The path of least regret

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Craig Bell: Because, of course, CDOR is going away in the next couple of years, at least according to the CARR white paper and the expectations of the CARR committee (alarm).

Ian Pollick: Was that the CARR alarm, being like don’t talk about CDOR on the podcast? (laughs) Ok, so listen, I want to drill down a little bit.

Ian Pollick: Ok, so we are back in the studio, and I’m really, really happy to be here with one of my close friends, market legend, you know him, Craig Bell. Craig, welcome to the studio.

Craig Bell: Wow, I always love the introductions here. Thanks for having me.

Ian Pollick: So I have a little trivia for you. The last time the Bank of Canada and the Fed had a meeting on the same day was what year? And were there any policy actions?

Craig Bell: (Laughs) I have no idea, and I’m going to say likely not.

Ian Pollick: So the last time this has happened was in 2019. The Fed cut rates. The bank did nothing. And prior to that, it was like 15 years earlier. So the fact that this is a Super Wednesday coming up, we have the bank, we have the Fed. A, it’s a rare occurrence. B, we are likely to see potentially some action next week. And that’s why I want to kick off the episode talking about. The house view here is that we do not get a hike from the Bank of Canada next week. Since our last Curve Your Enthusiasm podcast, we’ve seen half of the street switch to a hike. We’ve seen relatively good data. We had CPI this past week cycle high, highest in X amount of years. Why wouldn’t the Bank of Canada hike next week?

Craig Bell: Good question. Why wouldn’t they? Well, it’s strange. I mean, it’s strange times, obviously, but it’s strange to talk about hiking when Ontario is in a lockdown. Most commercial businesses, certainly restaurants, bars, sporting venues, concert venues, movie theatres, that type of thing, gyms, but also Quebec’s had a curfew until just this past Monday. It’s strange to think that such large parts of the population and the economy could be locked down and still be talking about a hike. But it is strange times and we are at zero or near zero rates, which is, I guess, the only thing that enable us to have this conversation.

Ian Pollick: Yeah. So I guess the question is, I think we agree in this, rates don’t need to be at zero. What I keep coming back to is this idea is, well, number one is we heard yesterday that Ontario is having a stage reopening. So by the 31st, we’ll have a 50 percent capacity in some of these businesses, so they’re going to be open again. I’m sure the bank knows about this, obviously, but the question I keep coming back to is, does delaying an interest rate hike by six weeks say to the March meeting, do any more damage to the inflation profile, to expectations of inflation that they need to do something next week? And my answer is no, I don’t think they do.

Craig Bell: I think you’re right about that. I don’t think to the extent that it was a marginal decision. I don’t think there’s a huge penalty in them waiting, for example, until March, when there’s a little more certainty around reopenings and how the consumers come back and how businesses have come back. I mean, arguably the bank learnt a lot in the 2020 to now period on how quickly things come back. Is it different this time? Is there less concern about scarring? Is there not a concern that, you know, after going through another lockdown, the consumers will be either slower or faster to come back? Those are the questions that I guess the bank is contemplating. And what really would be their path of least regrets? I mean, their last official guidance as to when they would tighten was in the middle quarter. So April to September is what we penciled in. Correct me if I’m wrong and I know you will, we are still tracking along the forecast from the last MPR to make that still be the case for the most part. So why would they bring it forward from April is the question. It’s certainly possible that they hike. We’ve had the highest inflation in 30 years just yesterday and the lowest unemployment in a long time. They could certainly hike and have it be the path of least regrets. But given the uncertainty and given that their guidance with forecasts at the time that are unfolding basically as they planned, why not keep to their initial guidance of April being the first hike?

Ian Pollick: So here’s a good question. One of the things we’re not talking about is, let’s say we get to the meeting next week. The meeting is, call it, 70 ish percent priced, 50 percent of the street’s now looking for a hike. If they don’t hike next week, does that January hike leave the full profile or does it get reallocated to say 2023, which only has two and a half hikes priced?

Craig Bell: I definitely think it gets reallocated whether it gets reallocated to the end of the cycle, whether it gets reallocated to a path still within 2022, I’m not sure, but I definitely think that the potential hike does get reallocated.

Ian Pollick: I would agree and I think that’s a really interesting theme, right? Because as you get to these meetings that are priced and if they decide not to go, does it get chopped off and does terminal decline or does terminal stay the same and we push it further out? I tend to think that’s what we’re going to see. So let’s say we get to next week, given what’s priced, what’s the market reaction on a hawkish hold? Talk to me about BAXes.

