Lay of the Land - Views from the North

Ben Reitzes:                       Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Darren Campbell, head of Canadian FICC Investor Sales. This week's episode is titled Lay of the Land.

                                                I'm Ben Reitzes and welcome to Views from the North. Each episode I will be joined by members of BMO's FICC sales and trading desk to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep this show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated. Darren, welcome back to the show. It's been many months for you, I believe. You're a busy man, so I finally managed to track you down.

Darren Campbell:             Thanks for having me, Ben.

Ben Reitzes:                       You're welcome. And last week we had our annual Government, Reserve and Asset Managers Conference.

Darren Campbell:             That's right. Yep.

Ben Reitzes:                       What was your main takeaway from our three-day event that brought together 300 clients, issuers, investors from around the world?

Darren Campbell:             Well, there were a number of takeaways. First and foremost, I think there was just a lot of demand for that type of thing. Clients were just really happy to get back out and be comparing notes with their peers and getting a sense of what other people are thinking about. So I would say that was the number one takeaway and it was a great conference in honesty, and I think we're already thinking about how to take it up a notch next year, but it was a really good week. Some really good content on the panels, some really good networking that was happening between issuers and clients, and it was a good opportunity for people to meet some of the specialists at BMO all in one shot. So it was a good week. Takeaways? A lot of the themes you wouldn't be surprised by, I would say that the banking crisis in the US for sure was probably discussed the most.

                                                I think that most people, from what I picked up, expect that situation to get worse before it gets better. And I think you're seeing that translate in just the client activity that we're seeing. A lot of clients are fairly defensive at the moment, and it feels like waiting for the next shoe to drop. We spent a lot of time on inflation during the conference. I would say that, again, the majority thinking that it's a tough go on the inflation front, it's likely to remain very sticky. I think a lot more people in that structural higher inflation camp. And so, again, we're seeing that just in our day-to-day client activity at the moment. I think people are very cautious adding too much duration at the moment. You're seeing people park cash in the front end of the curve, but further out again, I think it's people bracing for a structural higher inflation environment and trading accordingly.

                                                Dollar, a lot of discussion around dollar weakness. BMO has made a pretty large investment on the environmental commodity side where we are now active in carbon advisory, carbon trading, and I think what we're finding is amongst the investor client base, there's a lot of interest in this field. A lot of people are trying to get smart on it quick. And we're seeing people look at it from a number of different angles. And so that was a very relevant team last week as well. Yeah. I mean, those are a few of the things, but I would say generally speaking, its banking gets worse, inflation's sticky, recessions coming, dollars weaker.

Ben Reitzes:                       Very cheery. I mean, the vibe I got was much happier than that, but apparently your takeaways were slightly depressing. Why don't we bring it back to Canada for a little bit here? Though I admit the banking crisis might be worth at least a brief discussion. The thoughts around inflation in Canada, I mean, similar to the broader global themes of sticky higher inflation, but we got US CPI today that was about as expected. I think the whisper was higher and so that really came as a relief generally, and the fact that core services CPI ex-shelter came in at just 0.1% was certainly encouraging on that front and suggests we are seeing some slowdown in underlying inflation pressures.

                                                The Canadian numbers out next week. I have a similarly high headline month over month number at the moment. I'm getting about plus 0.6 or so, and then that should keep the headline steady at 4.3%. The cores, however, do look to slow a little bit. They were really strong a year ago, so it's going to be tough to get that strong again. And as much of the headline gain is in gasoline and the really big deceleration and inflation's going to come in the next two months. So this next week's print is for April. May and June have really, really high year ago increases. So the base effects are pretty sizable, and so it still looks like Canadian inflation's going to get down to 3%, but that doesn't mean rate cuts are coming. So I mean, what were the thoughts around the potential for cuts among the client base and relative to what the market is pricing right now?

