Why does the ‘Close Elevator’ button never work?

Jeremy Saunders: Governor Macklem and Sarah Powell have in their head that they will do this thing conditional on, obviously, the big asterisk, the economy not crashing in inflation, you know, the immaculate disinflation.

Ian Pollick: Ah the immaculate disinflation.

Jeremy Saunders: Yeah, if you will.

Ian Pollick: All right. Well, it’s a new year. This is the first podcast of the year. And I’m joined by my good friend, Jeremy Saunders. Jeremy, how are you?

Jeremy Saunders: Hey Ian, I’m good. How are you?

Ian Pollick: Do you remember as a kid the movie The NeverEnding Story? Do you remember that movie?

Jeremy Saunders: I think you might be dating yourself. That’s a couple of years before my time, my friend.

Ian Pollick: Well, the bags under your eyes tell me differently. No, but in the movie, there is something called the Nothing. And the Nothing was basically eating the entire universe and that’s what they were running away from. This market kind of feels like the Nothing. I am struggling to find a ten out of ten idea. Am I alone in this view?

Jeremy Saunders: I’m with you Ian. I think we’re in a waiting game here and we’ve got to wait for some of the contradictions in the forward and backward looking data to resolve themselves.

Ian Pollick: And so when you say that, you mean the hard data, the soft data. Yeah? 

Jeremy Saunders: Yeah, exactly.

Ian Pollick: Well, let’s frame this a little bit. Right. Three months ago. Let’s talk global macro for a second. Three months ago, the big story was Bank of Japan on the sidelines. Europe, coldest winter ever. They’re going to implode, UK imploding, Canadian consumer imploding, US no visible signs of imploding. Cleanest dirty shirt. You look at where we are today, we have an environment where Europe looks markedly better. The UK looks stable. Bank of Japan’s likely getting off the sidelines. The Canadian data is very resilient and the US seems to be treading water and so that’s a pretty big macro shift. What do you think that means if we’re talking about just the level of interest rates?

Jeremy Saunders: Good question. I think all of that sort of aside, the biggest shift seems to have been the cutting of the right tail for inflation. And I think there’s a general sort of view in the market that this rally has made rates too low. I think it’s really hard to come up with what is the fair level of ten year rates. And if you think about cross asset correlations, once you’re not worried about 10% inflation and you’re talking about will it be four and a half, will it be three and a half, you get back to that, the right way correlation between stocks and bonds and flows rule.

Ian Pollick: So let me ask you this, though, right? I mean, one of the things that we often talk about is that there’s a fair value for everything, right? And you can come up with a model. Everyone’s got a model. You rarely have actual values converging to a fair value level, Right? But you see the residuals, how far away you are from it. And one of the things I look at right now is, is Carry right? If you’re a leveraged investor and you look at the level of interest rates, the level of rates is still after the rally. You’re in the top quartile of level terms over the past 20 years. But the level of Carry associated with that level of interest rate is in the bottom decile. So how do you reconcile that? Like I understand flows, but at some point you’re a leveraged investor, you’re not being paid to do anything on the long side.

Jeremy Saunders: When you say leveraged investors, you mean actively managed and people trying to make mark to market PNL. And I don’t really think that’s what’s driving the market right now. I think it is people with a mandate to own a mix of assets and the portfolio effect of adding bonds back in has improved dramatically, at least on a model basis. And that’s what’s happening. And you’re going to be left

Ian Pollick: i.e. the return is 60/40.

Jeremy Saunders: Yeah, exactly. Let’s call it a 60/40, Right. The 60/40 makes sense because the stock bond correlation is negative. When it flips positive, then 60/40 doesn’t work. And I think anecdotally there’s it’s flows driving the market. Yeah, you’re right. At some point in the future when the dust settles will duration be left to itch probably but is that your trade for the next two weeks or the next month? I think it’s really difficult.

Ian Pollick: I mean, you do have some negative seasonals coming in March, but March feels like a really, really long time away. So, I mean, you know, the one thing, too, is that on this right hand distribution of inflation, what about China? China is reopening. Right. And so, you know, I speak to a lot of people that structurally believe that energy markets are very cheap right now. And so when I think about what the Bank of Canada told us two days ago, which is we believe there’s stability in CPI because of gas prices, this is a glaring hole. It’s a risk.

Jeremy Saunders: Yeah, for sure. And they’ve highlighted that as their as their biggest upside risk to inflation. I mean, I think that is the risk. But is interest rates the best way to express that?

