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Talking Terminal - Views from the North

FICC Podcasts Nos Balados 01 décembre 2022
FICC Podcasts Nos Balados 01 décembre 2022


Disponible en anglais seulement

In this episode, Chris D’Onofrio, a recent addition to BMO’s Canada swap trading desk, joins me to discuss next week’s Bank of Canada policy announcement, where he sees rates and the curve heading, the coming shift to CORRA and his favourite trade ideas.

As always, all feedback welcome.


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About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Disponible en anglais seulement

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week, I'm joined by Chris D'Onofrio, a recent addition to BMO's Canada swap trading desk. This week's episode is titled: Talking Terminal.

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," dot, R-E-I-T-Z-E-S, "@bmo.com." Your input is valued and greatly appreciated. Chris, welcome to the show. First time out here. How long have you been with BMO?

Chris D’Onofrio:

Yeah, it's been just over two months here.

Ben Reitzes:

Okay.

Chris D’Onofrio:

So new. Two months in at BMO, two months in the Canadian market, so it's been a good two months to start with, I'll say that for sure.

Ben Reitzes:

But then you'll have fresh ideas. You're not old and jaded like the rest of us.

Chris D’Onofrio:

Yeah, yeah, yeah. Yeah, exactly. Yeah. Well, yeah, I will say I think we passed the time of pandemonium in the dollar market just as I was leaving and got here just in time for the pandemonium in the CAD market.

Ben Reitzes:

So, we have the Bank of Canada next week.

Chris D’Onofrio:

We do.

Ben Reitzes:

December 7th. The market is on the fence as to what they're doing next time.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

We have 50 basis points. I think actually most Canadian banks have 50 basis points, from what I looked at in the Bloomberg survey recently. So, I mean, where do you think we're going here? Is the bank going 50 and then maybe they're done, or is it 50 and then the doors open? Or maybe a few 25s?

Chris D’Onofrio:

Yeah. Yeah. It's interesting because a lot of the banks probably are on the same camp, but it's not as uniform across the street, I would say. You look at a lot of the counterparties, a lot of the fast money guys, a lot of the people who trade meeting gaps, and it is quite two-way around the point where December becomes fairly priced. Now, after today's rally, it's a little bit on the richer side, implying something like 33 or 34. I think fair value for that meeting is somewhere in the middle, for sure. I would lean towards the 50 side. I am with you on that and I think that makes sense, but I don't think it's as much of a certainty as some people might suggest.

So, I think fair value of that meeting, if it's around 40, going into the bank next week, I think that probably makes a lot of sense. With that said, 50 and done seems possible, although a pretty remote idea for me. I think it's you either go 50/25, or a couple of 25s and kind of leave it on the table for March meeting. But I think, to go from a few months ago, we were doing 75, to all of a sudden, surprise, 50, to 50 and now we're done. It would be counterintuitive, and it would, again, go against the clear messaging that I think the bank was shooting for at least at some point earlier this year, if not last month.

Ben Reitzes:

You said clear messaging. That might have been the oxymoron part there for the banking.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

They've had trouble being clear.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

But I mean, at this point, I think you're right. One thing he did make clear is in both of his recent appearances, Macklem, he was like, "One big step or two small steps." So, like 50 or 25 at least.

Chris D’Onofrio:

Yeah, I think cumulative 50 should be a guarantee.

Ben Reitzes:

Exactly.

Chris D’Onofrio:

Right?

Ben Reitzes:

And then, after that it's kind of, meeting by meeting, we'll see how things go.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

The data leading up to this point have been very mixed, so like inflation was not as hot as maybe feared, but it wasn't cool by any stretch of the imagination.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

And the CORRA numbers were both ticked up, even if the three-month annualized rate of both of them went down. So very mixed on the inflation front, but not really cooling. And for GDP that we already have in hand, the headline was way better than expected. I mean, doubled expectations, but the details were really soft. But then, on the flip side of that, really big upward revisions to 2021, really, as much as anything else. And that means there's, at least in theory, that much more excess demand in the economy, and that's something the bank's been harping on for months and months. For me, that argues pretty meaningfully toward a 50. That's why I think we're still in that camp as much as anything else. And the inflation numbers, as well. Maybe the three-month annualized slowed a bit. You're still way over 2%, and you probably shouldn't be ringing the "all clear" on one month of numbers.

