Mid-Year Update – Balance Sheet Management

Roman Dubczak: Hello, everyone. I’m Roman Dubczak, Deputy Chair of CIBC Capital Markets. At CIBC, we’re here to provide you with valuable insights to help navigate the markets and I’m pleased to lead today’s discussion, a mid-year discussion on balance sheet management, where we’ll hear from our experts, Ian Pollick, Global Head of Fixed Income, Currencies and Commodity Strategy, Sarah Ying, Head of Foreign Exchange Strategy, and Jeff Gabriel, Head of Corporate Solutions. They’ll each recap their observations over the first half of 2024 and their outlook for the rest of the year. So, let’s get started. Ian, welcome to another episode of Unprecedented Times.

Ian Pollick: Yes. 

Roman Dubczak: Very exciting. We saw the Bank of Canada cut today for a second time in a row, maybe likely to be replicated. Maybe give us a bit of an overview as to where you think we are in terms of the general interest rate environment right now.

Ian Pollick: Sure. So listen, I think at the start of the year we had a very easy thesis. Inflation was coming down, growth would slow, overnight interest rates were very restrictive, and over time they needed to come down. They’re coming down at very different speeds across the world. You know, some central banks have eased like the European Central Bank, the Bank of Canada. But the big one in the room hasn’t yet, which is the Federal Reserve. And so when we think about the path ahead, very simple story. The economy is slowing.

You don’t need such high interest rates to kind of get supply and demand balance in the system. The problem, though, is that it’s having a very different impact on the term structure. So, not every bond is feeling these lower interest rates the same way. When you look at the start of the year, we said, you know, we think that short term interest rates like two year yields, five year yields, they’re going to rally. And that’s because overnight rates are falling.

But longer term interest rates you know it can be very very hard for them to fall this year. And that’s exactly what’s happened. And so the question is, why. I think the reason why there’s really three of them. Number one is remember there’s still quantitative tightening going around globally. And so what that really means is that it’s moving at different speeds in the system. You know the European Central Bank is just starting. The Bank of Japan is just starting it.

Bank Canada’s ongoing, and the fed is slowly starting to do it. And it means that the private sector is absorbing huge amount of bonds, and they want more compensation to own those bonds. Number two is that you have fiscal expansion. You know, this was probably the biggest missed opportunity over the past cycle where you had high inflation, full employment and government deficits that just grew. And so, the overall amount of bonds in the system grew. That gets exaggerated by the fact that well, the central banks are buying them anymore.

And so when you put those pieces together, what you’re seeing really is that long term interest rates really haven’t fallen all that much. In fact, they’re a little bit higher since the start of the year. The last thing to remember is that when you look at what the market is pricing in right now, The market is saying that we think the interest rate cycle is going to be completed by the end of 2025. And once you get to 2026, we’re starting to talk about interest rate hikes again.

And so at the very start of a hiking cycle what happens? Long term interest rates will always lead. And so the balance of those three things leads us to a couple of conclusions. Number one is when I look out over the balance of the year and our forecasts, we only see a very small rally from here in 10 year yields, 30 year yields. And so whether you’re a hedger, an investor, an end user, an issuer or what have you, long term interest rates are not falling all that much.

When we look ahead to 2025, you get a little bit more love. Just given the fact that we expect some more interest rate cuts next year, but by the end of next year, we do start to see again pressure building in the very long end of the curve. How about the belly? Like the 5 year. And so here’s what’s really interesting. You know this was the only interest rate hiking cycle in history where you had cuts priced at the same time. And so what that means is that today, a lot of the cuts that were actually priced live inside the belly of the curve. And so here’s where I get really nervous when I think about mortgage rates, when we think about the big refinancing wave in 2025 and 26.

Well, if you do the math and the Bank of Canada cuts it every single meeting for the next year and a half. 5 year bond yields only drop 20 basis points. So how much further are 5 year mortgage rates really dropping. And so it begs the question is number one are consumers and households really getting that rate relief that we need. And number two, you know, does the central bank actually have to go a little bit further to generate that type of mortgage savings that the economy actually needs?

Roman Dubczak: Right. So, you know, prime credit cards etc. do relatively better in terms of rates, but maybe not so much on the more.

Ian Pollick: Correct. Correct.

