The Rates vs Credit Intergalactic Royal Rumble

Josh Kay: The first is that money supply continues to be growing in Canada, and the second is that employment is pretty strong. And you probably hear all this. I tell clients, in respect of money supply, that Ian Pollick doesn’t look at the money supply as, as a factor that influences inflation. So if you’ve got any calls on that, thank you. That probably comes from me.

Ian Pollick: Thank you. Well good morning to everyone and Happy Friday. We have a weekend ahead of us, and we have a huge week of data and events that we need to unpack. I am joined today by my good friend Josh Kay. Josh how you doing man?

Josh Kay: I’m great. And how are you?

Ian Pollick: I’m good. I’m seeing Bob Dylan tonight. I’m super stoked. I hope he’s going to be good. But that’s neither here nor there. Let’s just talk about the week that was.

Josh Kay: We should probably hear from you first, Ian, on the recent bank announcement and the recent data. So why don’t you share with our listeners what the bank was talking about earlier in the week and some of the recent data that we’ve seen?

Ian Pollick: Look, I think the Bank Canada meeting was largely as expected. You know, there was never going to be a change in the overnight rate, and there was no change in the implementation of policy. That was the easy stuff. And actually, I’ve been calling it a two speed affair, because when I looked at the statement and I read it, it was hawkish and it was hawkish because they upgraded their assessment of the persistence of core inflation relative to what they had thought in July. And that’s all consistent with what we’ve seen now. They did go out of their way to not only reinforce the idea that the next move could be higher, but the reasons behind it. And so against that, though, when you look at the forecast details of the MPR, they were weird. And I’m going to use the word weird because you had a very material downgrade of current year growth, you had a slight downgrade to 2024 growth, but then you had this very large increase to 2025 growth. And so there is a U-shaped profile that the bank is telegraphing to people where growth starts to get very good in two years time, but in two years time, remember this is when all the big mortgage resets start. And so maybe it’s a bit too far out to put a lot of credibility into it. I am a bit nervous about the composition of growth because, you know, for example, GDP is now -1.7 for this year, which is consistent with a recession. And the output gap is now seen at the lower end at -0.75 to plus 0.25.

Ian Pollick: And so, you know we’re in a period of excess supply. And add on top of that the data yesterday which was the CEF which is Canada’s other jobs report. And it wasn’t very good. Fixed rate wages fell by half. The economy shed 50,000 jobs. But remember that the LFS had showed the economy gained 40,000 jobs. So okay, you take a step back and say, well, where was the real meat? Well, the real meat was in the Q and A, you know, in the Q and A, I think they did a very good job balancing the risks that they may have to do more with the notion that the economy is starting to decelerate. And maybe that means that the inflation target isn’t as far out as we think, because remember, they actually pushed the inflation target, the convergence to the target to the end of 2025. In the middle, Governor Rogers said something very interesting. She said that the Bank Canada may not have to wait until 2% is actually achieved before they can start cutting rates. And that’s just something that we’ve been talking about for a while. So, I mean, my sense is trim up, they hike, trim flat to down, they don’t hike. A forecast still remains. They don’t hike. How are you thinking about it?

Josh Kay: Excellent commentary and I appreciate all those comments. And I feel pretty strongly that the bank is done. So I don’t think we’re going to see any more hikes from here. And in talking to clients, sometimes I get pushed back on that thesis.

Ian Pollick: And what is the pushback? Where is the meat on that pushback coming from?

Josh Kay: So there’s there’s two reasons, actually the clients think the bank is probably going to go again.

Ian Pollick: Oh, okay.

Josh Kay: The first is that money supply continues to be growing in Canada. And the second is that employment is pretty strong. And you probably hear all this I tell clients in respect of money supply, that Ian Pollock doesn’t look at the money supply as a factor that influences inflation. So if you’ve got any calls on that, thank you. That probably comes from me. Thank you. In respect of employment. So employment is pretty strong. It’s come off though from 5% unemployment to five and a half or so. And the last time I was on this podcast, we talked about how the economy has never not undergone a recession after a 4/10 increase in unemployment.