Ian Pollick: Initially, yes, but it’s the maintenance of very high levels of interest rates for longer than they arguably should be. That probably is what does it.

Jeremy Saunders: Yeah, for sure. I think maybe we’re skipping ahead on topics here.

Ian Pollick: So let’s bring it local, let’s bring it local. Bank of Canada. What surprised you?

Jeremy Saunders: Yeah, you know, there’s a couple of ironies, right? One irony is you go 25 and your impact is an easing of financial conditions. So there was a question of I think going 25 is reasonable. Why signal so strongly that they’re getting ready to pause?

Ian Pollick: So this is the thing we had thought 25 for a long time, I should say. You know, really for the past two months we thought this was the last hike, but we did not think that you would get such explicit language that spends all your optionality so early on in the year. Because, you know, the way we thought about it was you’re regaining credibility after losing it because you missed inflation, you did the right thing. You’ve normalised rapidly. Why? Why would you box yourself into that? And the only thing I can think of is, number one, there is a lot of pain going on in the world, in Canada, I should say. And so maybe they’re telling people that rates aren’t going higher. You can still spend money, like do not worry. But I don’t know if that’s the real reason.

Jeremy Saunders: But that’s somewhat counter to their goals.

Ian Pollick: So ultimately, they must have extreme confidence in their forecasts, right? Because that’s the only thing that tells me why you would want to spend those bullets. And so the statement comes out 25 done the text in the middle part of the statement, neither here nor there, largely as anticipated. It’s not last paragraph, you know, where if things evolve broadly in line number one is what is broadly in line. It’s pretty ambiguous. I don’t know what the threshold for beating is that would prompt a hike, but at the very end they said that directionally we’ll still be forced to hike if we have to, but then in the presser we had Governor Macklem come out, he did rebrand it as conditional. And so you walk away and say, well, what is the bank’s credibility with conditional commitments? They’ve done one in the past. They broke it. They talk to the public about interest rates being low for a very long time. Obviously, that didn’t happen and now you’re in a situation you say, okay if I’m trading this market, the credibility of that commitment is the most binding very, very early on, and then it loses potency as the year goes on.

Jeremy Saunders: I’m certainly surprised that they removed themselves optionality, and particularly given that Governor Macklem spent most of the press conference trying to reinsert it. So it seems what I expected to happen was 25 and they’ll say we’ll continue to evaluate whether or not rates need to increase. And that is entirely consistent still with a pause in March, but doesn’t force them to sort of go back on themselves. Now, they’ve got a tricky situation where you’re going to have a couple of prints between now and March, and if they’re reasonably strong, are they going to pause and characterize that as broadly in line?

Ian Pollick: Well, that’s the thing you don’t know.

Jeremy Saunders: Yeah, you don’t know. And also remember, there are now they’re going to publish for the first time the minutes and also in between now and the March meeting they’re going to publish the index values for trim and median so that the entire world will

Ian Pollick: Actually see three month annually.

Jeremy Saunders: Exactly. Be able to calculate it and do a bunch of analysis. And so those the average of those two on three month annualised is 4%. If we get two more months down the line and they’re still 4% then is 4.5% interest rate. So call it 50 basis points real, sufficiently restrictive given their view on

Ian Pollick: No, that’s a good point. Right. You are boxing yourself in at a time where you’re about to open a rapid transparency. Right. Like you can see the underlying data that we haven’t seen before. I mean, the minutes are going to be pretty funny, right? There’s five Governing Council members. So is it going to be a few? Some? Many? You can pretty much figure out what’s going on. But I guess the question is an interesting one for our listeners is what are the implications of a conditional pause? And so I think the first one I want to talk to you about want to ask you is you have a conditional pause, you’ve probably had pent up demand in the housing market, let’s say, and you kind of look fixed rate mortgages are 75 through variable rate now, right? So if you are buying a house, you are electing to take out a fixed rate mortgage five years or the cheapest on the mortgage curve. Does this alleviate the theme from last year where asset replacement dominated the belly? Can you see five year spreads move higher?

Jeremy Saunders: Yeah. So I think that’s just sort of a time bleed thing. People are, I imagine sort of going through the five stages of grief on mortgage rates And I’ve got to imagine come spring will be getting to acceptance. I mean, at some point life goes on and people move for many reasons, not just trading houses, people get new jobs, people want to be in new school districts, etc., etc.. And I think my sense of it is that come spring there will be hopefully a closing of the gap between where sellers are and where buyers are. And on mortgage rates, they’ll probably be some sort of amelioration of the sticker shock of where things are.

