The Weakest Link - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and Macro podcast. This week I'm joined by Furaz Ahmad who covers the financial sector as part of BMO's Corporate Debt Strategy team. This week's episode is titled The Weakest Link.

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. Furaz, welcome to the show. I thought that you would be particularly topical given what is going on in the market. So great to have you.

Furaz Ahmad:

Thanks Ben. Great to be here. Really appreciate the invite.

Ben Reitzes:

Let's jump right into it. Very wild week in the markets. I think every market. I'm not even sure if it matters what market you'd be in. You'd know that it's been thrill a minute maybe literally. And zooming out to kind of 50,000 feet here, it started last week kind of before you got any kind of financial worries. And it started with Powell coming out and sounding very hawkish and prompting markets to add to their bets that the Fed's going to be more aggressive and those were ramped up pretty notably. And the rates market, you can really see that. And then come the end of the week, we start to get maybe the result of all of the feds tightening and we see where things can go wrong. And so moving past Powell, how has this evolved? Where did this start? And we'll get to where it's going afterwards.

Furaz Ahmad:

It kind of started on the West Coast where one of the top 20 banks there focus on Silicon Valley. They came out in the market, said they were doing an AFS debt security sale. Along with that, they also said they were going to issue common equity in the public markets as well as a common equity private placement as well as a preferred shared issuance. And so I think that announcement altogether kind of freaked out the market a little bit. The market took that as a sign of stress for that specific bank. And so we saw a good amount of weakness on that bank. And then what happened was clients started pulling their cash overnight and that led to a good old-fashioned run on the bank. And once that started to happen, it caused concern across the financial sector across a lot of their US regional banks.

A number of things that are, I think an issue with the US regional banks that kind of precipitated this, they don't have a lot of the regulations that the large money center banks have in the US, the GCIBs. And so a lot of the stuff that they did didn't catch the attention of the regulators and ultimately led to the issues on the liquidity side of things as well as a number of other things as well. And so I think broadly speaking, it started off as an idiosyncratic issue, but it turned into more of a broad regional bank issue and now we're starting to see it kind of spread out to the rest of the financial system as well.

Ben Reitzes:

So let's see if I can get this straight here. As soon as it kind of proliferated beyond just one bank, the Fed stepped in and they put in a facility for other banks to make sure the same type of event doesn't happen. But what seemed to impact the regionals and where they seem to be particularly vulnerable is due to the fact that they have large asset holdings. And a lot of that is in Treasuries and other fixed income products. And the fact that rates have backed up hundreds of basis points in the past year or two has put a lot of those securities well underwater. And then when they need cash, when they need liquidity, they have to sell those, then they take a loss and that hits their capital and then that's where the problems crop up. And I think the Fed has effectively short-circuited that negative feedback loop by enabling them to post their Treasury as collateral, get money back at par and everything's okay at least for a year or two until we'll see where we are. Is that the way things have kind of at least until Monday unfolded?

Furaz Ahmad:

Yeah, essentially. I mean, yeah, the Fed effectively backstopped most uninsured deposits once they saw that a lot of the other regional banks were starting to have these issues as well because from a depositor standpoint, if you have your money at a regional bank or you can move into a large money center bank, then you would rather do that just because of the stability. It's a GCIB. Largely too big to fail to a certain degree. So I think that is what was going on. People were essentially weighing the risks and rightfully so in my opinion. But yeah, so I think that facility certainly helped quell a lot of fears. Market reacted negatively on Monday once they kind of digested that information just because of the broader risk to the system I think. And then on Tuesday we saw the rally as people kind of saw that the Fed was supporting the market.

But what I think is interesting and important to know is with that Fed facility, it doesn't include all securities and it includes essentially Treasuries, mortgage-backed securities, anything that's qualifies for the Fed window. And so, for a regional bank that has a heavy concentration of their assets in commercial loans, non-real estate loans, they would have a hard time getting liquidity on their assets. So if they did see a large bank run, they wouldn't have the sufficient liquidity even with the Fed facility to meet those requirements. So I think that's still a risk in the regional banking system. I think that's why you're starting to see a number of banks deviate away from the broader sector performance wise. And I think that'll continue.

