CIBC Year-End Update and 2024 Outlook – Balance Sheet Management

Roman Dubczak: Hello, everyone. I’m Roman Dubczak, Deputy Chair of CIBC Capital Markets. At CIBC we’re here to help provide you with valuable insights to help navigate the markets. And I’m pleased to lead today’s year end discussion on balance sheet management, where we’ll hear from our experts. Ian Pollick, Global Head of Fixed Income Currencies and Commodities Strategy, Bipan Rai, Global Head of Foreign Exchange Strategy, and Jeff Gabriel, Interim Global Head of Corporate Solutions. They’ll each recap their observations over the past 12 months, and the key themes they’re seeing for 2024. So let’s get started, I hope you enjoy today’s session. Ian, perhaps share your perspectives on the key themes of 2024. Busy year.

Ian Pollick: It’s been a busy year. So, if we have to think back over the past couple months, I think there’s really two key themes that happen in the bond market. The first one was obviously trying to calibrate where interest rates were going to go. It was the second year that central banks were raising interest rates. And so really the first half of the year was trying to figure out where the so-called terminal rate was going to go. As the year progressed, obviously there were some hiccups related to bank failures in the US that was absolved very, very quickly. And so, as we got to the second half of the year, now we had to absorb a secondary source, which is supply. And so, really there was two key themes in 2023, which was the macro, and the micro. The macro was one that was telling us that central banks were very close to being done. The micro was saying, well, wait a second, deficits are growing. You know, even though the economy’s at full employment, inflation is still relatively high. There’s a huge amount of supply. And so for interest rates, there’s obviously been a huge amount of volatility. We saw it during the fiscal led steepening that we saw in September and October. And over the past month, we have seen this dramatic repricing of the market. And really what’s happened is this total abandonment of the ‘higher for longer’ narrative. You know, it happened so, so quickly. And so you take a step back and say, well, wait a second. You know, two months ago we were talking about higher interest rates being a substitute for rate hikes. Today, nobody’s talking about lower interest rates being a substitute for rate cuts. And yet the markets brought forward the timing of expected rate cuts. And so we take a step back and we look at the data and we ask ourselves one really important question, “Are we at the level of interest rates that’s consistent with a soft landing?” “How many interest rate cuts do you need if you are indeed going to a soft landing?” And so it’s our view the market’s moved a little bit too far, too fast, but it is giving us a very good preview of what to expect in 2024. So when I look ahead to next year, there’s really three key themes that have been socialized to investors. The first one is this ‘soft landing’. And what is this soft landing mean? It just means that you’ve got a right sizing of demand and supply. You don’t actually hit the unemployment rate. And so the economy progresses without a recession. The second theme is that you have a weaker US dollar, that Bipan’s going to talk to us about. And the third theme, of course, is that when you think about the marginal buyer in the market, it is shifted quite dramatically. And so you have a soft landing, you have lower interest rates because central banks will finally start to cut interest rates and you have a weaker US dollar. You know, our view is a little bit different from the market and we do think that the macro will dictate lower policy rates. That’s pretty much a given. And whether that’s because you have really bad data or whether it’s because inflation’s falling, real policy interest rates need to be maintained just to ensure that you don’t get too restrictive monetary policy. Where I’m a bit concerned, though, is that I don’t think interest rates are going to fall as much as markets are expecting. And that’s not just in the short end of the curve, because when I think about 2024, I’m very cognizant that there’s a supply shock globally. Europe is moving into a period of positive supply. Bank of Japan is going to normalize interest rates. They’re going to introduce a lot of supply into the market. We just saw our mini budget from the federal government a couple of months ago. And so supply is growing very aggressively. Someone has to buy that. And so the marginal buyer is where this market will be priced to. Commercial banks in the US are buying as readily as they were before. And so let’s just talk numbers here. Let’s throw it out. We expect a rally in, let’s say, a ten year yields next year, since we have about 50-basis points. It’s not a very big number. Against that, we see monetary policy falling by about 150-basis points in Canada, about 50-basis points in the US. Now, if we’re wrong, I think we’re wrong that there’s not as many cuts being introduced next year. And so, you go through the first half of 2024 and it’s what I like to call, ‘the financial conditions doom loop’. You know, you’re going to move from a period where you’re pricing in too much. Markets are going to start pushing against that such a price and too little. And the truth is somewhere in the middle, it’s really in the second half of the year, we’ll find some clarity.

Roman Dubczak: You reminded me of that word, ‘terminal rates’. It’s amazing. We don’t talk about that.

Ian Pollick: We don’t talk about it anymore.

Roman Dubczak: That’s all we talked about a year ago, but nonetheless. Bipan, good segue to you, FX. It’s always exciting in FX, but there are real significant shifts and differences between rates here and in the US. And I’ll hand it over to you for your view on all that.

