Well, that’s a big HELOC payment…

Ian Pollick: The euro is actually going to get weaker, right? Like these rate hikes don’t do a lot because your growth is now so bad.

Jeremy Saunders: You’re in a dollar doom loop. And I think that’s not unique to Canada. And so in terms of does Canada need to hike higher than the US?

Ian Pollick: It’s not implausible anymore.

Jeremy Saunders: I think you can make reasonable arguments either way.

Ian Pollick: Hey, everybody. Well, I’m joined today by my good friend and colleague Jeremy Saunders. Jeremy, we are doing a show and we have a show tonight.

Jeremy Saunders: That’s right. And I’m looking forward to both.

Ian Pollick: So we are seeing Pearl Jam this evening and last night, you know what I did? I started listening to Ten, great album. I started listening to Vs. on my way to work. And then I was like, do I want to listen to Anthology? I don’t remember it being the best album in the world, so I don’t know if I’m going know the whole set list this evening. But like if you had to choose Ten versus Vs., what would you choose?

Jeremy Saunders: I’m a Ten man myself.

Ian Pollick: Yeah. Like it was, it was the time, right? Okay. So speaking of moving along, let’s move along. Let’s talk about the Bank of Canada. So obviously a big week. We had the rate decision. We had Carolyn Rogers speak afterwards. I want to ask you to start the show. What stood out to you from the statement?

Jeremy Saunders: Yeah, I mean, I think the market was very focused on the last paragraph and whether they would signal some sort of pause, which to me didn’t really make a lot of sense. The one lesson I think central bankers, I mean, for sure the Fed and probably the Bank of Canada have taken out of the last six months is that the forward guidance has kind of handcuffed them a little bit and created problems. And it didn’t make any sense to me that they would issue forward guidance that was on the more dovish side of what was possible. And they did, in fact, leave the more hikes to come language in there. And that was really the most notable thing. The rest of it was very down the middle of the fairway.

Ian Pollick: See, I don’t know. I do agree with that. There’s not a huge amount of updated characterization of the economy because you’re working off stale forecasts. You’re going to update them in October. They didn’t really have a huge amount of data before then. So in the statement, I think, you know, what we were looking for was something that would have suggested that they’re slowing down or they’re closer to the end. I actually think you got it. Like in the very last, it depends how you want to interpret it, right? The last paragraph on the sentences was, I’m going to horribly paraphrase this, you know, we are going to, any future rate hikes will be assessed for the amount of slowing in the economy. And basically that says that there’s a lot of tightening. We haven’t felt that tightening yet. And so future sizes are contingent upon how that tightening is hitting growth and inflation. To me, that just signals you’re close to the end of the beginning, but that’s probably a matter of fact because by definition, you’ve already hiked 320 basis points or 300 basis points.

Jeremy Saunders: Rates are now above what they previously said was the range of neutral. I think that-. 

Ian Pollick: They’re restrictive.

Jeremy Saunders: Yeah, I mean there’s no question that, to the state the obvious, at some point the size of the hikes will decrease. And I think a lot of what’s going on right now is central banks are very nervous about expectations and they’re reading history books and what happened in the seventies. And the number one message that the Fed and the bank are both hammering in their own ways is that we’re not going to stop write. We’re not going to say mission accomplished when we see the first sign. Rates are going to stay high. They’re going to stay high for longer. The biggest thing they’re concerned about is expectations. And if you’re concerned mostly about expectations, then even if you think-

Ian Pollick: You do more.

Jeremy Saunders: But even if you aren’t going to do more, you say you’re going to do more and you hope the data lets you do less. But you don’t give anyone the idea.

Ian Pollick: There’s no breathing room, right? You can’t-

Jeremy Saunders: There’s no advantage to them to even suggest it.

Ian Pollick: I agree. And like, you know, I was thinking about this the other day and so when they were talking, remember his op ed that he did and was the last thing he told us and everyone in the market was like, you know, he’s speaking to us. And I really thought he was speaking to my dad. He was speaking to your dad. And I think it’s very apparent that, you know, it’s one in the same right now because they’re not letting any oxygen in this room in terms of what they have to do. But the market reaction was interesting, right? This is the second meeting in a row where you had this jumbo sized rate hike. You didn’t really get any weakness in bonds, faxes, did what they were supposed to do, right? You did have kind of this widespread flattening. Talk to me about what you think the market did right or did wrong at all.