Chris D’Onofrio:

Yeah. I totally agree with you there. I think some people in the market are definitely having some trouble seeing the forest from the trees a bit. We've gotten into, the past couple weeks, this kind of "bye, bye, bye" mentality for duration in general, and it's like, okay, yeah, monetary policy is starting to work. We are seeing a bit of softening, but we have to remember that inflation is still very high. Job growth is still there. There's still access demand, like you said, in the economy.

It's not like, "We did it, guys. Great work." It's like, "No, don't start celebrating just yet. We still have more to do," as Powell kind of said today in his appearance. So, yeah, I think you're right. I think people are getting a little bit over-excited on the buying side and on the softening side, but the data doesn't really back that up just about yet. So, there's still, going back to what we said before, cumulative 50 for sure. And then, I think there should be pricing for at least a chance of 75 or 100 total from this point to the end of the cycle.

Ben Reitzes:

I think the words they'll start using, "We'll make our decision meeting by meeting," instead of after that pitch is done.

Chris D’Onofrio:

Which is fair. Yeah. Which is totally fair, right? But the idea that... What the swap curve looks like right now in the ultra-front end, right?

Ben Reitzes:

What does it look like?

Chris D’Onofrio:

Exactly, yeah.

Ben Reitzes:

What does it look like?

Chris D’Onofrio:

So right now, we have just over 50 priced into Dec and Jan. 53 is what we're closing out today after today's rally. Which kind of goes against what we just said, right? That's like, okay, 50, and then a very, very, very small possibility of anything beyond that. It's like, okay, yeah, maybe, but you got to give them a chance to do 50/25 or a sequence of 25s, et cetera. Leave it on the table. And then, not only that. I do think Jan, I think as you've said before, you released in some of your notes how Jan is a very strong pay right now. I completely agree with that. I think there should be at least five more basis points priced into that meeting.

But even beyond that part of the curve, it's like we go hike, hike, hike, we hold for a couple of months, and then we start aggressively cutting. And it's like, "Okay, let's slow down. First of all, let's think about one thing at a time. Let's get the hiking cycle right, which we don't even know if we have that priced in properly." And then, it's like, "Well, we don't know what data's going to look like beyond mid of next year. We don't even know what data's going to look like next month. How can we begin talking about this aggressive cutting cycle towards the end of '23 and the beginning of '24?" It's kind of all over the place right now, the very front end of the curve.

Ben Reitzes:

And so, adding to that, still I see the risk for inflation. We've been wrong for... I don't know how long. Misjudging the pace of inflation. And why is it just going to evaporate? And it's interesting, the market's kind of just gone... One good US CPI print. Some decent prints in the world. Canada was arguably okay. Mixed. And all the fears just kind of melted away. And today, when Powell was talking and they had all the questions, I don't think there was one question on inflation. It was all about labor force participation, all sorts of other things, but nothing about inflation. And I was like, "Well, I don't understand. Is it done?"

Chris D’Onofrio:

People want good news. That's the problem. People want to be told everything is going to get better.

Ben Reitzes:

Certainly seems that way, and that's the risk. And then, we have the melt up in risk today, and that only adds to the likelihood that rates will have to go that much higher.

Chris D’Onofrio:

Yeah. Yeah, exactly. And I think the other thing that's worth mentioning on that front is some people, especially people closer to my age who have maybe only been in the market for a few or five or whatever years and haven't seen... Before this hiking cycle, rates were at ultra-low levels and had been for quite some time. And people kind of just think, "Oh, we're hiking and then when everything's fixed, when the problem's solved, we're going back to close to zero rates," which is possible. Sure. But there's also this entirely other regime shift that can occur where we can go back to 2% overnight for an extended period of time, and then that's our new baseline and we hike and cut from there. It's like, sure, why can't that happen? But a lot of people are just operating under the assumption that things are just going to go back to the way they were five years ago, which I-

Ben Reitzes:

I will take that bet against.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

For sure.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

Strongly.

Chris D’Onofrio:

Well, I'm not saying it's impossible, and I get why guys my age are, or around my age, are making that assumption when they're trading. But there's not enough of probability assigned to that not happening, I think, priced into the swap curve right now.

Ben Reitzes:

Okay.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

So, too inverted-

Chris D’Onofrio:

Too inverted.