Bipan Rai: Yeah, absolutely. And as an FX specialist, you know, I obsess over cross-border differences. What are the different things that are happening in, say, household indebtedness here in Canada versus in the United States? And of course, these are things that we’ve been talking about for quite some time. But, you know, when you have the Fed and the Bank of Canada, both at their so-called respective terminal rates, let’s call them, and and look into potentially ease next year, these themes come into sharp relief a lot more quickly. So we have to pay a lot of attention as to where the vulnerabilities are here in Canada relative to the United States. But frankly, I mean, we just think the US economy is better equipped to deal with higher interest rates relative to Canada. So, you know, we do have the Bank of Canada easing first, before the Federal Reserve. The market has moved in that direction. Now it could be a period of say, over correction where we see additional cuts being priced into the Bank of Canada for for next year. But that’s how our focus is. It’s really at this point, it’s about how much is being priced in for the Federal Reserve, which we don’t agree with at all. So in the early part of this year, I mean, we do think that’s going to be the catalyst that drives the US dollar stronger. And of course, that’s going to produce additional strains. Potentially, we could be in a situation where we could see funding strains or at least funding become an issue in the financial system in the US, in the early part of the year. We think that’s going to compound some of the issues for a lot of investors, lead to a lot of dollar sourcing and driving additional leg higher for the US dollar. So we are, in the early part of the year, expecting a much stronger US dollar relative to the Canadian dollar. We’re still looking for that 140, and potentially even 142 level by the end of Q1 of next year. But then the game changes a little bit. You know, FX is very much about also managing expectations. Once we see the markets course correct, priced the Fed appropriately, potentially even see some of the funding pressures ease a little bit towards the middle part of the year. That’s at a point at which we think some of the more longer term structural drivers of the US dollar are going to matter more. So things like valuation and fiscal policy and how that’s been developing in the United States. At that point, we think that’s going to start weighing on the US dollar valuation to a greater degree. Now, outside the United States, we also think that, you know, some of the things that are happening in Japan from a structural standpoint and the pivot from the Bank of Japan, that’s going to be a major story as well. And certainly we’re going to see some of that come into sharp relief for dollar-yen. And we wouldn’t discount that as a driver for foreign exchange movements elsewhere as well, because that is a large market. If we do see additional dollar downside from there, that could migrate to the Canadian dollar and potentially lead to a weaker US dollar from H2 next year, onwards.

Roman Dubczak: Yeah, Interesting. Yeah. And we’ll get some questions later, but there’s a lot of potential geopolitical issues going on and FX, but we’ll touch on that and I’ll let Jeff, give his overview as to where our clients are, on their hedging and what they’ve been doing.

Jeff Gabriel: Well, it’s a challenge, right? As you’ve heard from my colleagues here, you know, we’ve had some pretty monumental changes within the structure of interest rates with movements in FX. And quite frankly, you know, luckily a lot of our clients across both segments are growing. You know, there are some you know, some cases where, it’s a hang-on scenario, but what we’ve seen so far has been pretty positive in some robust activity, a lot of consolidation within certain markets, a lot of growth within others. But the name of the game for customers, really, at the end-of-the-day is navigating the variables and making sure that they can survive and operate and deliver on their promises in a higher cost-to-capital environment, in an environment where liquidity can be challenged, and you’re seeing alternate forms of liquidity come to the market, and, you know, certainly be able to deliver to the expectations of the market. So, you know, it’s been kind of a wild ride of some sort through 2023, and the dynamic of the game will probably change in 2024 as well. But really, the liquidity management on the balance sheet and having the dry powder and being able to operate has driven a lot of the ancillary and hedging decisions at the company level. So they make sure they can adequately supply to the needs of the firm and the business.

Roman Dubczak: Yeah. Well, I want to touch now on risks. Given the backdrop this time last year, this time maybe even six months ago, we were talking about terminal rates and where that’s all going. So now we’re seemingly sliding down, maybe calmly, maybe on a steep basis to a lower rate scenario, maybe lower volatility. There’s a lot of excitement that can kind of happen. So maybe Bipan, we’ll start with you in terms of the potential risks to everything that we’re talking about today and looking forward to next year.

Bipan Rai: Yeah, absolutely. I mean, we’ve got geopolitical conflicts happening at the moment in the Middle East, of course, and that matters for foreign exchange and other asset classes via the commodities channel for sure. And that’s something that we’re going to be keeping a close eye on. Also, of course, we can’t look past the impact of the conflict in Ukraine and what’s happening there. And of course, that’s been important, especially for the eurozone, given the fact that a trade partner of theirs for several decades has become persona non grata. So that’s meant some complications when it comes to sourcing energy, particularly natural gas. Looking forward, though, I mean, if 2024 is going to be a story about, let’s say, risk events to monitor, I mean, there’s an important election next year in the United States. And again, you know, we’re getting asked a lot of questions about what that means in the in the macro space in particular for foreign exchange. But simply, it’s too early to tell, right? There’s a lot of unknowns that we need to sort of get through before we can actually make a judgment as to what’s going to happen with respect to, say, the US dollar. If we see President Trump continue to lead into the polls, into the election. And if you recall, the 2016 run up was very different than the 2020 and what happened afterwards. So I mean, taking those two into consideration, what we would say is that investors need to be a little bit nimble and sort of see how things play out before they make judgments as to what they should do in manager hedging from a foreign exchange perspective.