Ian Pollick: So when was that? That was earlier this year, right.

Josh Kay: That was earlier this year. Yeah. And so those are the two factors I get pushback on from clients who are a little bit more hawkish. But I’ve got a couple of other thoughts around why I don’t think the bank is going to go again. Inflation is slowing. So you know we’ve seen inflation slow and we’ve seen it come down off its peak. And we’ve seen that happen against a backdrop where rates have been rising quickly. So I think that inflation has responded to yesterday’s rates as well because we all know there’s a policy lag and we’ve seen more hikes since. So I feel like we know from inflation slowing from old hikes that policy is sufficiently restrictive. The other thing that’s really interesting and we just cannot talk about this enough, is the nature of the Canadian mortgage market. So we know and I think you mentioned this as well. You know we have Canadians up for renewals on mortgages every single month. Canadians are refinancing at higher rates. And we have this huge wall of refinancings coming at the end of 20 2425. We cannot talk about this enough. People are going to be shocked with 50% increases in payments when they refinance in 2025. The last thing I just wanted to mention is this central bank higher for longer narrative. The market’s buying it. The market’s believing it.

Ian Pollick: It’s priced right.

Josh Kay: It’s priced right.

Ian Pollick: It’s in the price right now. And to me like I get it okay. And so we’ve talked a lot about. The two narratives in the market, right. There’s higher for longer, which is central bank has less of a tolerance or more of a tolerance to slower growth. And so you just don’t react as quickly. And when you do react, it’s just not as fast as in the past. And so I can believe that, you know, and I do believe that our star is higher. And I do believe that central banks would be slower. But to say that the laws of supply and demand have been rescinded is a joke. And so when I look at market pricing, you know, there’s obviously some comments from Macklem yesterday in a CBC interview. But prior to that, you know, you were in this environment where your first cut from the overnight rate today was not until 2025. So there’s no risk premium there and there’s no downside risk. And you know, we thought it didn’t make a ton of sense. And I’ll say it again the bank doesn’t need bad data to cut rates.

Ian Pollick: In that all they need is this idea that they are headed towards something close to 2%. Then they can normalise rates. And that normalisation. All it really means in practicality is you can start taking terminal closer to neutral. And they don’t see that as stimulative. And so that’s one of the reasons why we put out that trade idea yesterday. We like receiving March-June because I think you’re supposed to own that risk that they do start to normalise in the middle of 2024. Now listen, that’s all well and good. And you know, the macro has been very well covered this week. And I appreciate your thoughts. But here’s why I wanted you on the program today. You know, you have a very unique insight into the credit market. And so I want to talk about credit within the context of higher rates. So as a starting point, I am surprised that with 100 basis point back up in long end yields in the past, let’s say two months, that we have not seen a more material credit event. Can you walk us through what is actually going on.

Josh Kay: Yeah. So credit has been fairly stable to your point. You know we’ve seen 20 basis point ranges in five year bail in and credit is held in fairly well. And I think what happens is as you get higher yields you improve your breakevens on credit. And so in effect, the worse your rates have performed over the last year, once you add a credit spread to it, the more compelling that investment becomes for the next year. And I think investors generally are long credit and they like that position. They’re probably a little bit less long than they’ve been in the past with a potential recession coming. But because of overall higher yields, breakevens and protection in credit remains very compelling.

Ian Pollick: Let’s dissect that a little bit, okay. Because Canada, if you think about the traditional universe mandate, it means you’re very long credit, particularly in the back end. And so I do hear this word break even thrown around a lot. And so I’m a rates guy. And so I think a breakevens it’s either I think inflation or I think about carry. So for those of us not as versed in credit Breakevens, can you just walk us through what you’re actually talking about? Is it just I take my all in yield, I look at my credit spread and that is my buffer that rates have to sell off before I lose money.