Darren Campbell:             I think everybody acknowledges that the goal here is to keep rates elevated for a prolonged period of time. I think that that's the intention. One of the main things that derails that is obviously the situation in the US banking sector getting worse. And so I think it's a binary coming a way and so that's what makes it difficult to really act.

Ben Reitzes:                       Well, that goes back to the way the US is priced. So there's 50-ish basis points priced by the end of the year and 40 whatever. Then cuts price by the end of the year. That's not necessarily odds of them cutting by that amount by the end of the year. It's more like if things really derail, it's a 25% chance of 200 basis points or 50% chance of 100 rather than the modest cuts as they're currently priced.

Darren Campbell:             That's right.

Ben Reitzes:                       Yeah. And same for Canada. At the end of the day, I mean, there's 25 bps by the end of the year, which isn't outlandish I think even in a non-stress scenario. But the way it's structured into the curve, it's more like some small odds on them having to be a lot more aggressive at this point. It is still quite interesting and somewhat head scratching that there's just way more priced into the US than Canada right now in cuts over the next 18 months or so or really 12 months, call it.

                                                By the middle of next year, US rates are... I mean, I discussed this last time with Chris, but Fed policy rates effectively almost 40 bps through Canada, whereas right now we're 58 above. So you're talking 100-ish in the Fed going faster than the bank, which still seems mind-boggling, but the market has gotten more extreme, not less. So who am I to get in the way of that? But at the end of the day, I still have trouble believing that. Even if it is a US banking driven crisis, if the US economy has a meaningful slowdown, Canada will follow suit. We always do. I don't see a scenario in which we don't. And so the bank would likely be forced to act and not fall that far behind the Fed, I think.

Darren Campbell:             Yeah, I don't disagree with that. Canada's never been immune. So yes, it's the old, if the US sneezes, Canada catches a cold thing. That's right. If that hits and that escalates, then Canada's going to feel the effects and be along for the ride. And then the question is obviously around the pace of that and the market's obviously suggesting that it's going to be more aggressive cuts in the US than you need in Canada.

                                                But again, I think we're just pricing probabilities around this outcome. So it distorts it because what you typically see once you get to the end of the cycle, the cuts tend to be a little bit more one-to-one, right? And so that's what stands out right now is how aggressive the cuts are in the US certainly over the next six months versus Canada. And again, that's just distorted by the probabilities and the direct impact of the worst-case scenario in the US banking front.

Ben Reitzes:                       I want to look at both sides of the coin in Canada. So there's still some small odds of a rate hike price. I also want to look at the idiosyncratic weakness in Canada and what might drive that. So let's start on the rate hike side.

                                                So the probabilities over the next probably three meetings and maybe it's four, but I'd say three for sure is probably skewed toward a hike at this point. I personally don't see them going in June or July. It doesn't make sense to me. They don't get enough inflation data unless we get a monster next couple of prints. It just doesn't make sense that they would be pushing rates higher from here. Come the September meeting, we'll know what's happening beyond the June print, which is when we'll probably see that magical 3% number that the bank's looking for. But if we do get high side surprises on inflation, I think, I mean, it's hard to believe the bank isn't willing at least to push rates another, call it, 25 bps higher. They don't have to be aggressive about it, but they do need to show that their commitment to 2% is firm. The market's not really prepared for that, not at this point. Do you agree with that?

Darren Campbell:             I do agree with that, but I think that can be achieved with them sending a very firm message around rates staying elevated for a long period of time. I'm not sure that increasing another 25 does anything at this stage. I think it probably just introduces more uncertainty, more angst for the consumer base. I think you're at a point now where you can just, this was the intent, get it to an elevated level and then leave it high for a long period of time.

Ben Reitzes:                       I'll buy that.

Darren Campbell:             And at the same time, I think that US situation aside, you know pointed out a pretty telling chart this morning, which just shows like-

Ben Reitzes:                       Hold on. We'll get to that. That's the weak side. That's the rate cut side.