Ben Reitzes:

... I guess would be the way to word it.

Chris D’Onofrio:

Which, I think a lot of people... I mean, you see that, right? We were talking earlier about the five-year point. That's the new trade on the street that everybody's looking at, whether it's paying it outright, paying it against 2s, paying 2s, 5s, 10s, selling 5s outright. Whatever.

Ben Reitzes:

But haven't people been looking for months?

Chris D’Onofrio:

Yeah.

Ben Reitzes:

And it just keeps going?

Chris D’Onofrio:

That's the trouble, right? Jason and I were calling it the "Canadian widow maker" last week.

Ben Reitzes:

It is.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

And cash. It looks exactly the same, more or less. I mean, just different extremes, but both just met. Where is this flow coming from, one, and when does this end?

Chris D’Onofrio:

There's a lot of duration in that trade, for sure. And I don't think people have been buying duration in necessarily a risk-off type sentiment. I think it's just there have been duration needs, and going back to what we said before, people are absent-minded of the fact that we could entirely, in a year or two years, still have rates above 2% overnight. Or above 3% overnight even, right? So, I think that overwhelming flow of buying duration in the belly, buying duration in the belly, and anytime it sells off, "Oh, it's just another buying opportunity. It's not anything meaningful."

It's like, okay, well, that's put pressure on for the past, as you said, months and months. And, yeah, we saw guys coming in a month ago to start paying it, start wading in, taking shots as deepeners, et cetera, and then two weeks ago start stomping out and going the other way. And now some people are reinitiating it. It's very interesting that it has made it this far, but I do think we will see, in the next couple of months here, unless we go crazy and go to 2% 5s or anything like that, I think we will see a reversal on that. And I think the timing on the steepen or the timing on the 2s, 5s, 10s is never going to be perfect, but I think especially come the new year when people have fresh capital, we should see a bit of the tide turning in terms of people wanting to deploy one way or another, paying that point or selling that point on the curve.

Ben Reitzes:

At some point, central bankers should also highlight that risk, that the rate environment could be very different than the past decade.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

And rates will just stay relatively higher. That's not saying that we need to be at 4, 5, 6%, but-

Chris D’Onofrio:

No.

Ben Reitzes:

... not 0.

Chris D’Onofrio:

But not zero. Yeah, exactly.

Ben Reitzes:

The odds of zero need to go down substantially.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

And pricing that into the spectrum of probabilities should be probably far lower than it is.

Chris D’Onofrio:

Yeah. Yeah, I totally agree. There's been almost no talk of that, to be clear. Right? It's not like-

Ben Reitzes:

Not sufficient. They're very focused on where we are now, and they don't really look past getting inflation down.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

Because they don't know. And in fairness, no one really knows, so I give them a bit of a break on that front. And that's just my bias. I think inflation stays higher. I've outlined that a number of times. I just don't think we go back to the one-and-a-half percent inflation world that we lived in for 15, 20 years.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

It's going to be at least a point higher than that generally, if not biased even higher than that. And so, if you look at normal rates, they need to be that much higher. At least a percentage point higher, and probably more than that. And especially if you have labor force pressures persistently that keeps wages higher, you might want to keep rates even higher from that perspective, as well. So that's just my bias, so I don't blame them too much on that.

Chris D’Onofrio:

I don't know that how much weight this argument carries. I don't think it's that much, but I think it's worth asking you your opinion on. Maybe you've discussed this on the show already at this point. But the one argument I've heard from guys that are very bullish, buying duration, happy to price in cuts to an already inverted curve, happy to sell December meeting at 35 implied or whatever it is, receive I mean, to be clear when I say "sell," is the impact that incremental rate hikes, once the monetary policy lag of a few months or a few quarters has happened, is going to have on housing in Canada, because Canada is a naturally more leveraged country when it comes to housing than most other G10 countries. So, do you think that argument has weight and should have any merit in terms of what's being priced into the swap curve right now?

Ben Reitzes:

So, three months ago, I would've said, "Yes, for sure. A hundred percent. And Canada's going to get annihilated by rate hikes. If rate go over 4%, we're all going to crash."

Chris D’Onofrio:

Yeah. It seemed like it was going to be Armageddon. I was going to buy a mansion in six months. It was going to be awesome.