Craig Bell: I mean, on a hawkish hold, I mean, it’s interesting as to how hawkish they would be, I think even if they were to skip next week unless they are overtly dovish, which is wildly unlikely, I would say at this point.

Ian Pollick: For sure.

Craig Bell: You know, March is going to be priced at nearly one hundred percent, I would assume. So there could be a bit of a rally. But at the same time, our front end has been playing catch up with the notion of a January or March hike from the bank. So I think that if there’s a relief rally, it would be limited and I wouldn’t expect a huge reaction. I wouldn’t expect, for example, as you were just describing, take out that hike in terms of the total number of hikes the bank might do.

Ian Pollick: So here’s another question. You know, we’ve heard it from a lot of clients. I have mixed feelings on it. A no go in January, does that leave March pricing some probability of a 50 basis point move? And do you believe in a 50 basis point move is required?

Craig Bell: I mean, what I believe is required, I’ll separate that from my answer because it doesn’t really matter what I believe in terms of what the bank might or might not do. What the market believes the bank does I think factors probably less than the market thinks into what the bank actually ends up doing. And I’ll just leave that out there. Do they price you in 50 for March? It’s possible, but I doubt it. And the reason I doubt that is if you go back to Macklem’s recent statements, I believe it was a press conference coming out of the last MPR. He was very vague on a number of things. I don’t want to say wishy washy because he is our central bank governor, but the one thing that he did have a very strong opinion of was that the first hike didn’t need to be a 50 basis point hike.

Ian Pollick: Oh, so he said that?

Craig Bell: Yeah, I don’t have the exact quote in front of me, but that was my impression. I remember that as my distinct impression coming out of that last press conference.

Ian Pollick: Okay. And then just really quickly, if I were to say, which I am going to say, number of hikes this year in your heart of hearts, how many?

Craig Bell: In my heart of hearts, I believe the bank will go on a program of hikes, probably three or four to start and then pause and see where they are. A likely place to pause is over the summer for them. So whether that starts in January and ends in June or starts in March and ends in July, and then they take August to reassess and maybe the fall to reassess. And then from there, do they need another hike in the fall, another hike or two in the fall is the open question. So I would say minimum four, maximum six,

Ian Pollick: OK, minimum four. I think that’s probably a pretty realistic assumption, especially given what’s priced. So let’s just switch gears a little bit because I want to talk about something that we wrote about it this past week. We put out a report on quantitative tightening. It’s all the rage across the world right now. It’s not broadly understood because it changes from jurisdiction to jurisdiction. When we think about quantitative tightening in Canada, we talked about it last week. We think it’s a passive program. Let the balance sheet wind down. You don’t need to do maturity caps like you see in the United States. Now the question is, is we’ve heard some clients suggest, well, why don’t they sell bonds? Because if they bought so many bonds and push the market to its fragmented state like it is right now, i.e. the level of spreads, the smaller free float in the market, which means our markets more high beta because there’s fewer bonds to actually absorb some volatility. Does selling bonds unwind that distortion immediately? My gut says it does not. What do you think?

Craig Bell: Nothing’s immediate. Definitely the bank owning so much of the free float is distorting the market, and we’ll talk about that in a bit, I think. But you know, I’m in your camp. It’ll be a more passive unwind. Most likely, I mean, the bank can also become a little bit more strident, a little bit more active if they want. But the fact that we’re coming from a period, especially in December, where GC for example, was trading quite low, a lot of the benchmarks were showing some specialness and even negative repo, and the bank didn’t do a lot to address that at that time. I don’t think they’re, I don’t want to see they’re not overly concerned about market functioning because obviously market functioning is very much in their mandate. But I don’t think that they’re that concerned at this point about the distortions they might have caused to the market. I think, you know, some of the obvious ones, you know, the level of swap spreads, when the sovereign scarce swap spreads. And I know you love when I say that.

Ian Pollick: I love the sovereign.

Craig Bell: The sovereign is scarce. So when there’s not as many bonds around, swap spreads go wider naturally. So I would look at swap spreads as being the indicator there or one of the indicators there as the sovereign becomes more plentiful, swap spreads should narrow. So as more government bonds are around, sovereign curve cheapens but interest rate swaps don’t necessarily cheapen which narrow spreads. That would be the first place I’d look in terms of distortions, but I wouldn’t necessarily call that a distortion.

