The reflexivity doom loop

Jeremy Saunders: That sort of resolves the riddle a little bit. And now the question becomes, is the tail wagging the dog, right? Because again, this is not sophisticated analysis, but if I simply overlay ten year yields onto Polymarket’s odds for Trump.

Ian Pollick: It’s one for one.

Jeremy Saunders: I ran a good fit.

Ian Pollick: It’s wonderful: Good morning everyone and welcome to another edition of Curve Your Enthusiasm. I’m joined by Jeremy Saunders from our XPA desk. Jeremy, how you doing?

Jeremy Saunders: Good Ian, how’s it going?

Ian Pollick: I’m okay. Listen, we have a huge week ahead. I want to start off talking today, just framing where we are in terms of the data cycle and the most appropriate is look back at some of the labor market data we got from the US last week. When I looked at the internals of the JOLTS report, some of the internals of non-farms, my own bias is that this is a U.S. labor market that is showing significant deterioration in demand. I think it keeps the Fed maintaining their path, but I want to hear what you have to say.

Jeremy Saunders: Yeah, I mean, I don’t know if I’d go so far as to say that. I think the picture is of broad cooling. I think it’s tough to say the U.S. particularly is deteriorating rapidly.

Ian Pollick: The labor market, think.

Jeremy Saunders: Sure, I think it’s, I don’t want to say it was all transitory, but we do seem to be glide pathing back to a similar place where we were before the pandemic. And I think really the question is, do you believe there’s a natural glide back to previously or that the line continues down if nothing is done?

Ian Pollick: I mean, look, when I looked at, let’s just start with the JOLTS report. Like when I looked at the JOLTS report, when I look at the quits rate, which is perhaps the best leading indicator that we have for wages. It is now completely broken its post COVID relationship. It is on a downward decline. And if you actually look at the unemployment rate, even though it was set for one on Bloomberg, there was a small uptake to the third decimal and that was all entirely a function of private paid employment and permanent job losses. And like that’s ticking up, right? Like that is real. And so maybe deterioration is actually, I do think deterioration is the right word. Like a terrible view of the US labor market’s probably not the right characterization, but it is weakening. And so I think it keeps the Fed on track.

Jeremy Saunders: Sure, it’s definitely weakening from a strong pace. The Fed has firmly switched to focus on the labor market mandate. And as long as they think that inflation risks are not there, then they can be proactive. And they are doing that. And I think you’re seeing that in Canada as well. I think that’s the main sort of theme of last two months is central banks one by one and the Fed was early and perhaps the bank was, well, I mean, the bank’s been at it for a little bit, but the Fed’s firmly made the shift from being worried about inflation to being worried about jobs and we’re starting from a very high place just in absolute terms in rates and so the asymmetry for now is clear.

Ian Pollick: So let’s just talk about that a little bit more. So we have the Fed this week. It’s coming on Thursday, one day after the election. You know, this is not a forecasting round. I think that you’ll get very limited wording changes in the statement. I do think you get 25 basis points. Anything else to be excited for? Because I think this is relatively status quo.

Jeremy Saunders: Ironically, think Macklem is a pretty good lead for what the Fed will do here. 

Ian Pollick: Unbelievable, right?

Jeremy Saunders: Global leader. I think they will cut. They will say not much else, especially without a forecast and they’ll say we’re data dependent but not data point dependent and the bias of risk is much more in balance and maybe the subtext will be we’re much more concerned about the labor market than inflation at this point. Although I think if I were there I be a little more circumspect about that than they had been previously considering. You’ve had some less obviously bad labor market data and some less obviously good price data perhaps.

Ian Pollick: Well, it’s interesting right and like you take a global approach to seeing pricing like look what’s happened over the past really week and a half and like all the repricing has come from outside North America, you know European terminal has moved 25 basis points higher, UK terminal is 30 basis points higher in the past two weeks and you’re now seeing this divergence in such a way where it is actually you are repricing global central banks ex-North America to the upside. Canada really hasn’t moved. The Fed is anchored in all of this. So it’s very interesting to me what’s going to happen over the next week. And I think we have to talk about the elephant in the room. And that’s obviously the election. And I’m very, very hesitant to ever try to trade off an election. It’s just a mugged game, I think. But we need to talk about it.