Ben Reitzes:

But then I got more information, and what I thought really was not possible turns out to be the truth. A large chunk of mortgages don't actually move with rates. About half of the variable ones move with rates, more or less, and even then, not fully. And the other half don't move at all.

Chris D’Onofrio:

Right.

Ben Reitzes:

At least those taken out through the major banks. The non-bank lenders tend to move their payments as rates move to keep the amortization schedule a little bit more constant. But a number of banks, at least about half the market, don't move payments at all no matter what, pretty much. And the criteria for them to force a payment change is something that we may not even get to. You got to get to 105% of the original borrower amount.

Chris D’Onofrio:

Right, right.

Ben Reitzes:

So, to get to that point is really not that easy. And so, if you had the lowest rate at the highest price, and then maybe if then you had that rotten luck, then sorry. But that is not the majority of household. So, if you've had your mortgage for a year, for example, you paid off whatever few percentage points, that means you can add those percentage points back on at another 5%, and that takes years to do. Or a much higher rate. So, there is a lot more cushion at least in the near term than it looks.

Where it could hurt is in if in 2024, 2025, when those mortgages taken out in 2020 and 2021 that were five-year term variable mortgages, when they need to renew, and if rates are still high, the payment shock on those folks is going to be very challenging. So, luckily, wages go up, what, 3, 4, 5% a year. The compounding of that will help a lot. But still, you'd be in for a pretty meaningful shock, and so there's kind of a medium-term downside risk for Canada that's just looming out there if rates don't go back down. But in the meantime, all it means is that rates need to go even higher than you otherwise thought, because we're not as sensitive to rates as we thought we were, even with all that debt.

Chris D’Onofrio:

That's the argument. Yeah, yeah, okay.

Ben Reitzes:

Even with all that debt, when payments don't change, it doesn't matter.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

It doesn't matter how much debt you have, because your payment's not changing.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

So, unless people are really adamant that they need to pay down more... And we are seeing that. I'm told that a good amount of households are increasing their payments. But they're doing that because they can afford to, and so that's not going to crush them. They're going to do it because they can. And so, put it all together, we just aren't as rate sensitive as we thought we were. We still are. I'm sure everybody is, and that's fair. But you look at household checking balances: still extraordinarily high. Savings rate actually went up in the third quarter instead of going down, and maybe that's a change in preferences.

It probably is, given higher rates and higher inflation, but there's still that much more ammunition and people are still clearly... It looks as though at least they're still willing to spend. We'll have to see how things pan out over the next bit. I still think there's downside for housing. Don't get me wrong. Prices still have 10 to 20% downside. That mansion you're looking at, maybe it'll work out.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

I don't know. It's still damn expensive here, to say it at least. But we're just not quite as sensitive as maybe everybody thought. So, we won't necessarily need to lag the US to the same extent. Where they go is largely where we'll end up, probably less 50 basis points. And so, if there's upside risk to US policy rates, there's the same risk to Canada, almost certainly.

Chris D’Onofrio:

Yeah. Okay. Well, there you go then. So, we've debunked that argument, and pay Jan meeting until it's at 65.

Ben Reitzes:

Yes. Exactly. I think that is a good trade.

Chris D’Onofrio:

Right. Yeah, agreed.

Ben Reitzes:

So, I think that covers off the bank pretty well.

Chris D’Onofrio:

Yeah.

Ben Reitzes:

I guess we'll see what next week brings, but not done yet clearly. I would like you to talk to our listeners about the coming changes to the swap market.

Chris D’Onofrio:

Yeah, definitely.

Ben Reitzes:

And the shift we're going to have from CDOR to CORRA, and some timelines, and how you think this will evolve.

Chris D’Onofrio:

Yeah. Yeah, for sure. So I fortunately got the pleasure, or will have the pleasure, of seeing the credit to non-credit component floating rate transition in both the US and Canada, so I can speak a bit to what we saw when we went from LIBOR to SOFR last summer when I was in the US market. But just dates-wise and timing-wise, yeah, let's start with that. For CORRA first, as they're calling it, the transition is supposed to start occurring at the beginning of next year. So, January of next year is when brokers will be, for us dealers, trading with each other. Brokers will be set up to make markets in CORRA-type products, swap spreads, swap flies, et cetera, stuff like that, and that's when we will be comfortable making markets for medium-term swaps in both CDOR and CORRA for whatever clients are looking for.