Ian Pollick: The sticker shock feels gone, right? Yeah, especially if it’s coming down a little bit.

Jeremy Saunders: It’s getting there.

Ian Pollick: So what do you do on spreads? Like, do you think this is enough in the next, let’s say, three months that you could see bank portfolios switch their behavior that they’ve had for the past year?

Jeremy Saunders: Well, let’s I mean, let’s talk about the starting point for swap spreads, right? You’ve got over the last sort of six months, you’ve had a lot of receiving and fives from asset replacement, let’s say bank treasuries who aren’t issuing mortgages and need duration and at the same time what mortgage paying there has been has been in the sort of 2 to 3 year area, which is, I think, a rational place where people might say, well, I don’t want to lock in these high rates for a very long time

Ian Pollick: But I don’t want to miss out when I’m going higher.

Jeremy Saunders: And more importantly, I can’t take a right tail risk of rates going substantially higher. So I got to lock something in. But I don’t want 

Ian Pollick: Rational, totally rational.

Jeremy Saunders: So will that go away? I mean, I think you’ll start to see some more paying out the curve. And I also think that partly the asset replacement story is been a result of the difficulty in forecasting behavior of depositors and behavior of borrowers simultaneously, and

Ian Pollick: But like all borrowers like corporate boards too. 

Jeremy Saunders: Yeah, across the curve and

Ian Pollick: Because what’s interesting, I’m just going to digress for a second is one of things we looked at. We looked at line utilisation, and so we thought, okay, banks have been the dominant issuer in the corporate market in Canada for the past year and a half. Pent up demand. People cannot issue their drawing down their lines, but in actuality line utilisation is falling. It’s not rising. So you’re still losing another asset.

Jeremy Saunders: Yeah, I mean, I think part of the difficulty for treasuries surely have been the volatility in macro data over the last two years, making it very difficult to forecast. And I think some of that is going to abate and the forecasting of the assets and liabilities side of balance sheets should get less divergent. And I don’t think that those treasuries are necessarily going to be coming out and paying out of all that duration, but

Ian Pollick: Maybe it’s the incremental lack of receiving of that pops it.

Jeremy Saunders: Yeah, I think the second derivative of that flow should start to change. And then on the two year side, the two year spreads are on an OIS basis, they’re quite high and on the CDOR basis they are even higher because FRA-OIS levels have been elevated, which is a reasonable reaction to the uncertainty and in the range of possibilities of what the central bank is going to do. And there again, right now we’re talking about a conditional pause. But the strongest guidance I really think you can take out of all this is their decisions are now in 25 basis point increments.

Ian Pollick: Yeah, I mean, and that’s fair, right? But let’s dig down a little bit, right? Because one of the things we’ve been talking about is, you had this rapid rate of normalization. You had volatility around the decisions before you moved this, now that you’re in a 25 basis point increment may be a longer term pause. It should give physical BA buyers a bit more assurance that they can actually go and take term in the market. And that was one of the big drivers FRA-OIS last year. You just didn’t have a ton of people willing to take that risk in between two bank meetings where they could have gone 150 and two meetings, you weren’t being compensated for it. And so one of the implications of a pause is that you get these buyers coming back into the market and CDOR following the past two days. And so the question I have for you is have we seen the top in the near term in CDOR?

Jeremy Saunders: Yeah. I mean, I think, look, the insurance in place for money market participants is quite wide and it’s reasonable to see it bleed off as we get more certainty on sort of whether the top of the cycle is in. But that goes back to my point of I think when you’re talking about 25 or zero or -25, then you need a lot less insurance in sort of three month term than when you’re talking about is it 50 or 75 or 100. And so I do think that that is going to come out. Now, we’re sitting here on Thursday morning and, you know, in the 24 hours after the bank yesterday, already the sort of micro FRA-OIS in the curve has come off quite a lot. Call it three or four basis points. 

Ian Pollick: Like M3 moved four or five basis points in 24 hours.

Jeremy Saunders: Yeah, exactly. To my earlier point, I do think where the opportunity there is is further out the curve in two year spreads, in two year seed or spreads that still have a lot of that in there and I think there’s an opportunity for that spread to compress. I mean two year FRA-OAS is something like 39 and should probably settle in and something like 35. So twos five steepening is an attractive trade

Ian Pollick: The Widowmaker. 