Josh Kay: That’s it. Yeah. So I mean, if you look at like a five year bail in security or something, rates were four and a quarter probably coming into this. I don’t know what’s going to happen by the time this podcast gets released with the volatility we’ve seen in the market. But when you add a bail in spread of call it 160, you get an all in return of call it 585. And in the five year bucket the risk is about $0.04 for $0.04 and change. So the break, even at a 585 yield on a five year bail in is about 150 or so. So if you think about what break even means when you invest in credit, you can buy something with a yield of call it 585 and you can widen to about 730 before you lose any money. And that widening can come from either rates or credit spread. And so you have a very compelling amount of protection in credit right now because of higher yields, which come both from government yields and spread.

Ian Pollick: That is so weird. Like if I if I’m hearing you correctly, what it sounds like is even though your end of cycle, even though we have concerns about liquidity solvency, the Canadian consumer, it almost sounds like owning credits a defensive play because, you know, rates can rally, right. And you would need to see a widening of credit that is in excess of a rally that’s induced by something before you really start to lose money. And so I guess the question is, and I’m putting you on the spot here, the last time that we saw an event where rates rallied and credit spreads widened by a similar amount, that’s probably March 2020. But outside of that, like financial crisis.

Josh Kay: Yeah, I’m trying to think back. I think there was a time in 2011, maybe it was like August 2011, something like that. I’m I’m trying to dig back in my memory.

Ian Pollick: So it’s rare is the point, right?

Josh Kay: It’s exceptionally rare. I think the way I see the future states, if rates do rally, it’s because we’re sort of unwinding. There’s a potential recession looming. There may be a little bit of widening in credit into that environment, but your breakeven should protect you from losing money should that materialise. And then what’s going to happen is bad news for the economy. Good news for bonds. Rates go down and rates go down. Should be good for corporates, should be good for corporate credit.

Ian Pollick: So bad news is good for credit?

Josh Kay: Bad news should be good for credit like initial knee jerk. Maybe credit leaks a little wider, but you have to own it because if rates trade sideways, you capture the carry in the meantime and then you’re protected on the downside and you could tighten on an unwind of if QT.

Ian Pollick: So let me talk about something. Let’s just talk about what I hear a lot about that I focus on in my space, which is supply. We do hear about a huge wall of maturities in the US next year. You know, in Canada it’s not as dramatic, but you do have a lot of maturities. And so you’re an issuer. You have three choices. You issue equity which is too expensive for you because equities are so very cheap basically giving away free capital. You can go into the public fixed income market or you tap your bank line. Now in a higher for longer world, that bank line is still very expensive. So you’re still incentivised to come to public fixed income. Do you believe in this idea that a wave of issuance in of itself is the catalyst for wider spreads, or is there enough demand? So maybe talk about flows a little bit within that context.

Josh Kay: September saw a lot of supply in the Canadian market. I think we saw one of our largest Septembers in history. We saw 15 billion come to market here in Canada. It was very well absorbed. You know, clients had capacity, they had room to buy credit. And the deals in general went well and traded well. There’s not a lot of supply on the near term horizon here in Canada that could push spreads wider. You know. That being said, if supply does come it does come at a new issue concession. So it comes at a at a at a at a better level than where spreads are being reflected in the secondary. That should be an opportunity to add credit. The last piece I would say is that because the recession has been coming for a while, right. We’ve all been talking about end of cycle a while. We’ve all been looking at peak equities for a while. Credit investors have been able to position for that. And by that I mean even though Canadian accounts are overweight credit, it doesn’t feel like they’re max overweight credit.

Ian Pollick: So there’s is there room.

Josh Kay: So there’s room to add and there’s cash on the sidelines to come into the space from the existing base. And then I think the last point is when investors start to appreciate that there are compelling breakevens in this space. Cash will find its way into fixed income and credit, and you’ll see flows into the space as well. And I think that’s a 2024 story. So do you.

Ian Pollick: Have a snapshot for us? Just, you know, contextually what flows have looked like, let’s say, in the past six months to a year.

Josh Kay: So that data for Canada is pretty hard to obtain. I would say flows have been challenged in general, and fixed income investors are backward looking. Returns have not been constructive. So I would say flows have been challenged. I think that flows should be should stabilise and I think we should see inflows starting at the end of this year and into next year because, you know, investors are going to start to appreciate, like I can make six 7% in investment grade credit with upside. And it’s very hard to lose money because I have so much break even protection.