Ian Pollick: Yeah, I think it’s just an adaption to what the market liquidity environment is. And so let’s talk about distortions for a little bit. And I know the first rule about CDOR is we don’t talk about CDOR, but one of the things that we’re seeing right now is very misaligned front end. We have bills trading relatively high. We have BAs trading relatively higher almost every day. CDOR is playing catch up every day. Is the momentum in the repricing of CDOR something that you expect to see into the bank in the early days of next week?

Craig Bell: I think at this point, we’re more aligned. I mean, I don’t really have any kind of insight into what CDOR might do day to day or moment to moment, for sure. But, you know, it seemed like we were at a place, and certainly there was a repricing in the last 10 days about the possibility of a January hike from the Bank of Canada. As you mentioned, a lot of the economists and strategists around the street have brought their calls forward. And so there was a bit of a catch up that needed to happen in money market that maybe the BAX market or the futures market had anticipated earlier, and I feel like most of that is done. CDOR inevitably is going to drift higher all things being equal, because we’re probably not going to see these low rates again in the future of CDOR, because of course, CDOR is going away in the next couple of years, at least according to the CAR white paper and the expectations of the CARR committee. (alarm)

Ian Pollick: Was that the CARR alarm, being like don’t talk about CDOR on the podcast? (laughs) Ok, so listen, I want to drill down a little bit. If you were to take an alien bond trader, land him in Toronto and say, look at this market, and he saw CDOR OAS 30 basis points, he saw two year spreads where they were, he’d be like, I don’t think I understand anything. Walk us through why that’s happened really quickly and then let’s talk about the rest of the curve.

Craig Bell: Two spreads, where they are specifically? I mean, you know, it does go back to the quantitative easing to a certain extent and the amount of bonds that the bank holds on its sheet. There had been through December, certainly, and we’re seeing a bit of an unwind of that, sort of a global collateral squeeze going on. We didn’t repo on two year bonds was trading at negative eighty five beeps at some points in December, which means you can’t really be short those bonds or you can’t really sell them, which means as an extension, you can’t sell two year swap spreads or three year swap spreads, because inherent in that is selling the bonds, receiving the swap, selling the bonds. And if you can’t get short the bonds, you can’t really sell them and in order to cover your short bonds, your incented to buy them. And it also distorts, it makes two year bond yields lower than they otherwise would be because people aren’t willing to short them as easily in the market. So two year bond yields become extremely low. But two year yields overall, looking at the swap market aren’t as affected by that. So the absorber of that is swap spreads have to widen if the two year bonds are held artificially low. So as that repo situation and collateral squeeze has unwound itself to a certain extent, we’ll see spreads continue to come down.

Ian Pollick: And I think that’s a big theme, that we’ve talked about this all year, that we think this growth in net supply, when the bank steps back fully, we’ll start to hit spreads. I want to talk about belly spreads in particular because it’s so, so interesting. If you look back at net supply since QE was introduced in April 2020, the five year sector in particular was held down in terms of how much net supply growth could happen, so the bank was buying a disproportionate amount of five years, the Department of Finance was issuing fewer five years. And so that made a lot of sense because that’s probably the sector of the curve that’s most consistent or most directly aligned to household borrowing. Now you’re on the other side of this argument whereby you’re trying to tighten rates, you’re trying to slow down credit growth to an extent. So five years are becoming a bit less protected. When you start hiking rates, and we know it’s not going to happen right away, but there will be an incremental hit to mortgage originations, can we think reasonably that belly spreads, five year spreads would underperform the curve in a hiking cycle?

Craig Bell: Spreads? I mean, I’m not so sure. There’s definitely more room to move lower in two year, three year spreads and so on and so forth than fives. But I mean, the whole spread curve is a little bit on the high side historically, well not a little bit, a lot of it. (laughs) You know, I think it flows as much as anything. So mortgage origination potentially takes a hit. What is it going to mean for issuance? Are banks going to issue domestically or not? And will there be hedging needs there? Are other issuers going to come domestically? Are we going to see a big upswing in maple production, which normally has swapped flow? And those are the types of things that in the short term flows really override fundamentals. And so I’m looking at the flows and what it means. But you also have to look at what people’s expectations for the curve are going to be and is the bank well-served by having a steeper twos fives curve, for example? Will that sort of thing, you know, as a policy tool slow down the housing market? If five year rates are higher, they keep that curve steeper or if we’re going to have a front loaded tightening cycle where the bank is in a rush to get rates off zero and is hiking more towards the six times this year and four times next year or whatever they feel they need to get to neutral. That has a big flattening impact on the twos fives curve. And I think your international fast money and real money community will look to anticipate that and depending on what they think the bank’s timetable might actually be.