Now, we would encourage clients to, as of January of next year, whether it's transition their portfolio or whether it's just for initiating new risk, start to look towards CORRA. It's not going to happen overnight. It didn't with SOFR. But that gradually... And I think it'll probably take over fully or close to fully by the middle of next year. So if people were to start at the beginning January/February into the spring to start really transitioning any new risk, that's when we expect liquidity to start shifting from CDOR to more CORRA-based products. You'll get tighter spreads, et cetera, in the CORRA products I would expect by the midterm of next year.

The other thing worth mentioning is that's when I think we would expect futures in the front end tied Quora to start picking up in terms of liquidity. Right now, what we're seeing is obviously backs are still... I want to say very liquid. They're not very liquid, but they're more liquid than CORRA. But the CORRA futures are gaining some traction. We trade those from time to time. You can trade them. You can't get a lot of size done in them, but you can trade them. So, I would expect the pool of liquidity to start migrating towards the CORRA futures around the same time. I would say the first few months of next year and into the middle of next year.

Ben Reitzes:

When does CDOR stop altogether? When does the backs market effectively shut?

Chris D’Onofrio:

Yeah. Yeah. So CDOR cessation is in June of 2024. So, we still have some time where we'll still have risk. If we trade CDOR against CORRA at some point next year, there still is risk there. There'll still be about a year of possible variability on any trades going there, so that basis actually should become very active. But if it's anything like the US was when we transitioned from LIBOR to SOFR, what'll happen is a lot of dealers will start worrying about their 1-year or 18-month or whatever until fallback CDOR risk in the US SOFR, LIBOR obviously. And then the forwards, because there's a fixed fallback point, they should be stagnant. As long as guys can hold it on their balance sheet, I don't think there'll be a lot of 30-year ODOR trading or anything like that. I think guys will worry about where the risk is, which is in the next two years or next year and a half, and go from there when making markets.

Ben Reitzes:

Okay. Cool. Good update. Thank you for that.

Chris D’Onofrio:

Yeah, yeah, of course.

Ben Reitzes:

What are your favorite trade ideas other than... You can't say "paying Jan"-

Chris D’Onofrio:

Okay.

Ben Reitzes:

... because we've already said it four times, and so we need a different one.

Chris D’Onofrio:

Yeah. People have gotten the message on that front. I think the one thing that I do right now, the level's getting to optimal. It's around optimal. But going back to what we said before, a lot of people like 5s on the curve, on the fly, et cetera. I think there are good and less good ways of expressing that trade, and we've seen some guys experimenting with picking apart the forward rates three years forward and five years forward, et cetera, and optimally paying that curve in a way that carries well.

So, I think the best way to target that piece of the curve is probably paying three-year forward two-year rate against something that'll carry well. So three-year forward two-year against five-year forward two-year. Pseudo 3s, 5-7s, if you will, with a bit of a bias on the 5-7s. That'll actually take advantage of the cheapness of the 2s, 5s, 10s, or richness depending on how you look at the curve, while maintaining... I think it has a five or a six basis point 3-month carry.

So, if you put it there and nothing changes in the next three months, you're still going to be up a bunch of money, even if the trade hasn't started to pan out in terms of spots starting terms. So, I think that's kind of the best way to take advantage of that market dislocation at the moment, and that's probably my favorite trade. So that's something that maybe people would be comfortable holding on their books for the next six months or whatever; however long it takes to correct.

Ben Reitzes:

All right. That sounds good to me. I guess I'll have to take a look at the lineup.

Chris D’Onofrio:

Yeah. Yeah, yeah.

Ben Reitzes:

My favorite's still going to be "to pay Jan," but I can say that because it's my podcast, so I can do what I want.

Chris D’Onofrio:

Hey, me too. Pay Jan, everyone.

Ben Reitzes:

So, thanks for coming on, Chris.

Chris D’Onofrio:

Yeah, of course.

Ben Reitzes:

I appreciate it. And given your natural podcasting abilities that we've just displayed here, I'll have to have you back on soon.

Chris D’Onofrio:

Yeah, look forward to it. That'd be awesome.

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 4:

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.

Benjamin Reitzes Directeur général, spécialiste en stratégie – taux canadiens et macroéconomie

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