Jeremy Saunders: Well, you’re not going to like my trade idea. (laughs)

Ian Pollick: OK, well, I mean, we’ve got to talk about it. So like, give everyone your broad strokes how you’re thinking about the election and how it gets transmitted back into the rates market.

Jeremy Saunders: I think I think if you look at the potential outcomes, let’s divide it into quadrants, right? Like, you know, red sweep, blue sweep.

Ian Pollick: Red divided, blue divided.

Jeremy Saunders: Red divided, blue divided. Exactly.

Ian Pollick: One more: contested.

Jeremy Saunders: (laughs) Yeah, sure. I mean, one of those has an outsized market impact, I think relative to the rest. And so I think that goes a long way to explaining the conundrum of betting markets, right? People, you look at betting markets, and they seem much more slanted towards red sweep than what the polling suggests. And I think that’s a reasonable outcome when you take the expected value from other markets of each of those outcomes, right? If you have a risk book, then you’re more significant impact from red sweep than anything else. So even if the true odds are 53, 47, you should be willing to pay that bet at 53 because it’s a good expected value hedge for the rest of the universe. And so I think that sort of resolves the riddle a little bit. And now the question becomes, is the tail wagging the dog, right? Because again, this is not sophisticated analysis, but if I simply overlay ten year yields onto Polymarket’s odds for Trump.

Ian Pollick: It’s one for one.

Jeremy Saunders: I ran a good fit. If I follow this logic down the road and I say rates markets, $10 trillion market are being driven by Polymarket, which is a $25 million market, then on a risk adjusted basis without making a comment on what I prefer to happen or what I think about polling, I mean, it seems like a good trade is to fade.

Ian Pollick: So I mean, listen, we had put together a matrix of our expected market outcomes on the back of the election and we kind of had to do it just because we’re getting all the questions and it’s pretty clear, right? On a red sweep, you get kind of this bear steepening. You are pricing in fiscal. You are pricing in tariffs. That cheapens up collateral. So it hurts spreads. Maybe at the margin it helps breaks. I don’t know. I think on a blue sweep, you get this twist bull flattening of the curve. And I think that is a very interesting trade.

Jeremy Saunders: We think that’s a pretty unlikely outcome, right?

Ian Pollick: Yeah, I don’t think you got a blue sweep. Also, you get probably wider spreads because you’re just not adding to bond supply as much. I think the most interesting outcomes here and this is where people’s understanding of US politics actually shows up quite aggressively is, when you have a divided White House in Congress, there are rules here, right? There’s not actually a huge amount that can be done unilaterally. And so I think in the case of a red White House but divided, I still think you probably have a bull flattening of the curve. To me, that is an interesting trade, especially when you look at some of the momentum in trades like 10s, 30s, Canada, US. And then when you have like this blue White House red Congress, I would almost argue that’s another bull flattener. So I think you’re sucking out some term premium. So I’m curious to hear what was your trade, man? What was your great trade?

Jeremy Saunders: (laughs) I mean, I think you just have to look at what’s happened over the last two weeks is we priced in more Trump and unwind those. So, you know, there’s an interesting dynamic here where the first Trump presidency was a big steepener.

Ian Pollick: Different time, different time. Rates were low.

Jeremy Saunders: Yeah, different time, rates were low. And the inflation dynamic was very different. And the policy dynamic was different.

Ian Pollick: You were low growth, low inflation, low rates, balance sheets were still expanding. And so you had the suppression of term premium. So like everything was ready and the whole developed world was in a synchronized growth cycle.

Jeremy Saunders: I’m not sure that Trump is a steepener this time. And one thing I’d point you towards is, look what’s just happened in the UK, right? We had the Liz Truss moment, and it was a massive steepener, right? Well, we just had another similar type of event where a UK government presented a budget that, pick your description, but is anywhere from very stimulative to-

Ian Pollick: Very growthy, very inflation.

Jeremy Saunders: To irresponsibly profligate.

Ian Pollick: (laughs) You heard it here first.

Jeremy Saunders: Yeah. But nevertheless, the reaction was a giant bear flattener.

Ian Pollick: Yeah, I mean, rates higher but flattened on steeper.

Jeremy Saunders: And my suspicion is that Trump v2 is the same reaction as that. We priced the impact of growth and the impact of inflation in the here and now.