Ian Pollick: And so let’s talk about the long end of the curve because I think 10 year and 30 year spreads are very interesting. For the most part, those sectors of the cash curve or the sovereign curve, as you like to call it, have experienced the largest and most consistent growth in supply. And yet, 10 year and 30 year spreads, as you said earlier, are just as high as the front end of the curve. Do you expect, let’s say, three months from now, do we have, I know that you think we have lower spreads across the curve, what does the shape of the spread curve do and is the long end leading that move? Do we have a flatter spread curve or a steeper spread curve. That’s a big question.

Craig Bell: You know, that’s a good question. I mean, I think there’s the most room to come down in twos. So twos, thirties, I would definitely think it becomes steeper. The question, if you base it more around five thirties, is a little bit more open discussion. Does finance continue with, in 2020, there was a big push from the finance minister and the prime minister to term out the borrowing, taking advantage of these lower rates. Are we going to see that continue as rates move up or will they move away from that, at least to a certain extent?

Ian Pollick: I think they’ve said that as long as there’s COVID related debt and there’s COVID related stimulus, that stimulus is 10 year plus maturities. So if you look at the latest Parliamentary Budget Office estimates, if you look at the liberal costing platform from the fall economic statement, you still have something like 80 billion of COVID debt that has to get funded. So I do expect for fiscal 22, 23, we are going to see a very similar composition of issuance where 10 year plus maturities, call it 45, 50 percent of gross issuance comes from that sector of the curve. Is that enough to flatten the spread curve even with the move that we can see in twos potentially?

Craig Bell: I mean, that’s what I would argue flattens the fives thirties spread curve. Ok, but twos like thirties, twos have the most to come in, but thirties could definitely keep pace with twos. But I don’t think thirties outperform fives on the move lower.

Ian Pollick: So let’s switch gears a little bit, and we talked a little bit. You teased us a little bit on this idea of issuance. Now the big thing that we could see next year, provincial issuance is back, budget beats are harder. But when we look at the percentage of non Canadian dollar issuance this year, it was pretty low. It was twenty three percent. Historically, it’s been between 30 to even 40 percent. If we get a more active cross market provincial issuance profile, what happens to BA LIBOR, call in that five to 30 year sectors?

Craig Bell: Well, the first thing that happens to BA LIBOR is nothing because BA LIBOR doesn’t exist anymore. BA SOFR are cross currency because of course, LIBOR is being phased out in dollars. It’s a good question. There’ll be a balance between potential maple issuance and Canadians issuing abroad and swapping proceeds back. And how that plays out is a good question. Like I say, I like to follow the flows for that type of information. We’ve certainly seen the first couple of weeks of this of 2022 as any example, we’ve seen a lot of issuance abroad from Canadian banks, Canadian provinces and so on and so forth. That’s obviously supportive for cross currency market. You know, you can think of different shapes to that market. Will the maples tend to be shorter term by and large? We have had 30 year maples in the past, but think of them in the three to five year, mostly sometimes seven year sector. Will we have Canadian corporates and provinces borrowing abroad and swapping them back for Canadian dollar proceeds? What the provincial financing needs are going to be certainly towards the end of last year before Omicron started. Federal transfers to the provinces kept them in pretty good fiscal shape. Will the federal government be as generous with the provinces through this wave and future waves? Or will the federal government start focusing on its own priorities separate from the provinces? And then the provinces might need to issue more and as part of issuing more, issuing more abroad, thereby supporting the cross-currency market? But I mean, these are open questions and we’re just three weeks into the year. So, you know, it’s still an open question how all of that plays out.

Ian Pollick: Okay, listen, we’ve nerded it up quite a bit. Before we leave everyone, famous last words. What is your favourite trade over the next week?

Craig Bell: Over the next week? Ok. I mean, January to March meeting switch is probably a little bit obvious, but I would say maybe go something a little bit further out March, April or April, June to take advantage of, like I said, they’re going to be going, they’re definitely going and we might see a 50 along the way. There’s no way that certainly past March that there’s going to be the bank holding back, so expect continued weakness in the front end.

Ian Pollick: All right. Well, you heard it here, folks from the man himself. Craig, thank you very much for joining us. Remember, we are on the hunt for our new co-host. Any feedback? Please direct it to us. And remember, there were no bonds harmed in the making of this podcast.

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