Jeremy Saunders: Yeah, I thought that there was some low hanging fruit on the table into the meeting and it was basically a version of set meeting versus setbacks is pretty technical, I think. There was an unusually low degree of conviction of what they would actually do. We were priced 73 going in and I thought, you know, there was a-

Ian Pollick: They could have done anything. They could’ve had 50. They could’ve 100. They could have gone 75, which they did. And, you know, I think you’re right. And I think the last day or two, it was like, oh, wait, they’re going to be super dovish. Oh, wait, they’re going 100. And so the market didn’t really know what to do.

Jeremy Saunders: Various strategists and market participants have made-

Ian Pollick: Wait. Hold on, there’s more than one?

Jeremy Saunders: (laughs) None I talk to. None I talk to. I heard. A friend of mine have put forth arguments that they were going 100 with quite a lot of conviction and that they were going to go 50 with some conviction. And both of those arguments were not implausible. So, I mean, they did go down in the middle of the fairway. In the end, I think probably the bank is quite satisfied that they didn’t cause a significant disturbance. But the reality is you’re talking about wide spreads flattening, Wide spreads flattened in the US as well.

Ian Pollick: Yeah, it was, it wasn’t specific to Canada. I’ll say this though. There is a narrative that is starting to get a little bit of attention. A lot of the global macro accounts and I do have a little bit of sympathy for this, are questioning whether or not the bank actually has to finish the cycle above the Fed. And that’s something that for a long time, as an institution, we would have argued against because we are CAD sell side folk and therefore we believe in the idea of faster transmission, rate hikes work faster here. They’re more impactful. The line of argument is now that, you know what? If the Fed is as hawkish as we think they are and they sound four and a quarter hawkish, maybe four and one half hawkish, you know, they don’t sound three and three quarters hawkish. The spread to where we’re now expecting terminal to being CAD is going to start negatively impacting the currency in such a way that you get the secondary impact of inflation through currency spill-over. That is a very concerning kind of topic and I actually think there is some credit to it. Like if you have dollar CAD at 140 and you think the bank is done and inflation is falling, well, you’re absorbing a whole new round of inflation, which actually means maybe it’s not the craziest idea. So that kind of brings me to my next point. Talk to me about your expectations going forward. Where’s terminal? When do you think this happens?

Jeremy Saunders: Well, I think there’s a very interesting point there that you’re touching on, which is that for the last ten years, global central banks have been in a race to devalue their own currencies and competing against each other to effectively juice their growth.

Ian Pollick: Because you were in a low growth, low inflation environment.

Jeremy Saunders: And now it’s flipped and developed market central banks are having to think and act much more like emerging market central banks, which is that when your economy is weak or you have inflation, you have capital outflows and it hurts the currency and that causes a self-perpetuating spiral. And they’re now having to race against each other to protect their currencies. And I think that’s maybe editorializing for a bit here.

Ian Pollick: But there’s been no signs of that yet, right? At least in Canada, there’s been no signs that they’re trying to protect any. There’s been you know, mum’s the word on the currency.

Jeremy Saunders: Mum’s the word. But nevertheless, they’ve hiked 175 bps in two meetings. And in the UK they have been more forthright in discussing what they’re up to and have said basically, look, we don’t have a choice. We know it’s bad and we don’t have a choice. European Union, ECB, they hiked 75 basis points this morning. They may not be saying it, but they’re all thinking it. Cable is off what, 50 points?

Ian Pollick: Our own kind of thoughts on the euro is like the euro is actually going to get weaker, right? These rate hikes don’t do a lot because your growth is now so bad.

Jeremy Saunders: You’re in a dollar doom loop. And I think that’s not unique to Canada. And so in terms of does Canada need to hike higher than the US?

Ian Pollick: It’s not implausible anymore.

Jeremy Saunders: I think you can make reasonable arguments either way. So we’re both priced, by the way, right now as of-

Ian Pollick: 390?

Jeremy Saunders: 387, both in Canada and the US, to the basis point terminal.