Ian Pollick: And the implications for the Fed?

Jeremy Saunders: Yeah. Right. And impact further out onto things like term premium is-

Ian Pollick: Neutral assessment.

Jeremy Saunders: Well, it’s just, it’s just more ambiguous. It’s just harder to say given the lack of forward guidance and you know, the other major theme I’d say I’m seeing from central banks everywhere is a strong reluctance to give forward guidance and the reason is they just don’t know and they’ve been burned both ways by forward guidance.

Ian Pollick: No, they are truly in in data discovery mode and I do believe them when they said they’re taking every meeting by meeting.

Jeremy Saunders: Which gives the front end a lot of freedom to move.

Ian Pollick: It does. Listen, the front end is where you are getting, it’s the pivot point right? And so it is much easier to both steepen bear flatten led by the front than it is by the back, which was more of a late 23 story.

Jeremy Saunders: So back to my, If I conclude-

Ian Pollick: Ipso facto.

Jeremy Saunders: Ipso facto. In closing, I think if you want to trade what’s priced in for Trump, then the trades are-

Ian Pollick: It’s a flattener.

Jeremy Saunders: No, I’m not sure about that. I mean, the US curve’s flattened for the last month. I think it’s probably a buy the belly.

Ian Pollick: Like twos, fives, tens? Are you just buying belly cross-marketing?

Jeremy Saunders: I think you can buy fives, thirties. This is what happens if you get not red sweep. So either divided government, one way or the other, or blue sweep, which I don’t think is that likely. And I think it’s essentially reverse what’s happened, so you buy duration, you probably buy duration focused on the belly. I mean, we’ve seen twos fives tens go higher, we’ve seen fives, tens, thirties go higher, we’ve seen duration cheapen, we’ve seen tens, thirties flatten on a cross market basis. We’ve seen tens, thirties flatten dramatically.

Ian Pollick: Dramatically.

Jeremy Saunders: Dramatically. And so any version of that is-

Ian Pollick: In as much as you think also what helps that is, you know, we have talked about the quarterly refunding we got last week and it was exceptionally benign. You saw the slight increase in financing requirements is not really being matched one for one for marketable boring because you know, rates are rallied, you’re getting more cash when you’re issuing your bills. And also that issuance is being soaked up in the very front end through the bill market. And I want to get back to duration in a moment, but let’s bring this back to the Bank of Canada for a second. So, you know, when I look back at the GDP report from last week, the revisions to the level of growth earlier in the summer were quite bad. And so I think that, you’re now tracking, let’s call it to be generous, 1% kind of Q3. And that’s relative to the bank’s downwardly revised 1.5 from 2.8. There’s nothing in Canada that gives me any confidence that the bank is diverting from a near term non-standard size cut. And I think the story is pretty clear for the bank. You have a different view?

Jeremy Saunders: Yeah, I agree with that. I don’t see any reason why they wouldn’t go 50. They’ve set themselves up to go 50. Remember, this is a GDP number that they’re going to miss that was, three months ago, it was 2.8. And then they revised it to 1.5 and they missed that. And if you look at the, again, the near term trajectory of the inflation numbers and they can take some comfort from global inflation. I don’t see why they wouldn’t and monetary policy is still tightening somewhat rapidly in Canada. The average mortgage we buy right now is happening 100 to 125 basis points above where the rates rolling off. So every month that goes by is another, call it, 2% of mortgage holders that have their payments reset 100 basis points higher. It’s doing, you know, for the bank to get that to a neutral setting where monetary policy is no longer contracting consumer spending, they’ve got to do a lot.

Ian Pollick: No, they do. And so like you, can quantify this in a couple of different ways. And a great chart that I’ve been using in my deck. and when it shows is just nominal income growth since 2020 to date, which is let’s call it 15, 16%. You basically need to lower rates enough such that your percentage increase in your mortgage payment is lower than that level and that’s like another 140, 150 basis points from here. And like from here, And that kind of validates this view that like you go, you deliver another non-standard size cut 50 in December, but then you don’t stop. Like even if they revert back to 25, which I think is probably a practical move, you just don’t stop until you get to a level that’s below neutral and then you reassess. And so the whole, I think, trade opportunity here is that the market is still higher and longer. And so I think this is a cycle that ends earlier. But like one of the big themes we’ve been talking about is like, does the market have the ability to both bring the cycle deeper and bring it forward? I don’t think it does. And so that’s why I kind of like owning reds in some way, because I think the first order of operations is they price the bank from 280 today to closer to our level, like two and a quarter, 2% and then they move it forward.

