to see the end to know that the good guys win, right? So I felt like we knew how this whole thing was going to play out. We know lockdowns create a bit of demand restriction, but we also know that they cause inflation. 

Ian Pollick: Yea, what comes out on the other side?

Josh Kay: No question, right? So I was more concerned about the inflationary impact of Omicron. I didn’t think we had to wait to see how it played out. I think the bank had an opportunity to go twenty five basis points in January, and I think that could have been a missed opportunity. So all that being said, in moving forward to March, I feel like the bank should really strongly consider moving 50 basis points.

Ian Pollick: So you’re going to draw up a 50 basis points. Do you think it’s 50, right?

Josh Kay: I think it’s 50. I think they got to go and I think it does two things, and I think it signals to the market that they’re concerned about inflation. And I think they can also message that we’re no longer in a crisis environment. Zero rates is not where we need to be anymore. So let me ask you this again. The bank is concerned about their credibility. They said the train’s leaving. The station rates are going up. Does it affect their credibility if they go 50 basis points in March? And do you think that this is a reason that only twenty five could be in the cards?

Ian Pollick: So it’s a good question. I’d say that I vehemently disagree with you and I’ll tell you why. The first thing is is that credibility is very important, and I think the reason that they didn’t go in January was to maintain their credibility. And what I mean by that is if they had gone in January, then effectively they would have neutered using Ford guidance as a tool going forward because they hadn’t spoken to us really since the December meeting, they hadn’t changed the narrative around the output gap and needing that to be the goalpost before they started raising rates. So by not going in Jan., I think that they just preserve the ability to use forward guidance as a tool. The other reason I don’t think they go 50 is that when I look at the forecasts in the last MPR from January, nothing seems to be out of whack, i.e. yes, we had higher inflation last week, but that was one month print, you know? For the quarter, they’re looking for relatively high inflation, we don’t really know what the trajectory is yet. That could overwhelm, you know, but we’re not going to know that until after the March decision. And the other thing too, is that I keep coming back to this idea that, you know, GDP growth looks relatively low. We’re still a couple of percentage points behind in level terms.

Ian Pollick: So I don’t know what the justification would be from a forecast perspective. The other reason and this is a bit more technical, it’s this idea that, you know, because of QE, there’s all this cash in the system that cash is putting downward pressure on very short term interest rates. And it’s not like when the Bank of Canada raises or cuts rates that rates automatically just move. It needs various market participants to push and pull in Arb and non-Arb T get to that kind of point in the market. That is where the target rate sets. And in Canada, that’s Cora and Cora is sitting materially lower than where the target rate is lower than would normally be the case. So I worry that if you provide a non-standard size hike of 50 basis points, some of these technical considerations may actually prohibit how much tightening gets into the market. So from the bank and I just delivered 50. I want to be really sure that the plumbing is completely clean so that I’m passing on or transmitting that full hike. That’s why I don’t think it happens. But I know you disagree, and I know that when we’ve talked a lot about, you look at the landscape around us and things just don’t line up. So talk to me a little bit about what isn’t lining up right for you right now.

Josh Kay: So, Ian, there’s a lot to unpack there, but I wanted to ask you to imagine something before we talk a little bit about the output gap. Potentially.

Ian Pollick: Ok, I’m going to imagine my eyes are closed.

Josh Kay: Okay, so imagine imagine that you’re an alien from outer space, OK, and you’re doing your job up there, and we invite you down here to look at our world, to look at our universe. And the first things you see are Canadian and U.S. unemployment and inflation. Ok, so Canadian inflation, let me remind you and our listeners five percent Canadian unemployment, just over five percent U.S. inflation seven and a half percent U.S. unemployment four percent. Ok, you’ve just arrived. You see those four data points. Where do you think rates should be? Where do you think they are? And why aren’t we there? And then how can you not think 50 basis points should be in the cards?