Jeremy Saunders: Yeah, it’s, well, you know, it has been an attractive trade the last sort of 30/40 basis points down. But nevertheless, if you’re going to ask me what sort of curve trades I like, I think the receiving leg of twos should be in CDOR space. And then what you do against that can be either an OIS or in cash space.

Ian Pollick: Well, I just think duration is expensive, right. And so I think the mode that the curve needs to take when we’re talking about the big curve is, I think you’re in a bear steepening environment because I really do believe that you have very expensive duration in the back end. And even in an environment where you’re pausing, you know, a lot of people lose sight of the fact that even if inflation decelerates in level terms, the price level is still rising and that higher price level warrants higher policy. And so therefore, you know, ten years that are this far through funding doesn’t make a ton of sense to me. And so that initial pop in duration and that gets back to the global macro we’re talking about, that’s what’s driving it because it’s been a term premia lead story. It hasn’t been a repricing of terminal. Right. And so, you know, one of the things we looked at is we asked the question is and I’ll ask you this question, do you believe that whenever cuts come, whether it’s the bank, whether it’s the Fed, are you going back below, let’s say the top end of neutral, below 3%? And are you doing it starting this year? Do you believe in that path?

Jeremy Saunders: Well, so the neutral question is actually a really interesting question. If you look back to before COVID, the market’s view of let’s just use your I think your preferred measure is like a five year, one year or a five year three month for what the market’s view of neutral is. I mean, in Canada and the US, we’re kind of back to where we have always been. The market is priced a return to the old world, the things that have really changed are in Europe and in the UK.

Ian Pollick: Where our STAR seems to be rising very quickly.

Jeremy Saunders: Yeah, it does.

Ian Pollick: Or the estimates of our STAR.

Jeremy Saunders: But nevertheless they have risen quite a lot. So I think for your global term, premium story to make global duration cheaper, which is what story really is going to have to be in the near term to get a belly light cheapening. You have to believe that that repricing has more to go, and I have some difficulty believing that. I mean, there’s an interesting question about what a place like the United Kingdom will do with a very poor growth inflation trade off.

Jeremy Saunders: In the case of Europe, there’s to a similar extent the same story. I mean, there inflation. This gets into a difficulty, I think, of measuring inflation. I mean, you talk about what is energy lead inflation and what is sort of service. Yeah, but energy is isn’t everything right?

Ian Pollick: And therefore shelters and everything and therefore services.

Jeremy Saunders: And so the length central banks have gone through to try to disentangle that statistically.

Ian Pollick: Oh, it’s wild.

Jeremy Saunders: But also I think possibly an effort, a futile effort to some extent. They’re all really correlated.

Ian Pollick: But let me ask you this. So I hear your point. Right. And it’s a very good point. You have these small open economies are hypersensitive. You have these very large closed economies. Europe has repriced honestly more than anyone would have thought. And you are getting pushed back on this idea that they’re dialing down. But the question is, what if you don’t need just higher rates? What if our STAR or terminal stays here for longer than the market thinks? That is very disruptive because that’s not what’s being priced right now. And so I wonder that as you get this game of attrition, as the year goes on, where what if you do increasingly see this soft landing signs and that you don’t necessarily price more, but you price in the current level for longer? That matters because stuff starts falling out of the bottom half and the front end.

Jeremy Saunders: Yeah, for sure. I mean I think I take your point is twos are too rich, and my view on that is that we’re going to price normalization in policy somewhere.

Ian Pollick: We should and you have too. 

Jeremy Saunders: And if you’re going to be short twos you’ve got to be received something somewhere else.

Ian Pollick: It’s got to be relative. Right. Absolute is very hard because the dot is very hard.

Jeremy Saunders: So I think, I think that trade, if you want to push out normalization and those reasons to do that, I think central banks will probably error on the side of caution, particularly while risk assets are trading well and so on and so forth. Then I think it’s like a ones, twos, threes trade, it’s a butterfly trade. 

Ian Pollick: It’s just concavity, right? It’s a relative differential. 

Jeremy Saunders: And I’m just not sure that I buy this story that we’ve reached a permanently higher plateau in, call it neutral rate.

Ian Pollick: I think I don’t think we have either, like you know, I think in my heart of hearts I still believe in secular stagnation. But I think in the very near term, the dogmatic approach here is to be like, well, I’m going to listen to what central bankers are telling me because I think they are realistic in their motivation to keep rates higher for as long as possible. I don’t mind where the end point is, I just don’t like the starting point and I think it’s a bit crazy to have so much price from like September to December in Canada and then next year you have a cut basically at every meeting and you have these mini micro cuts after June, basically, which doesn’t make a ton of sense to me.