Jeremy Saunders: There’s a feedback loop here, right? Because as soon as the market prices that then buy your mortgage rates reflect that and the stimulus comes in without them having to do anything. And so you get this natural attenuating function, right? Where once the market believes they’ll go to two and a quarter.

Ian Pollick: Well, it’s reflexive, right?

Jeremy Saunders: Like by definition.

Ian Pollick: But let’s just talk about that, right? And so the biggest question we have with clients or one of the biggest questions is at what point and at what level of overnight rates do five year yields drop enough or five year swap rates fall enough such that mortgage preferences shift into fives and so that swap spreads can now become mine instead of yours. And so I’d be curious to hear, A, when do you think you see that transition from three year production into five year production on like really on a sustainable basis?

Jeremy Saunders: Yeah, that’s the $64,000 question, isn’t it? So I think we’ll see some. We are seeing some now, I think. It’s not a wholesale shift. It’s a tricky one because at a level of overnight that is low enough to get five year rates into the sort of psychological zone.

Ian Pollick: What is that, sub four? Three and a half?

Jeremy Saunders: Well, you could have rate locked three ninety nine in the last few weeks. And so I think that’s probably caused some movement, but not a wholesale movement. But yeah, probably. I mean, frankly, I think it has a lot to do with the person who’s taking that rate, what they’re rolling out of. And right now people are rolling out of two and three quarters. And so yeah, it’s not 399. Is it three and a half, three and a quarter? Sure. But if you get down to three and a half, three and a quarter on five year rate, what does that mean a variable is?

Ian Pollick: That takes a lot, right? 

Jeremy Saunders: Also it probably means a variable was lower than that.

Ian Pollick: So that’s the thing. Like for, for you to get to that level of five year rate, let’s say the prime spread of 220 is maintained. You really are talking, you’re, you’re overnight. That’s sub 2%. I don’t think that’s realistic.

Jeremy Saunders: Advertised prime plus 220. But realistically, you’ll get prime plus 150, which means overnight rates have to be in the two and a quarter, which is exactly where-

Ian Pollick: Yeah, that’s where we think it adds up. I think there’s some like, I do know some people who are just traded and lifted property and then they took variable. But so what do think it means for spreads? And let’s talk about this more generally, because I would say, obviously, I’ve been in a world where or a mindset of there is a global factor here where global collateral is cheapening. We saw what happened with UK swap spreads, German swap spreads in the past two weeks. So some of that obviously matters for Canada, especially in a world where QT is continuing. Second thing though is, you know, I just looked at some numbers before we recorded. I am now earning almost 20 basis points a year carry and roll being long two year spreads in Canada. And so compared to other carry harvested trades like basis, which is very, light on carry right now. I think rightfully people are looking at spreads as a carry kind of trade. And I’d like to hear your thoughts on this before I go any further.

Jeremy Saunders: Yeah. Okay. So high level global spreads. Yes. Gone down a lot. Not abating. There’s been a lot of attempts to explain why that’s happening in various regions in Canada. We’ve got things like lack of mortgage production in US. We’ve got things like GSIB scores and SLR and things like that in Europe. I think I haven’t had anyone I know there’s newly a lot of consternation and those spreads have gone down quite a lot in the last three weeks, like quite a lot.

Ian Pollick: But there’s a positioning indicator inside here as well.

Jeremy Saunders: Yeah, sure. But if you like zoom out and there is a global factor, right? There’s a lot of bonds being made.

Ian Pollick: Expectations of a lot of bonds continuing to be made.

Jeremy Saunders: Yeah. And the amount of system leverage, there’s a supply and demand of levered ownership of risk-free securities and the demand is increasing because each newly created bond creates some amount of demand to have levered ownership and the supply is not really increasing.

Ian Pollick: And iBOR medians are rising to the right and it is changing the carry profile for a lot of the stuff.