Roman Dubczak: Very interesting. Sarah, over to you on FX. So, summer, barbecue season. People are asking, you know, Ian’s talking about interest rates. You’re talking about effects. What’s your view on the seeming to be recently rallying and continuing to be rallying US dollar and you know, where’s that all going to go?

Sarah Ying: Yeah, absolutely. So, the biggest theme this year is really one of dollar strength. And the reason why the dollar has been so strong it’s really very simple. The data in the US has been very strong. Post-pandemic, you saw a lot of upside surprises in the labour market that caused wages to be stronger. And then ultimately that led to a stronger consumer. The problem with all this is that you really saw service inflation started to reaccelerate in the first half of the year. And this is really concerning for the Fed because it really caused the Fed to doubt whether or not they can reach the 2% inflation target in a reasonable period of time.

Because of this, that’s why the Fed held interest rates higher for longer. Meanwhile, in other economies such as Canada, we did make good progress on inflation. So if you look at inflation in Canada, if you take out mortgage interest costs, inflation is already running at 2%. So you have this big divergence in fundamentals between Canada and the US that caused dollar CAD to move higher. And aside from this we also had some global developments as well. So for example we had a geopolitical shock in April and also uncertainty around the French elections in late June that caused the dollar to rally as well. So right now dollar Canada is around 138.

We think that this story of fundamental divergence can continue for a little bit longer. So we’re looking for the currency to move to around 138 to 139 by Q3. Okay. And just to round that out I know people are interested in this. Clearly a lot of news-slash-noise on the US election. Any influence on the dollar therein or … Well, if we look back at what happened in 2016 when Trump won the election, that really was a story of dollar strength. But this year, we’re not so sure, because the story of political uncertainty or even the story around call it the bring industry back into America causing dollar go stronger. That’s conflicting against the signal we’re getting from the Fed. If the Fed does enter an easing cycle in a period of time when the US elections are going on, there’s conflicting signals there. So I would say that the currency story around the elections is not as clear as you would think.

Roman Dubczak: Okay, good. Well, certainly everyone’s watching that movie, that’s for sure. So, Jeff, you’re at the forefront of dealing with our corporate clients. What are they looking at right now and what sort of trades are they putting on and hedging themselves?

Jeff Gabriel: Well, it really has actually been a tale. of you know, it’s a two sided story, if you will, at the front half of the year. You know, in the mainstay industries such as manufacturing, you would see, you know, the regular cash flow trades that would occur. As inflation set in, you know, the dollar’s weakening off. People are inflating the cost margin in their budgets.

You’re seeing a lot of currency hedging. You know interest rates were on the trajectory higher. So you saw a lot of insulation on that front through, you know some pretty simple through complex derivative patterns of trading. Then as inflation tapered and we sat, markets became somewhat stagnant. So as a business abated or that, you know, that that risk management practice abated, what you really saw is an uptake in derivative trades that resulted in financing and derivative trades that were more akin or suited to M&A transactions.

And you really saw that in the project finance space. You really saw it in the gold space. Like certainly there’s a lot of consolidation. So, companies would come in and they would use derivative platforms to hedge the sales, but also use it as a liquidity mechanism to raise capital to go after that asset that they really wanted. Once the owner has certainty on the budget front, you know, we really did see the shift in the client behavior in the client pattern, which I thought was really interesting.

Will it continue going forward? I think we’re in for a little bit of a change as we see the marketplace from a monetary perspective, the monetary policy perspective changed. And then also I think from just an overall, you know, geopolitical policy perspective, I think it’s going to help really drive and dictate the kind of trade pattern that we see out of our corporate customers.

Roman Dubczak: Well, let me push on that a bit the impact of politics on activity. You touched on that geopolitics, like how our clients so far because, you know, keeps going. How are they playing that?

Jeff Gabriel: They’re really giving it a dollar cost averaging in these in these circumstances because the monetary policy, although debatable at what speed the trajectory of markets are going to change, is up in the air. We’re pretty much directionally in agreement, at least in the short run. of the curve. But what I think you’re going to find is it’s the political and policy side with the, you know, the numerous elections, particularly North America, that are in play. You know, if you get a different regime in either the US or in Canada, you know, the view on renewables could change, the view on permits.

You know, just the overall tack, and approach to what’s key and core here in Canada, the energy space, you know, could have different outcomes and outcomes that aren’t expected. So, I really think that prudency is the is the case because when you look at changes at the policy level, the hedge insulates and protects you in the short run or medium term. But your overall approach and how you’re going to, you know, what projects you’re going to choose to develop, can change based on the economics of the policy and what gets permitted and what doesn’t.