Ian Pollick: So talk to me about that because I’ll tell you that internally, you know, what’s the CIBC house here? I think the CIBC has a few right now and it is changing quite a bit, to be fair, is kind of 375 is probably the right number. You know, in my heart of hearts, 4% is probably about right. And I think there’s nothing that tells me that we are shifting the narrative from that three and a half to 4% terminal pricing to a 4 to 4 and a half. Now, that might happen and it probably will. And that means you have to recalibrate curve and yields and all that good stuff. But let me ask you this. Do you believe the house forecast 375. Are you a buyer or a seller?

Jeremy Saunders: Well, I’ve asked market participants, colleagues on the floor and a couple outside the bank. This question, which I’ll put back to you now, and it’s maybe a little stale, but my question was, when we were priced for three and a quarter terminal, what do you think happens first, 6% rates or effective lower bound? So call it a quarter. And now maybe given where we’re priced, you need to update the upper band of that coin flip slightly. But I mean, my question to you is, where do you think the balance of risks lie?

Ian Pollick: I’ll say this and, you know, my own experience, my own life and the inflation that I feel in my life, coupled with the message that I think I’m hearing from central bankers, I choose seven before zero any day, right? And there’s nothing that tells me that in an environment where you have most of your inflation, at least in Canada, coming from not your own borders, you can’t do anything about that other than raise rates. And the problem I see right now is that, correct me if I’m wrong, you know, I did my undergrad in economics, I did my master’s in economics. And I always learned that the worst thing to do is to fight inflation with money. And, you know, you’re seeing fiscal policy move in a very rapidly, diametrically opposed position by just giving people money.

Jeremy Saunders: Well, the incentives are very different for politics.

Ian Pollick: 100%. But that broke what had been a very nice simpatico relationship over the past two years where monetary and fiscal working together. Now you’re getting checks to fight inflation?

Jeremy Saunders: Yeah, well, monetary policy has the luxury of helping growth when it doesn’t have to fight inflation and when it has to fight inflation, they have to choose between one of the mandates and they’re obviously all choosing inflation. I mean, I have another question for you. You put a piece out today talking about what the sort of lower bound is. I mean, I think my question to you about zero and seven is if you choose seven, you’re basically short of time option because you’re short theta. If they don’t get to seven in this cycle, then demographics, types, arguments take over and eventually something bad will happen. And the learned policy response to things that are bad for growth and bad for inflation is they’ll cut to zero right away. So do you think that’s still the policy response to an exogenous negative shock? Like, let me ask you this. If COVID were to happen again today, what would the monetary policy response be?

Ian Pollick: I think absolutely you’d go back to zero lower bound. I think tail events, regardless of where they come from, necessitate you going to zero because that’s just what you’re supposed to do. Again, the risk management tells you, you do more rather than less. But the piece that I put out today, it was a very, very simple thesis and it said, look, there is now a very big disconnect between your traditional GDP paced measures of output gap and core inflation, which is another way to say that slack in the economy is no longer dictating the level of inflation or how fast it comes down. That’s the most important one. So slowing growth doesn’t necessarily bring down inflation the way that it used to. And if you believe that and when you look at kind of the base effects, the base effects of inflation, tell us that, yes, in 2023, you are going to get very close to that 2% target. But then in a really perverse way, you get to 2024, you start to reaccelerate again because you have these negative base effects that push you back up very quickly. So in that environment, what is the central bank to do in the face of your average normal course recession? Our argument is that the lower bound is probably not zero anymore. It’s probably 1 to 1 and a half percent. And what that means for the shape of the curve is pretty important because by doctrine, you know that when you’re leaving a hiking cycle and you have kind of this nothingness, that nothingness typically leads to a cutting cycle. You rarely see I’m hiking, I’m pausing for a long period of time. Whoops, I got to hike again. That was kind of the 2004 experience.

Jeremy Saunders: Well, that was the seventies.

Ian Pollick: Yeah. As well as the seventies, too.

Jeremy Saunders: That’s what happened in the Arthur Burns era. I mean, that’s what they’re also deathly afraid of right now.

Ian Pollick: So I mean, from our perspective, we think that if you go into the next downturn, number one, is restrictive policy actually means keeping rates at a very high level for a very long period of time and you have fewer degrees of freedom to actually cut rates. And therefore, in the very simple model of the bond market, you only have two things that drive yields. You have some type of average policy rate and you have some type of term premium. If you hike rates, you’re going to lower inflation expectations at some point. So your term premium falls. But the average level of policy, the average level stays relatively high. And so in that world, you have term premium falling, you have your average level of policy that’s priced in yields doesn’t really move. And when you look at the back end of our curve, like five year five year and rates like that, those are very high rates. Your curve is going to continue to flatten. And so that’s why I think this next cycle we may not be as inverted from the starting point, but I think for any location in the cycle we will be flatter, period.