Ian Pollick: Ok, so I’m an alien. I come down, travelled a long time. I land on Earth and I say, OK, I look at this inflation. I look at the level of employment and unemployment, and the first thing I would think is, wow, we just went through a massive productivity shock. Interest rates are probably closer to four percent, right? But then I sit down and someone’s like, Well, actually, that’s not the case. And being an alien, there’s no pandemics in my world because we’ve mastered technologically how to combat disease. So I’m on used to this and I’m like, Well, explain this to me. And so someone tells me that we just had a pandemic. Inflation is being driven by capacity pressures, not demand pressures. But someone also tells me that there’s been a huge fiscal response and someone else tells me that there’s been a massive expansion of central bank balance sheets. So all of a sudden, and if we’re talking about this theme of contextualising, I’ve just been contextualised why we are where we are, why this silhouette looks so strange with zero rates. And I would say, you know, this alien IP, that rates are probably not needed, but I think you need internal consistency. I think those reasons that I just elaborate on are the reasons why I think I would understand why policy is still so low. But look, I think I think we’re splitting hairs here a bit. The point that we’re both making is that policy is going up. Whether they do 50 or twenty five rates are going to go higher. Policy is getting tighter, financial conditions are getting tighter. And I want to talk about this idea of financial conditions getting tighter. I guess we’ll just agree to disagree on that. But you speak to a lot of credit accounts. Yeah. And credit clients are a bit different than rates clients in the sense that, you know, it’s usually the tail wagging the dog that rates move, risk assets move. We often don’t talk about portfolio construction on this podcast, and that’s why I want to focus a little bit on right now, OK? You know, you have the benefit of talking to these credit investors. Can you enlighten all of us rates, folk, how credit investors think about the movement and rates right now?

Josh Kay: Right? Ok, sure. So there’s a lot of different kinds of credit managers and a lot of different types of portfolio managers that look at credit here in Canada. But I think when you take a step back, you can think about it as two different types of credit managers. There’s the hedge fund manager who buys credit sells candidate against it. Has it stated in their mandate that their view is to be rate neutral and make money in all rate environments? And then you have on the other side, you have index type managers who run either corporate or universe type mandates. So speaking first about the hedge fund manager and how they think about rates, obviously they’re hedged on every position, so they’re not actively placing rates bets, but rates still matter. So, for example, a five 10s is flat in Canada. As it is, you may find a credit hedge fund manager is saying, I don’t think I want to be in the 10 year sector in credit because the credit curve fives 10s maybe steepening out to compensate for the flat rates curve. So on that side, you’re not seeing active rates bets, you’re seeing credit investments made with rates in mind. On the other side, the index type players who are investing in credit invest in corporates generally close to the index. And I’m going to be I’m going to say that’s generally because credit isn’t really that liquid. And if you want to move big blocks around to sort of shape your duration view, it’s really hard to do that. And Canadian corporate credit, so 

Ian Pollick: And its going to Cost you bit offer, right?

Josh Kay: It’s going to cost you bit off offer. It’s hard to move around. So you’re going to shape your credit portfolio by sector generally close ish to the index. And if you want to make a rates bet in one in either a universe or corporate mandate, you may use futures or other types of hedging tools.

Ian Pollick: Ok. And so let’s say you, you know you weren’t at CIBC. Let’s say you were running your own credit shop right now. How would you be positioned.

Josh Kay: Right. Ok, so good question. I think that because I think the bank is going to go in the front end and I think they’re going to go fairly aggressively, at least at the outset. I think two fives is going to flatten. So to start, I’d be Underweight 2’s overweight 5s moving out the curve. I’m not a huge fan of times. I talked about five or 10s being flat. As a result, I think I’d be underweight 10s and long the long end. I know you’ve talked on your show a lot about the long end being at risk as a result of potential supply. I think the long end probably hangs in here. It can probably flatten a little bit more. I think we see some asset reallocation trades out of equity into fixed income. I think we see that ongoing as pension funds are increasingly achieving funded status. And I also think we’re still learning a bit about IFRS 17, the impacts there. And I think Boogie Man, the bogeyman, exactly. I think we might see some extensions resulting from IFRS 17

Ian Pollick: A few years so far. And I listen, I think if you did get this 50 basis point move, as much as I agree with you like I think twos 5s is very steep for where we are in the cycle.

Josh Kay: Agreed. Ok on that?

Ian Pollick: And just to contextualise it, because I love using that word contextualise.

Josh Kay: There we go.