Roman Dubczak: Yeah, yeah. No, I hear you. And so Ian, if you kind of think of the last three, four, five years shock, after shock, after shock to markets, you name it and, you know, don’t want to see anymore. We’re good. Thanks. But we’ll likely see further shocks, to the market geopolitically. What’s your view on how this market can behave going into that type of higher risk scenario. Or is it already in a PTSD kind of scenario?

Ian Pollick: I think you’re going to be white knuckle for a while. You know, you go back to this really rolling series of shock that really pushed against what central bankers are trying to arrest. And a lot of it is inflationary, you know, whether it’s, you know, a lack of fiscal conservatism, whether it’s a rise in energy prices. So it’s all had a very, very consistent theme. I think the offset here is that the business cycle is in a very different place than we’ve been the past few years. and so you are weakening, you are seeing slowing and quite materially in some countries, in a country like Canada, for example. That’s the offset. and so I think from a cross asset perspective it’s spectacularly interesting. but ultimately we don’t think it has as much of an impact, just given the weakness in the overall macro economy.

Roman Dubczak: Right. Thanks for that, Ian. Sarah one last question on, FX and specifically, you know, going back to conversations over the barbecue, Hearing a lot on 139 is kind of like the the next waypost. Your views on that? Or do you think we can we go that far in CAD US?

Sarah Ying: Yeah, absolutely. I think the biggest risk around that 139 is really we have forecasted two Fed cuts this year. Once in September, once in December. The market, however, has forecasted a potential third cut. Right now that third cut is priced at around 60%. If we do see more cuts than we expect in our forecast. That’s really where we can see some uncertainty in our 139 kind of handle. That means that probably dollar CAD goes lower than we had expected.

There’s also a risk to the upside as well. If I know we mentioned a lot on politics, but we do see some uncertainty around the elections in November. If we do see, let’s say, equity markets sell off more than anticipated, we can have that risk of flight to safety move, causing dollar CAD to move higher than 139 as well. So there are some risks around that forecast but fairly confident. Call it at the end of the year, we should be between 138 to 139.

Roman Dubczak: Okay. That makes good sense. Thanks, Sarah. Ian I’ll end it off with you in a just a general view on the impact of politics. Capital P politics these days and the impact that would have on, say, the bond market.

Ian Pollick: So, I think we’ve talked about this before. There is no edge trading politics ever. But I think we need a framework to think about it. So the way that we tend to think about it is saying, well, you know, what is the common denominator here in something like the US presidential election, right. And it’s the lack of fiscal conservatism. And these are very reoccurring themes in this discussion. And so when we think about, you know, at the limit, regardless of who wins, what is the outcome for, let’s say, the bond market, we know there’s going to be a growth of bond supply.

And so that bond supply again has to get absorbed. We talked about that being exaggerated by QT, fiscal expansion is largely unfunded. So when we kind of look back and say, well, if you look at every single fiscal shock you’ve seen over the past 30 or 40 years, how is it actually transmitted to the bond market? And it’s not what people think. Now it’s all about capital mobility, meaning that it is non-foreign investors that tend to move their cash around the world very, very quickly. Think back to France two months ago. You know the French bond market is 45% owned by nonresidents.

You can yank your money very quickly. You can cause a lot of disruption and frictions. And so that’s the channel that we think could be disruptive. we do think ultimately that you can have a very knee jerk reaction depending on who wins, resulting in two things higher bond yields, steeper yield curve. Whether or not that’s persistent depends on, again, who ultimately wins. And depending on what their underlying policies are, you may have this kind of offsetting impact from the decline in global growth that ultimately leads to potentially more easing. That exaggerates the dollar. And so we’re really talking about here is this really vicious circle that we can’t answer right now. But it’s all very, very interrelated.

Roman Dubczak: I agree that, you know, foreign investors are substantially making bets on, politics and the bond market. So, we’ll see where that all pans out the next couple of months. Thanks for that Ian, appreciate the views. Jeff, Sarah, excellent conversation today I really appreciate you spending the time And I’d like to thank all of you for joining us today. Really appreciate the business that we do with you and if you have further observations, questions, discussions ideas for our team, please feel free to reach out, thanks.