Jeremy Saunders: I agree. I think curves have to continue to flatten from here, especially with all central banks rowing in the same direction on the short rate. I don’t buy the increase in term premium from Q2 story, I think.

Ian Pollick: Oh, it’s theoretically nice, but, and that’s why it leads me to believe that, you know, there is another school of thought that says what if the curve, let’s say twos tens goes to minus infinity? Is that going to activate active QT? Yeah, I kind of get it in theory. You sell bonds in the back end, you do a reverse operation twist, you steepen the curve. But is it going to actually help? That just may be worse liquidity conditions like you know, I find it very hard unless we’re talking about issuance falling all that much, that the private sector really needs those bonds.

Jeremy Saunders: It has to come from the treasury if you actually want to do that. It can’t come from the bank. I’m a buyer at minus infinity, though. (laughs)

Ian Pollick: (laughs) Okay. Speaking of a buyer minus infinity, let’s talk about swap spreads and I want to talk about five year swap spreads because one of the things that we are seeing right now, wherever terminal is, by definition, we are closer to the end than the beginning. But the spread between a variable rate product and a fixed rate product is now shrinking such that maybe people are incentivized to take out fixed. That’s obviously going to help the belly. But talk to me about your view on spreads.

Jeremy Saunders: Yeah. So I think the spread curve is somewhat interesting here. Since we last spoke, fives tens has steepened dramatically, twos have gone down a lot, gone up a lot and have now gone down somewhat.

Ian Pollick: But why? Because implies don’t look all that crazy.

Jeremy Saunders: So for the most part, I think there’s been, my sort of view is there has been a real lack of real money participation and what mostly has been driving twos is systematic, CTA, trend following. Twos have been very directional with rate. They now sit above four OIS, but nevertheless and four OIS is quite, quite wide.

Ian Pollick: You should probably be a little bit wider.

Jeremy Saunders: Yeah, but, spreads are, call it, you know, maybe seven or eight above that. So call that a flow premium. I do think that as we narrow the band on where terminal will be, which admittedly is an imprecise science that the flow, the paying flow will abate. For my stuff that I look at, a lot of CTAs in the belly are probably getting close to a mach short here and it would be hard for them to be the dominant flow on the paying side going forward. And so I do think that there is at least an imbalance for when the market does rally, that those types of accounts will have to come back and receive in force at some point. Fives. So the fives tens is interesting, has been very steep and that’s been partly a function of ten year paying from fast, you know, call it fast money-

Ian Pollick: But also financial issuance, too. Right?

Jeremy Saunders: Yeah. And a lack of, whether there’s been a setup for domestic issuance in banks, which hasn’t materialized as of yet. And I do think that’s an opportunity in the fives, especially with what the dynamics you’re talking about in the mortgage market. If they hike another 75, then prime for most new mortgagees will be 50 bps above where a five year fixed is assuming that the belly doesn’t-

Ian Pollick: Or assuming they don’t reprice mortgages.

Jeremy Saunders: Yeah, I mean, well, assuming that we still have this view that more hikes now flattens the curve and it doesn’t travel through the fives. And I think there’s going to be the opposite of what we’ve had for the last, we’ve gotten into a world where affordability concerns dictate that people take out floating to try and have a lower payment. Well, fixed is going to be a lower payment.

Ian Pollick: Yeah, it’s an equal minimize monthly payment. Go.

Jeremy Saunders: Which is the algorithm most people-

Ian Pollick: I get it. I get it. So you think spreads in the belly have an opportunity?

Jeremy Saunders: I think five tens can flatten and I think it is in the near term likely to be driven by paying in fives. More than receiving.

Ian Pollick: It has to come from the Treasuries.

Jeremy Saunders: I mean, I think that’s your risk. And if you think there’s going to be a big rally in rates, then you can probably, I think, spreads, if I’m a macro view, will be fairly directional in the belly to the level of rates. And if you think there’s going to be a substantial rally, then you probably sell spreads. If you think there’s going to be a huge sell off, then you probably pay them. And in the absence of a large move in, call it the broad level of global duration, I think that fives tens flattening can be precipitated by mortgage fixing in fives.