Roman Dubczak: Okay. Thanks, Bipan. Ian, perhaps your views on other, like I’m sure there are shared risks all across the curve, but… all across the curve, but…

Ian Pollick: – There’s lots of risks. Now, I would just echo what Bipan said. You know, I’ll tell you a startling stat when I think about political risk next year, you know that, 50% of the human population heads to the polls next year? India, Taiwan, Europe, America, these are very big non-linear events. And so you don’t know what’s going to happen.

Roman Dubczak: – Right.

Ian Pollick: And so obviously, when you think about outcomes, we’ve seen stranger things happen. But against that, I would say that central banks have a problem right now. They are losing the narrative relative to what they are willing to tolerate. And so markets are pushing against that very aggressively. And so when you are losing your ability to provide forward guidance, particularly around the pivot in the cycle, it leads to very big swings in the market. One of the bigger themes that we’ve been talking about, too, is that when you look at the amount of debt that’s grown outstanding over the past three or four years, it has greatly surpassed the growth in bank balance sheets. And so the intermediating capability of the market is much more reduced. And what that means by definition is that, any big event, even the medium size event, it just gets pushed straight through into the market. So your level of volatility is just not much higher. When you have leverage and you have volatility, you get a surprise that’s a shock to the system. And so, it’s not clear to me what these risks ultimately will look like. But we know they’re there. And so I suspect in the very near term that we’re going to get higher yields. And that’s not really what people had had been looking for. The question is, is how does that manifest itself into the early part of 2024? Is it a similar size, rapid increase in rates that we saw in October or November? Maybe not, but I can’t say that it won’t. And so I do think it very much is the year of two halves.

Roman Dubczak: Okay. Well, speaking of risk, Jeff, like what are our clients looking at here? Like, what are the key risks that they’re currently looking to hedge?

Jeff Gabriel: Certainly in 2023, it was really a story about interest rates. You know, the amount of interest rate hedging that we’ve seen was unprecedented. It follows both on the corporate and almost in the project finance space as well.

Roman Dubczak: – Yeah.

Jeff Gabriel: I mean, certainly there’s been a large inflow of government spending to get projects and people back to work after the pandemic. There’s a huge push into renewables, so that space has been exceptionally busy. The FX market, I would say, it’s been very robust on that side of the equation as well. And even in the compensation hedging, you know, people wanting to hedge their stock price for their employee programs has been quite robust as well, albeit there’s been some tax changes and some government rule changes around that, which will make its way through the market over time. But certainly, you know, everyone’s looking to ensure they can have liquidity they need smoothing out their earnings profile. So it’s been a very, very active year and I expect that trend to continue.

Roman Dubczak: – Yeah. A little bit of perhaps an inside baseball question for you, Jeff.

Jeff Gabriel: – Sure.

Roman Dubczak: In terms of our offerings to our clients, how have we adapted on our desk in terms of…

Jeff Gabriel: – Well, certainly, like, the name of the game for us has been ‘product innovation’. We’ve seen a lot of standard hedging instruments used in 2023 and with the changes that are anticipated in 2024, if they come to fruition, you know, we are adapting our products to help people stay hedged but yet monetize as well because, you know, companies do take a view on rates in the project and the timelines, they all change. So our deal contingent hedging program that we’ve had has been very, very successful. We’ve had a very successful prepaid program that’s been operating in metals and commodities, that’s been very successful with a big uptake to it because it satisfies two things. It satisfies a sales contract for, you know, for the producer, but also acts as a fundamental hedge in the background to give the, you know, the consistent earnings and sales profile that you’d want to see in a business. I expect those trends to continue. And I expect, you know, the market to evolve and look to more bespoke financing opportunities with embedded derivatives in place. So ultimately, at the end of the day, I think that it’s going to be a busy 2024.

Roman Dubczak: All right, well, we can end off on a busy 2024. Busy, likely exciting 2024, and 50% of the world’s population going to the polls. I don’t know what would be more exciting than that, as it relates to markets. So thanks, gentlemen, and thank you all for joining us today. I hope you all enjoy a happy, healthy and prosperous holiday season and wishing you all the very best. And thanks for joining us and we hope to see you again soon. Thank you.