Jeremy Saunders: Yeah, people don’t like that. I think that’s a, I mean, Canada doesn’t give as fulsome a forecast out into the future as the US, but with the Fed upcoming next week, it’s probably reasonable to talk about that and what I can take away from their last round of projections is that you can back out a level of real rates that they think that they should have, and not remember all these forecasts are conditional. And really what a central bank ought to be doing is setting a level of real interest rates and so

Ian Pollick: We’re guiding the market to a plateauing level

Jeremy Saunders: Yeah. Let’s just say that the stylized model of financial conditions is a real rates model, not a economical rates model. And so it’s interesting that the Fed’s projections for 2023 and 2024, if you combine their core PCE forecasts with their median forecast is 1.5% Reals for both years, very, not about it’s the exact same number. So I take that as a signal, but I think the implication of that signal is that 1.5% Real with 3.5% inflation gives you 5%, which is their median. Right, and then they see inflation coming down. And they do see they have explicitly in their dots some normalization cuts like what people don’t think makes sense in the in the Canada curve, which is why would they cut 25 basis points without anything happening? And I think the answer is that it’s predicated on their forecast of inflation.

Ian Pollick: Well, you’ve got to realize those forwards, right? You have to realize the inflation forwards, it gets that real rate that you want.

Jeremy Saunders: My only point is if you go back to Canada and you say, well these cuts don’t really make any sense, I think that every central banker, both Governor Macklem and Sarah Powell, have in their head that they will do this thing conditional on obviously the big asterisk, the economy not crashing in inflation, the immaculate disinflation. 

Ian Pollick: Ah the immaculate disinflation.

Jeremy Saunders: Yeah, if you will. So,

Ian Pollick: Let me ask you this, in a nutshell 25 or 50 next week from the Fed?

Jeremy Saunders: Oh, I think 25 I think 

Ian Pollick: It’s been telegraph, right?

Jeremy Saunders: Yeah. I mean, I think pricing is very fair. We’ve got 25, 25 and half of 25 and can you really fade that one way or another? I think the Fed’s done the same sort of thing that the bank has done, which is they said fifties are done, it’s 25 now.

Ian Pollick: Yeah. You’ve downshifted. I get it. They probably should do 50. I mean I think it reduces some of the complexities with downshifting. Given your thesis, you know, it is very hard to communicate such a rapid exit from normalization to the upside to normalization to the downside. So you probably get there at a faster rate. And I think this whole front loading was miscalculated because, you know, it made sense at the start, but it should have continued to a level because I think they always knew where they wanted to get to. You know, it was very clear as of last fall that rates were still too low. Everyone had a version of that four and a half to five, and you need to get there as fast as possible. Any big thoughts on trades? What would you have on? What are you going in with?

Jeremy Saunders: I think it’s stuff I like, micro stuff. I like to your spreads lower. I did like your trade idea that you put out yesterday, but I think that has moved. Yeah. I mean it’s you realize half of the value there already. 

Ian Pollick: And for those listening that was in H3 M3 steep or just being outright sold H3 OTR.

Jeremy Saunders: We’re venturing far field, I think the rates that look the highest out there are EURO rates. You’ve got a central bank or central bank that’s promising to do a lot, but I’m not sure that the Mack that’s kind of it’s a lot for insurance. In terms of Canada, everyone likes Canada cheapening, which suggests to me it’s probably a good trade to buy Canada on dips.

Ian Pollick: Yeah I mean I like it, I can use two years on I like selling Canada. It’s just this idea that you have the US price to start easing later because you have hikes extending further, and so if you normalize that path and you pull Canada towards the Feds as opposed to vice versa, then our front ends is just too expensive.

Jeremy Saunders: Yeah, but I do think that we have similar shapes happening in both markets and probably the macro circumstances that allow that to happen in Canada allow that to happen. 

Ian Pollick: I was actually looking at and I never look at this, but I was looking at just short end OIS spreads and so I was looking at bills versus OIS. You know when your bills are like eight through OIS, anyone can tell me, the reason why that’s actually happening and why it’s a terrible trade. I’d love to know. Get in touch with me, but some of the stuff looks very, very expensive.

Jeremy Saunders: Yeah, I think those are pretty technical trades. Not for the faint of heart.

Ian Pollick: Correct. Anyways, listen, we’ve talked a lot. Thank you for being on the show for us one of the year. I’m sure we’ll see you back here. I hope everyone has a great weekend. And remember the 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.