Ian Pollick: I actually think that you’re going to get more divergence across market, right? Because you look at Europe, you look at the U.K., you know, these responses to the energy crisis in the U.K. via unfunded kind of effectively tax cuts, that short circuits the Bank of England. And then you have the ECB that’s going to try and do what they can. But the economy is not good and in North America. So I actually think that global duration, if you think about the world in a PCA kind of framework, your residuals are now shifting, whereas before it was Canada, the US had very, very tight residuals. Everything was in Europe. I actually think it might be going the other way.

Jeremy Saunders: Global curve shape is definitely getting idiosyncratic, but I still do think Canada is very beta one to the US for all this stuff.

Ian Pollick: Oh it’s beta greater than one I would say. And like, let’s talk about that for a second because cross market, you know, I put on some Canada, US tens, a kind of -14 in cash the other day. But like, you know, usually I will just put a DVA one flat trade on, but I actually did the beta trade where I am more underweight Canada on the risk that Canada underperforms in a rally. That’s what I’m the most concerned about is the US rallying and then CGBs have one of those weird days where they just move $0.40 and they just massively outperform. So I am less short Canada, more long the US. A day like today it’s working. But that actually has an implication for spreads because we had this huge cross market outperformance. Canada looks very rich to me and then you had the situation where spreads actually start to move. So there’s a cross market element. So what do you think cross market? What do you like?

Jeremy Saunders: Yeah, I think you’re definitely right about the risks on a rally CGBs are a liquidity point, and the risk is that we out rally in the ten year point in the belly if there’s a big rally, you know, other than that, our five year point has gotten extremely rich and I think it’s been a version of the same dynamics-

Ian Pollick: What we were just talking about.

Jeremy Saunders: Yeah. And I mean, again, same thing. I like I like to be short there now. I think there’s a catalyst on the horizon, you know, between which one you do, twos five tens or buy five year spreads. Again, the one thing that stops the five year spreads from going up is if fives implode along with additional hikes. And so I think you do something like half and half and one of those is going to work.

Ian Pollick: Yeah, yeah. Okay. So we’re running a little bit long in the tooth here. I have a couple of questions for you before we go. Number one is the CME, earlier in the week, they kind of said, look, any contract that doesn’t expire after June 30th, 2024, that gets converted back to so for fallback plus whatever, can we take anything out of that for boxes? Do we have any indication that our permanent cessation date is June 2024? Does that mean like June 2023 we’re going to experience this in Canada, or is that more likely to be in 2024?

Jeremy Saunders: I think that the contracts will remain the same as in the US, just on a two year delay. So from 2023 to 2024, I think you’re going to have a live four OIS, but there will be a discouragement from actually trading them and then they’ll fix. I don’t know that there’s that much to do there.

Ian Pollick: I don’t know if there’s a lot to do there. The forwards kind of look price to me. Second question to you is, do you think the Jays are going to take the wild card?

Jeremy Saunders: (laughs) We had discussed no Jays questions.

Ian Pollick: I’m just kidding. Last question for real. Where do you think terminal is?

Jeremy Saunders: So I was in the zero camp and I frankly, between zero and my six question, I still am. I think that every central bank rowing in the same direction here at full speed, these things are going to have an impact. They just are.

Ian Pollick: Yeah, stuff breaks.

Jeremy Saunders: Suffering and inflation is going to start to come off. It is not going to go back down to 2%, but, once it starts to come off, even though central banks, including the Bank, are talking tough, they will moderate the pace. They will take some pauses and as it goes down, they will stop. And so basically the real question about terminal being substantially higher, like could it be four and a half? Yeah. Is it going to be six? I’m a seller, so I think at 387, given what they’ve said, I think it’s hard to fade that in any size.

Ian Pollick: You don’t, because you’re going to move above four.

Jeremy Saunders: Well your best bet is that they hike 25, 25 and then stop and you’ve made 25. And there was a chance they go 75, 75 if the inflation data. So I mean, I’m a payer at 387, I think at some point our lag data is going to reveal that every central bank in the world, having hiked 350 basis points simultaneously, has had an impact. (laughs)

Ian Pollick: (laughs) I would think so. I would hope so. Okay, listen, great episode. I hope everyone had a great 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.