Ian Pollick: When you look at what the market is priced for the endpoint of policy, you know, we are very high. We are two and a quarter. Yeah, and you’d really have to go back to the 90s and we talk about this all the time to find any cycle that had a higher peak interest rate than the one before it. And remember, we finish our last cycle at 175 in this cycle. What makes it so weird is that we’re effectively priced in the forwards for end of cycle behaviour in the very early stages of the tightening campaign. And what I mean by that is, you know, the front end is inverted. That’s not just Canada. The U.S. is inverted to like one year, one year out to 70 or one year in Canada. When I look at when you’re one year, five or five year in office space, it is zero that usually doesn’t happen to the end of the cycle. And what that means is that because there’s such a concentrated pricing where like 80 percent of the cycle is expected to be delivered in 2022, it’s hard for the twenty three 23 four rates not to be inverted relative to where we are today. That can’t persist with twos fives as steep as it is now. If the bank did go 50 right away, I think the knee jerk reaction would be 5s. Probably don’t do that well, but that’s an opportunity to own them. So I do agree with you on that when it comes to the bogeyman, a.k.a. IFRS 17. You’re right. I mean, yeah, I think for our steepening view, intense bonds, that’s the biggest risk. Now we don’t know a ton about it. What we do know a lot about it, but we don’t know what is the final prescription is going to look like because I think it’s very much in flux. But but you’re right, that’s definitely a risk that we need to think of going forward. But you know, one of the things that I spent a lot of time thinking about is liquidity. And in particular, what I like to call macro liquidity and macro liquidity to me is when I look at the global sum of reserves, when I look at the expansion of central bank balance sheets and I kind of create a run rate. What we saw obviously in 2020, this massive run rate of this liquidity, this macro liquidity, it was running like 50 percent a year. Yeah, but balance sheets are shrinking. Yeah, QE is stopping. And you know, the U.S. dollar is rising, which pushes lower the value of X reserves and net net. What we’re seeing is this massive deceleration in the pace of liquidity growth. One of the things that we’ve often talked about is what happens when that happens and what happens is that you have a much more normalised correlation environment. And I think you were talking about this earlier. You have a flat Canada curve. You’re supposed to have a steep credit curve. That’s not how the market’s been trading over the past year, but I do agree with you. I think going forward then that is the correlation mode that I think those two curves will move in. So if you were to look at credit curves right now, what is the steepest part of the credit curve is it tends bonds, is it five 10s? Is a five thirties?

Josh Kay: Well, it certainly depends on the sector. I think you’re seeing a good amount of steepness. 

Ian Pollick: Give me a generic, like a generic sector like a generic Triple B.

Josh Kay: I think you’re probably seeing most of the steepness and fives 10s. The 10 year sector has really struggled. There are certainly structural demand for long, so there’s definitely an opportunity in the 10 year sector in corporate credit as a result of the flatness of the 5s 10s curve and just generally tend. As being out of favour, and I think there’s also an expectation that issuers are going to be coming soon, are going to be paying new issue concessions and if you want, we can unpack that a little bit. And they’ll be coming in the 10 year or in the long end.

Ian Pollick: Ok, so let me ask you a couple of things, and let’s just set this up this discussion for context, because I actually don’t know the answer. If I were to earmark it from, let’s say, November last year to date, how much wider is generic corporate credit in Canada, as I say, 10 years?

Josh Kay: Right? So I actually so I know you’re talking about 10 years Ian, and I think the best way to think about corporate credit spreads is probably looking at a five year bail in security. Ok. And so if you look at five year Canadian bail in going back to sort of three six months ago, you’re probably thirty five, forty basis points tighter than here. That’s a big number. So that’s a pretty it’s a pretty significant move like round numbers, call it from 70 basis points to call it one hundred and ten basis points. So credit has underperformed and it’s underperformed equity, if you can kind of compare it that way.

Ian Pollick: Ok, well, that’s interesting because I don’t think you hear a lot about that. So let me take this one step further. So you’ve had this widening in credit, right? Rates are rising, too. So you have rates fall underneath. You know, I wonder from the perspective of these new issues concessions, right? So that is, you know, explain that to us in a bit more detail. But, you know, compare and contrast to me where we’re new issue concessions in November. Where are they now?

Josh Kay: Right. Ok, so it’s important to understand what what a new issue concession is. So in general, there’s a price for securities, which is determined by dealer runs, so dealers send out indications of where they think this stuff trades in the corporate market. And it’s their best guess on where some amount of volume trades could be two million, five million, 10 million, 20 million really depends on the security, and that is sort of an indication of where we think that security is. When a new issue comes, they come with three hundred and four hundred and five hundred one hundred a billion dollars, $2 billion. And generally issuers have to pay a concession, which is extra basis points above and beyond where we think the secondary is going to trade in a normal market. It might be two basis points, three basis points, five basis points. We saw a lot of that last year in the last number of weeks. New issue concessions have really grown because liquidity has been choppy. The backdrop has been volatile to call it 10 basis points, 15 basis points. And that’s the price for new issuers to come to market above and beyond where we suspect secondary is trading.