Ben Reitzes:

That's an angle that I hadn't heard yet, but makes a lot of sense. I mean that would be a liquidity issue that they couldn't really solve. Fed can't really easily step in there. So I guess, we'll, hopefully that doesn't unfold. From a liquidity perspective, I kind of half assume the Fed had solved things, but not entirely it seems, and hopefully we don't get anything else from any of the major banks because I think at that point it would be more of a credit issue than a liquidity issue and then we'd be probably in real trouble.

Furaz Ahmad:

Yeah. The major banks have, the money centers have seen big inflows coming out of this. So I think for the most part they're relatively well-supported in the near term from a liquidity perspective. Longer term, let's see how it plays off because usually when deposits come in that quickly it's going to weigh in your margins a little bit. So that'll probably be something in the near term to watch.

Ben Reitzes:

I've had some, fielded some questions asking, well what about regional banks? And just they'll probably pull back on lending on the back of some deposit outflows and my response was, I'm assuming the big banks are going to step right in there more than happily and take some market share. Reasonable, or is it maybe there's a time mismatch there and that means that there may be a bit of a larger macro drag than expected?

Furaz Ahmad:

Yeah, no, I totally agree. I think the big banks are going to take advantage of this opportunity. I mean why not, right? A lot of them have been wanting to buy these smaller regionals for a while. Like consolidation has been a theme in the US banking sector for years now and it's been pretty slow for it to happen. And now you see it with some of the Canadian banks that are buying some of the US banks as well and US regional banks as well. We'll see what happens there. But I think over the next couple of years we're going to see consolidation. We're going to see the number of deposits kind of be concentrated with the money center banks. And just I think an interesting to note is if you compare the US to the rest of the world, the major economies, the concentration of deposits within the top six banks in the US is at the lowest versus the major economies. They're as low as Japan, whereas most economies in Europe as well as Asia, as well as Canada, certainly the deposit concentration is in just a handful of banks.

Ben Reitzes:

Interesting. Okay. Didn't know that. Things have changed, I guess since Monday. We've had a stress on a big name in Europe. I don't want to say that they're a major European bank anymore because I just, I'm skeptical of that given the evolution of the sector over the past few years in that in particular. But is that indicative of where we're heading? Are we going to see more global stress? Are they just a weak link and so the market's leaning on them or is there maybe more trouble to come for large financial institutions? Will this end up being a credit event I guess at the end of the day is the question?

Furaz Ahmad:

Yeah, that's a really good question. I think most investors are worrying about that right now. I think with the situation you're referring to it's ultimately become a confidence issue and investors are looking at the banks globally and they're seeing who's the weakest link effectively and where is the issue going to turn to next. And with that specific bank, they've had a number of issues over the years. I think we all know what they are and there's one thing after another, there's always a ton of stuff in the headlines specifically. This specific issue though, I mean it really came out of a non-event to a large degree in my opinion. It just kind of spiraled out of control, like I said before, just due to confidence.

And so I think if things go okay and end okay for this particular bank, I don't think we'll see a broader issue. If it goes the other way, then there's a risk to the broader system to a certain degree. I don't think it's going to be global financial crisis part two to be fair, but at this point it's a little bit unclear just because there's a number of things that would need to happen and just questions about whether the regulator would step in or not as well.

Ben Reitzes:

Well we've heard that the government's already kind of under pressure to step in a bit and there's been some talks around that. So we'll see how that evolves, but encouraging that this probably is not a larger event, I don't think either of us, either one of us is going to rule that out because you just never know where the next cockroach is hiding. But it doesn't look that way. And just from a broader macro perspective, you just look at the data over the past month or plus even, there's really no sign of real stress. I mean, retail sales for the US were amazing today and I don't really see the market entirely dismissed it because I think fear is really driving things right now, but the persistent strength from retail sales Q1, GDP might be north of 3%, which is, I mean, amazing. And you'll have lots of people yelling about recession and yada, yada, yada, given what's going on in the financial sector, I get that.