Ian Pollick: Okay. So let me challenge you on that for a second. So I’m thinking about my new interest rate forecast that was released a couple of weeks ago. And so one of the ways that I calibrate where I think longer term yields should be, is to try and get a good understanding of the relationship between the build and term premia, but also where the neutral rate is. And so we put out a paper this week, and we kind of made the argument that while we think the implied neutral rate from the market is too high, which is right now let’s call it 390, it’s higher than it was pre pandemic. So we think neutral is probably fair at 3%. And that means ten year yields should probably be three and a quarter which is actually exactly where we’re forecasting them to finish 2024. So I buy ten year bond today. If it exactly hits my forecast by end of the next year, that’s a total return of let’s call it 1,011%. So why do I even need to own credit if my total return in risk free fixed income is 10 to 11%?

Josh Kay: So a good question.

Ian Pollick: I mean it’s true, right. Like why bother.

Josh Kay: So a good question. And I think when you put on your investor hat and you think about what the point of portfolio construction is, it’s about building a portfolio that will make you money on a risk adjusted basis in various different scenarios. Okay, so if you’re wrong, it’s probably not going to happen. But if you are wrong and rates stay steady, you’re better off owning credit because you get incremental carry. 

Ian Pollick: Well the carry you’re running yield is higher, right?

Josh Kay: Correct. If bond returns and yields move lower, as we talked about just a little bit earlier, it actually could be good for credit if yields move higher. And we just saw what happened in the last year with yields moving higher credit held in pretty well actually. So you you still actually earn incremental return with yields moving higher and credit spreads moving higher. The only situation where you’re not better off is if credit really widens meaningfully.

Ian Pollick: What is it meaningfully? Just for the uninitiated, is that 25 basis points? Is that 50 basis points?

Josh Kay: So it’s going to be more than 30 probably. And so like a five year note might be 155 160. The range for the year the last couple of years really is probably been 140 to 190. I’m thinking big picture numbers. So another 30 from here. I feel like that’s the least likely scenario because of where breakevens are, because investors have room to add and because I think we should see cash come back into the fixed income market. So to answer your question, it almost seems like in three out of the four most possible scenarios, you’re better off owning credit and it’s going to juice up your risk adjusted returns.

Ian Pollick: Okay, let’s just switch gears for a little bit, because I think one of the things that I’ve been spending a ton of time talking to clients about is. The shape of the curve. You know, this is not the traditional steepening that we normally associated with end of cycle. We all know the reasons why the back end is misbehaving so much a reflection of supply and fiscal, a lack of fiscal discipline in the US that’s spilling out. And even in Canada, we’re starting to see, just given the recent auction numbers, our own mini supply shock. Again, for the uninitiated, where is like a 1030 credit curve for some generic name in Canada? Maybe use the banking sector if you have to, but like, you know, I’m just curious, where would that spread box be?

Josh Kay: fFr something like a telco you’re looking at around 40 basis points spread box, positive, tens longs. And for something like a utility it’s probably more like in the 20 basis point area.

Ian Pollick: Okay. So that is you know you get this flattening of the sovereign curve. Have you seen a steepening of the credit curve as Tens bonds is flattened?

Josh Kay: Good question. And the answer is not really.

Ian Pollick: Okay. What a weird asset class.

Josh Kay: You know I think when you look at the Canadian long end in particular, I see you shaking your head. The performance of the long is very peculiar right. And very strong. So I think we see here that there’s a structural demand for longs and there’s a structural undersupply for longs, and that extends into the credit sphere. So you know, with the inversion of the Canada curve you would expect a steepening of the of the credit curve. We haven’t really seen that because there hasn’t been a lot of lungs for sale. So is that a function of supply. That’s a function of supply. Right. So there’s just not enough to satiate investor demand, whether it be rate, whether it be government spread product, whether it be credit spread product. So there’s just not a lot coming out. So the tens longs credit curve is actually pretty flat in the context.

Ian Pollick: So even a pick of 40 is still flat.