Darren Campbell:             We'll get to that. All right.

Ben Reitzes:                       So it's rate hikes for now, but I think you're right. I think you're right. That actually makes more sense. Maybe just signal that rates are not going down anytime soon and what difference does 25 basis points make? Probably not much. The only value is the signal value is just to show that you're puff out your chest and be like, "Yeah, I'm here to fight inflation." Other than that, yeah, it might just mean a harder landing at the end of the day and more pain for households for sure.

                                                So now, okay, let's switch to the rate cut side and the potential for domestic weakness to drive the bank to start trimming rates at some point maybe later, maybe in the very later part of this year. I've said for a while, Q4 is probably the earliest. I still think that. You mentioned the chart I put out today. You can go ahead on that, Doug’s going to put it out later.

Darren Campbell:             Yeah. I just think that like this, it was interesting and I'm not sure as you said, whether or not it's actually getting that much attention and it just shows consumer delinquencies and it shows that it was very suppressed levels of delinquencies over the last four years, call it. It has spiked higher, it is spiked to levels that we haven't seen outside of, I think, 2019. Some levels in 2019, levels that we haven't seen in the last 15 years.

Ben Reitzes:                       So that's for businesses, so just to get the data clear. So our chief economist, Doug Porter, pointed this out to me, but the business insolvencies are at the highest since 2011 for the month of March. And the consumer insolvencies are back to normal. They had been extremely depressed through the entire pandemic period. All the support programs in place and the various things in place to support households and consumers kept those numbers very low. Something changed in March.

                                                I don't know if it was the economy slowing or a program ending, I haven't seen any programs that ended or something ending, that really drove this big change, but you're back to normal for consumers and businesses are at the highest in more than a decade and that doesn't seem to bode well for the economy from my perspective. And we've already seen to some extent that maybe an early sign of that, March GDP, the flash estimate was already negative. So maybe this goes in hand with that a little bit, early signs of softness.

Darren Campbell:             I think everybody's expecting it. We know that the stress is going to start showing on the back of an overleveraged consumer. It's just a matter of time.

Ben Reitzes:                       Yeah, no, time is exactly right. It was always a question of when and the fact that the economy's held in so well so far has been pretty shocking. I'm fond of saying if you told me, I don't know, a year ago, 18 months ago that rates will be a four and a half percent and the economy would be fine, I would've said, "No, you're wrong." And I probably would've laughed at your face, and I would've been wrong. So shame on me. Anything's possible.

                                                So yeah, I mean, the other things to keep in mind in Canada, two things. So we already have that March flash estimate that was negative. In April, we had the public sector strike that's going to weigh pretty heavily on GDP for that month. So that month probably ends up being flat to negative as well. And then in May, which we're only 10 days in, but we have wildfires in Alberta and that could shut in a decent amount of oil production. So about that, saw an headline yesterday. It's currently Wednesday. So on Tuesday I saw a headline stating that about 300,000 barrels of production were shut in at that point in time. We'll see how these fires progress if they get worse. In 2016, the last time we had really big fires in Alberta, about a million barrels ended up being shut in. So I'm not suggesting that will be the case this time, but it can be a very material impact.

                                                So in May, you may get the reversal of the public sector strike, so that'll be a positive. But the offset to that, and maybe a larger negative, will be the decline in oil production. So that's maybe a negative for March, maybe a negative for April, maybe a negative for May. Not good for the second quarter. You'll probably get some rebound in June as production comes back, but still, momentum pretty bad there. And then we'll see what starts to happen in the third quarter. Almost too far away, too much uncertainty to have a strong opinion on that at this point. So where does that leave us at rates? What trades are clients looking at the moment? What do you like? Where is the market headed?