Ian Pollick: Ok, so let’s think about this for a second. I come at this from a rates perspective, right? Where NICs do not exist at auctions, so you have NICs that have been widening out, let’s say, 10 to 15 relative to secondary. Am I being paid as an investor to own this and do I immediately monetise it, i.e. on the break? Are we seeing recent deals tighten up that eat up that nick so I can crystallise it? Or is it lingering? So like again, the other side of this is so you have these NICs, but do you realise them i.e., yes, you’re going to get that additional carry. But for the faster folks out there, do I have to sit on my bonds for a long time? What I’m really trying to say is frame for me how much new issues are breaking today relative to, again, let’s say, in November last year?

Josh Kay: Right? Ok, so going back to last year, when things were more stable, you’d see a three five basis point nick. It would perform on the break relatively consistently, at least to where it was trading in the secondary and sometimes through. So in a healthy market, an investor should realise a nick, maybe more and you might see a good deal mobilising attention, getting people focussed on an issue. And it might even cause secondary to trade tighter after the issue than it did before in the last number of weeks. I guess really to start the year, we’ve been seeing these larger new issue concessions of five, 10, 15 basis points and in general, they’re not being realised. So in the secondary market, trading has been sort of for lack of a better word and and new issues as a result have been repricing secondary wider. And what happens in that environment is that investors become more cautious about adding secondary because they’re concerned that a new issue might come behind them at some stage and reprice the secondary they just bought wider. So I think that’s why we’ve seen credit move 40 basis points wider. That’s why we’ve seen credit underperform the equity markets. If you could line them up because issuers want to come, they want to fund ahead of what looks like a higher yield environment, and they’re willing to pay NICS of five, 10 or 15 basis points to get ahead of higher rates.

Ian Pollick: Ok, so walk me through something here because you know again, as a rates guide not too familiar with it, corporate issuers know rates are rising. There’s a lot of volatility in the rates market. Clearly that’s impacting risk assets as well. What is the pipeline look like and do these issuers have the ability to, for example, rate locks? They don’t have to worry too much about the underlying rates fall.

Josh Kay: Right. Ok, so a good question. So there’s normal course borrowing that takes place to refinance existing maturities to fund for capex. If you look at all. Easier shores and you think about what’s in their head if rates are going up and they need to fund at some point this quarter or next quarter. Maybe they would consider advancing their funding to get ahead of what could be rising rates. So I suspect that’s the discussion my DXM colleagues are having with all these issuers. If rates are going up, is it better to pay 10 or 15 basis points, NIC, in this environment, which is volatile, then wait for a smaller new issue concession, which might materialise when rates are much higher, resulting in a higher overall coupon. I suspect our DXM colleagues are all over the conversations with their issuers about rate locking, and I think that’s a very interesting point yet. I don’t think all corporate issuers are set up to consider rate locks, but I do suspect that conversation is ongoing.

Ian Pollick: Interesting. Ok, so listen, I want to wind that one. That’s down a little bit because we’re running a little bit long. But, you know, give me your kind of bird’s eye view, let’s say, over the next three months. You mentioned it a little bit earlier, but what are your favourite trades here?

Josh Kay: So I like being short 2s, long fives just like you. I like being long credit in the five year area. I think there’s a lot of opportunity there, and then I think it gives you the ability to add new issues and tens of longs when issuers come there at a new issue concession.

Ian Pollick: Ok, so here’s one last thing I want to ask you and I did this a couple of weeks ago with Nick Extra’s, who was on the call. I made him a bet that we’ve seen the tights in provincial spreads for the year. What’s your perspective? Have we seen the tights in IG this year or not?

Josh Kay: I think we have.

Ian Pollick: Oh you do. Okay. 

Josh Kay: I think we could move tighter, but I don’t think we move 40 tighter, I think in the face of rising rates. Risk assets remain vulnerable.

Ian Pollick: So the benefit there is, obviously is that you just get more carry, but you may not realise a huge amount of capital appreciation right away. Is that the way to think about it?

Josh Kay: I think that’s right, Ian.

Ian Pollick: Ok, cool. Well, listen, man, welcome to the show. Welcome back to the show. You’re welcome back anytime you want. I hope everyone had a great long weekend and remember there are no bonds harmed in the making of this podcast.

Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s), except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.