Josh Kay: A pick of 40 is still flat. So in a triple B world you might be 60. You might be 65. Like a provincial box will go from 14 to 22 I think, or thereabouts. A higher beta box will go from 35 to 40 to 60 to 65. And we’re at the kind of tightest end of that range.

Ian Pollick: What about the front end of the curve? You know, twos, fives obviously still invert in Canada, but steepened a bit. Where were the twos fives bank spread be or telco spread. Yeah.

Josh Kay: So two fives the twos fives credit curve is where you have the most steepness kind of twos fives out to sevens. And then from sevens to tens it flattens in a little bit. You saw a lot of inversion there. And then because of that you saw a lot of credit investors moving into the front end. And so the five year credit spreads.

Ian Pollick: So that’s a function of flow.

Josh Kay: That’s a function of flow and positioning. Right. So when you saw twos fives invert meaningfully, you saw a lot of retraction trades from credit investors because they were able to pick and retract meaningfully. Right. Because of the inversion of the Canada curve. And it wasn’t a supply demand story. It was more of a positioning story in that case. And then the five year credit spread kind of steepened out. 

Ian Pollick: So this is an important question. You know, it’s interesting from a credit perspective, but where issuers could potentially go, let’s say when we think about a year from now, okay, the CAD curve is most likely to steepen to the point where stuff like ten’s bonds and twos tens are now in positive territory. What does that mean for credit curves and how do issuers respond to that?

Josh Kay: I think the dynamic inside of tenure is it probably unwinds as the rates curve. Steepens. I think you see credit curves flatten inside of ten years in the long end because of what we just discussed. It’s quite flat. Still tens longs. I don’t think you see a big change in the long end when the curve unwinds. From a rates perspective out there, what does it mean for issuance? I think issuers in general are focussed on all in coupons and sort of try and align with their projects. So I think you probably continue to see most of the issuance and the kind of 5 to 10 year bucket, and then you have your kind of structural, continuous ongoing long issuers.

Ian Pollick: Okay. So let’s wrap this up a little bit. We’re running a little long in the tooth. I’m going to give you a pile of money. What are you going do with that money to make me money. What’s your portfolio look like other than buying CIBC stock at 7.5%?

Josh Kay: Yeah. So I like fives and tens in general. I think you got to be careful in the long end, both from a rate perspective and a credit perspective as as we discussed. But I think you want to be careful to get underweight there because if yields hang out around these levels, you could see some incremental buying in the curve from LDI types. So overall you own fives you own tens. You’re kind of neutral longs underweight twos and the five year sector I like Banks and Triple B’s. If you’re super bullish in the ten year bucket own more Triple B’s than utility.. 

Ian Pollick: Bullish on macro or Bullish on rates.

Josh Kay: Good question. Bullish on credit. If you’re bullish on risk you own more Triple B’s than utilities. If not, own more utilities and Triple B’s. And then use the new issue supply you might see in any potential widening to add more credit into the end of the year.

Ian Pollick: Okay. And what is your favourite trade idea, let’s say for the next month? Okay.

Josh Kay: So I’m going to ask you your favourite trade idea after this. Okay. I was pretty negative on Canada to start. I like being long Canada, probably on a rate from a rate perspective, twos or fives. I think the US probably is faring a little bit better than us. So long Canada twos versus us twos or long Canada fives versus us fives I think. Makes a lot of sense. How about you?

Ian Pollick: I mean, look, I think that one of my favourite trades right now is just the steepness of the curve. So something like, you know, March, June or anything that speaks to the likelihood of a cut in the middle of next year. And also this one’s a bit more controversial, but I’d be selling ten year spreads here.

Josh Kay: Oh, that is controversial.

Ian Pollick: Or I’d be sleeping either 510 cms or I’d just be selling.

Josh Kay: Fred’s outright interest in the tender sector. Yeah, we’ll have to watch that one in the end of the year.

Ian Pollick: Yeah, I hope GG’s not listening to this. Anyways, thank you very much, everyone. We hope you have a great weekend ahead. And remember, there are no bonds harmed in the making of this podcast.

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