Darren Campbell:             We know that June 1 is always a big theme in Canada and we did some analysis on that earlier in the week, which was again, it breaks down a lot of themes that we're familiar with, but there's some pretty analysis around it and numbers around it. And the trades traditionally are to be long. That's probably the most clear signal is just to be long and it's long in the belly and 70 to 80% of the time in the 30 days leading up to June 1, you're going to do well being long.

                                                Long versus the US would be second to that and then curve would be after that. I think that, with respect to the curve, it's still all the talk and focuses around curve steepening, timing it, where to play it. I think what we've seen is there's been false starts as you'd expect through the year. A lot of it's cleaned up further out the curve. We think that there's still some pain and some uncomfortable positioning in the 2s/10s part of the curve, but there's no doubt that's still what everybody's trying to figure out, what's the right timing for it. Still an extremely expensive trade to have on and so there's a lot of clients looking at ways to just be mitigating the carry.

                                                But I think what we're seeing is that there's no clear view. Like I said, I think that people are really struggling with what to do here. That's the trade that everybody really wants to have on, probably has been burned once or twice already trying to get the trade on. So there's no doubt about it, that trade will perform. It's just whether or not we're talking about Q3, Q4, or even Q1 of next year. Our view would be that you want to show a little patient still on entry, perhaps something closer to the back half of Q3 when there's a little bit more convincing story on the data front. By then you're probably going to have a much better sense of the way things are playing out in the US and that could potentially provide the right entry point. But that is definitely still where most of the most of the attention is.

Ben Reitzes:                       That's fair. I thought maybe the US banking crisis might have been the event to kickstart that steepening. Didn't quite pan out that way. So still trying to figure that part out. But I think going into June 1, the big part of the market I'll be looking at is Canada-US spreads. And we've seen Canada underperform pretty meaningfully, especially in the front end, consistently for a number of weeks now. If we end up getting some outperformance into June 1, I think I would look to fade that at this point there just is too much appetite at this point from the market's perspective to have. Even if I don't believe it's true to have the Fed be that much more aggressive than the bank and longer-term fundamentals, the population growth in Canada is going to make Canada look better from a growth perspective kind of medium term.

                                                And so maybe spread, maybe Canada shouldn't be quite as rich fundamentally as it has been over the past few years. And maybe we shouldn't be base case be 50 bps through the US in 10s and a little bit more in longs. Maybe it's more like 25 or something like that. And that might be where we settle at the end of the day. And near term we could easily see that the Canada-US two-year spreads be closer to flat, whereas we're 23 at the moment. So that would be probably, I think, the one best trade I'd look at my highest conviction at this point, and I know Sam Buckley, our Canada traders, very much on board with that.

Darren Campbell:             Yeah, probably the only other thing to highlight would maybe be the 10s/30s curve in Canada versus the US. You know that that's something that Canada's now out flattened is now at the extreme ends of the range versus the US. And I think what we're seeing is there's just not a lot of demand for the long end. It's difficult to be building books in the long end at the moment. And like I said, I think that there's a number of accounts that are concerned about duration that are in that structurally higher inflation camp. And do we think that the Canadian curve can steepen back out to the top of that fairly well-defined range versus the US of, call it, flat to neg 20? We think so. And so right here around neg 20, it's a good entry level into that trade.

Ben Reitzes:                       I'm going to vote to be a bit more patient. I think mid-20s, maybe 30 is where you want to get in on that one. And just especially going into June 1, at that point in time, if we're still at negative 20 on June 1, or June 2, or June 3, somewhere in that month, then it looks more attractive. But heading into that period, when you do get that structural demand for the long end and general flattening trend, I think you probably want to be a little bit more patient if you can. Maybe you can put a little piece on here, but I think you might see better levels over the next month or so.

Darren Campbell:             Fair enough.

Ben Reitzes:                       Darren, since we already more or less discussed our ideas here, I think I'm going to wrap it up there. Thanks for coming on this week and very much appreciate it.

Darren Campbell:             Thank you, Ben.

Ben Reitzes:                       Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:                           The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.