Jeremy Saunders: Yeah, and so, if you are a carry book, you are probably looking to keep it as short as possible. 20 beeps for two-year paper. I mean, it’s not quite 20 yet, but it’s 16. And in Canada, you could have got 16 beeps, 15 beeps on some one-year paper that just fell out of the index.

Ian Pollick: That stuff is very cheap.

Jeremy Saunders: Outrageously cheap and to your headline spreads have been very rich and now that’s all kind of corrected and everything sort of in that 15, 16 range so anything you do in there is probably fine. And I think the appeal to that to most people is they don’t really have to worry about mark to market.

Ian Pollick: No, you just mature that.

Jeremy Saunders: Yeah, and you’re getting your money from the government.

Ian Pollick: Well, let’s talk about longer terms spreads.

Jeremy Saunders: Yeah, and so longer term spreads. I know you had written a piece saying you like 210 steepeners and spreads. I like the opposite of that.

Ian Pollick: And you know, talked about Tuesday. Give me your 10 year view.

Jeremy Saunders: Yeah, so specific to Canada, A, I think the global factor is continuing to weigh and so to like being long a swap spread outright you have to explain why that global driver is going to stop and I just don’t, so far I would like more than anyone to come up with one, but I can’t figure it. So if anyone has one, please email me but until then, I have a hard time wanting to be long a spread outright. In terms of Canada, the dynamic has been different from most places. Look at US swap spreads, the curve is deeply inverted. And if you look at most jurisdictions globally, the curve is deeply inverted. And that is very consistent with the explanation of swap spreads as a, call it, term funding premium for locking up levered balance sheet. In Canada, our fives, tens and even our twos, tens curve is very flat. And the reason is well socialized. There’s been five year receiving from bank treasuries because mortgage production has been low and so on and so forth. Despite the fact that we don’t think all the mortgage production is going back to five years, it is going somewhere. And all of the mortgage growth that happened in 2020 and 2021 is about to get rebid in 2025, spring of 2025, and that should provide support, relative support to somewhere on the swap spread curve. And if that’s threes or fours or fives, that’s all fine. And so I think the trade I really like in Canada is swap spread flatteners.

Ian Pollick: I don’t know, man. I don’t know. I’ll tell you my view in a second, but please, please conclude.

Jeremy Saunders: The added kicker. Swap spread flatteners carry positive.

Ian Pollick: They do. And so first to agree that spread steepener is an expensive trade as a starting point. I am still the view that global factor matters, even with some of the carry and roll that you see in the front end. And I do think mostly that is harvested in very, very cheap one year paper. But for me, it’s what I heard from some of the provincial budgets recently. Absent Ontario, which was actually a very spectacular budget if you are a GSP holder, I don’t think it was on many people’s radars that not only was the deficit falling a half, but it only didn’t fall more because we’re each getting 200 bucks in Ontario. But also that issuance actually doesn’t look that different. Now when I take a look at the federal deficit and I mark to mark where it’s supposed to be versus what they told us it would be in the April budget, you’re now roughly, let’s call it almost 15 to 20 billion worse on a 45 billion dollar deficit. And so typically that will translate into more issuance. That issuance isn’t going to be termed out. I suspect it’s mostly bills and twos. And so I think twos can move from five to five and a half auction to five and a half, six. And that is an additional, let’s call it five to six billion of two years without the Bank of Canada participating in any purchases. And so I do think that weighs a little bit on two years, given some of the momentum that we’ve seen, but I do think getting back to the provincial landscape, we saw what happened in British Columbia. We look at what the oil price assumption used by Alberta has been, and we’re deteriorating relative to that. And so I just think you’re in this world where to say that there is no upside in provisional issuance, which therefore means that there’s no upside for non-Canadian dollar issuance. It’s malarkey, right? Like I’m going to use the word malarkey because it’s ridiculous. You can’t have this deterioration of the federal deficit and doesn’t filter down to the provinces. And that may not be immediate, but I think people’s steady state supply expectations are too low in probes. And I do think that your non-Canadian dollar issuance profile will be somewhat persistent and that is supporting 10 year spreads. And so to me, that is the angle I take to look at this trade.

Jeremy Saunders: I’m not sure. I mean, I think if I look across markets, like 10 year cross currency basis in Canada is very high.

Ian Pollick: Has been for a long time.

Jeremy Saunders: Yeah, but that’s being supported in anticipation of further cross currency issuance.

Ian Pollick: I haven’t had much in a while, so like why is it still there?

Jeremy Saunders: Well, in anticipation of future issuance. But I mean, I think you have to say the same thing is probably true in spreads. I think Ontario and Quebec are the biggest issuers. You’re right about some of the other provinces, but their footprint is just not as big. There is a steady drip of bringing foreign assets back into Canada by Canadian asset managers, which is straws on a camel’s back to both spreads and cross currency basis. I mean, look, we did 40 billion, let’s call it, in foreign issuance, provincial issuance in this year, March to now.

Ian Pollick: A little bit higher, but yeah.

Jeremy Saunders: Sure. Are we going to do, I mean, what’s your guess for the next three months? I’d be shocked if it was 10.

Ian Pollick: Oh, I think it’s sub 10. But I think the expectations are there. And I still think you have a downward force on spreads. But 10s are being supported by that view, right? Like it’s all, again, reflexive.

Jeremy Saunders: Well, one of us can be right.

Ian Pollick: Correct. And so let’s talk about our favorite trades just to end the episode. You know, obviously it’s a big week. It’s not one of those things. And we do have actually, by the way, Canadian employment at end of this week too. I hate trading around politics. It’s always a mugs game, but you can’t ignore it. I’d have to say I am maintaining my twos, fives, tens in my book. That trade is finally starting to work in Canada.

Jeremy Saunders: And you’re paid?

Ian Pollick: Yeah. It’s starting to work. I think it works well. Particularly, I think if you get some flattening bias this week, which really is my expectation. I do think that a lot of the movement we’ve seen, especially with the data from last week, I don’t mind flatteners of some sort. I don’t want to do it in tens bonds, just given some of, or at least cross market. But I think on an outright basis, I don’t mind 10s, 30s flattening in Canada. I think I prefer twos, fives, tens and overweighing that fives, tens leg. And I think that the front end is going to be very hard to trade this week. Like I think any of the policy trades, like reds are cheap, et cetera. don’t necessarily work the way they’re supposed to this week.

Jeremy Saunders: I hate betting a coin toss, but for choice, I’ll take the bank to go 50. Against that I like I like reversal of Trump trade ideas. So that is, call it, us US steepeners, CAD flatteners. I don’t mind it in tens, 30s. I think there’s just come out of month end.

Ian Pollick: Wait, you say you like an unwinding Trump trades, but you still like US steepers?

Jeremy Saunders: We haven’t steepened. We’ve flattened. If you go look at tens, thrities in the US, what’s happened over the last month as we’ve priced in Trump, it’s flattened.

Ian Pollick: It feels like you’ve gotten a lot of steep.

Jeremy Saunders: I know, but check the chart.

Ian Pollick: It’s been a term premium trade really. Okay. I hear what you’re saying. So you just like the belly is what you’re saying.

Jeremy Saunders: I don’t mind the belly of the US against Canada. I like the bank to go 50.

Ian Pollick: I agree.

Jeremy Saunders: Which I think has the same effect as what it had in the US ultimately, which is more near term easing actually ends up taking future easing out. And so, yeah.

Ian Pollick: It’s not a redistribution. We actually had a really good chart on this in our two year auction preview last week. What we showed is situations where the net amount of easing added over the next two years was less than the move in the distribution bringing it forward. And that’s happened actually quite a bit, i.e. you can bring forward 40 basis points of cuts into the next quarter, but maybe only add 30 to the profile. Like that is what I think.

Jeremy Saunders: So you end up with a cheapening of the belly, like a twos, fives, 10s, I don’t mind that. And I do think that ultimately supports the shorter end of swap spreads against the global dynamic. And I like spread curve flatteners, I like much sense flatteners.

Ian Pollick: You don’t know anything. (laughs) Listen, it’s a very busy week, very busy week ahead. Jeremy, thank you very much for being on the show. Good luck with everyone with all of your trading this week. Please tune into our next episode. Obviously Jeremy, you’re a very special guest, but we do have a very, very special guest coming on the next episode, ex-Bank Canada Governor Stephen Poloz will be with us in two weeks’ time. Good luck this week, as I said, and remember, at least now, there are no bonds harmed in the making of this podcast.

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