But I'm not convinced that most people really pay attention to the bond market that closely that shop at any store really. Regular people just don't care. And when Fed odds change by 50 basis points in a day, you ask anybody in Walmart what they think about that and they'll say they have no idea what you're talking about, get out of my face. And so unless this really hits stocks hard and you see a broader decline in wealth and that really getting into the headlines and more bank fears and all that kind of stuff, then things change a little bit. But for now going into this at least momentum was really good. And in Canada as well, the Canadian data have been rock solid for January. We might get a monster January GDP print and stat scan had a plus 0.3 and I can model out a plus 0.6.

So it probably mean that won't be that strong. But again, good start to the year for both Canada and the US and when you're dealing with that kind of strong macro backdrop, at least we're starting from a position of strength as we go into this period of financial stress where we won't really see the impact on the data for at least a, I mean six weeks minimum, I guess. We'll see. We'll get March jobs in about two to three weeks. I guess that's the first print. But other than that, it's going to be hard to see much impact immediately, I think. Let's look at Canada because this is a Canadian podcast and that's what we do for a living. What are the ramifications for the Canadian financial sector? What are the risks here? Have we seen any real liquidity problems here? Why don't I start with that and then I'll ask the rest of my 1000 questions?

Furaz Ahmad:

So we haven't really seen any real risks in the Canadian financial system. OSFI is monitoring the situation. The Canadian banks have to submit liquidity reports on a daily basis now to OSFI. And so I think they're looking at it very, very closely. Rightfully so. Outside of that, at the start of this whole situation, there was a risk that if the uninsured depositors weren't made whole in the US at those specific banks, that it could flow through to loan losses, particularly at some of the banks that are heavy on the tech lending side. But I think now with that risk kind of gone, I think that's less likely. So that's certainly one thing. The other thing I think that's important to note in Canada versus the US is just going to your earlier point on the securities portfolios. So the Canadian banks for their debt portfolios, whether they're AFS held to maturity. What was interesting was in the US those banks, they don't hedge those portfolios. So their debt securities fixed rate to a large degree and they're unhedged.

Ben Reitzes:

Why? Sorry, but, and let me just step in for a second. AFS stands for available for sale, for those out there who don't know. Why wouldn't they hedge them? That's part of what crushed the US regional, and I just don't understand why you wouldn't hedge your duration risk. That makes no sense to me.

Furaz Ahmad:

That's a really good question. I wish we had the answer.

Ben Reitzes:

There is no answer. That's fine. Head scratching.

Furaz Ahmad:

They used, some of the banks used to have swaps in place. As of late, I mean a lot of them have not, I think as just to boost their returns a little bit. That's the only thing I can think of that makes sense. But when you look at the Canadian banks, the conservative entities that they are, they've hedged a good portion of their portfolios and so they're not as exposed to that fair value markdown risk on the portfolios that they do hold. So I think that's certainly something that differentiates them. Plus if you look at the Canadian banking landscape, we have six big banks, a couple of regional banks. So if you think about it from a deposit perspective, the large banks that have relatively well diversified deposit bases, and so a transfer from one bank to another I think wouldn't have a large impact.

At the regional banks though, you could see a little bit of movement in my opinion. Perhaps not in the regulated banking side of things. In the startup side of things, maybe, in the new neobanks that we've seen. Plus the other thing to note I think in the Canadian landscape is that the big six plus the regionals are all regulated by OSFI and they have liquidity requirements. So the LCR and SOFR requirements, and this is a key distinction versus the US regionals which don't have those requirements. And so I think it just makes the Canadian banks a bit more stable from a liquidity perspective. And so even if they did have a little bit of a run on deposit, which I don't think they will, they would be relatively well suited to meet those liquidity needs.

Ben Reitzes:

Good, that's good to hear on that. I mean there's been a lot of talk in the media and I've been on about it for a long time and everyone else seems to be catching on finally about fixed payment variable mortgages and bank exposure to the extended amortization for pretty much all of those loans. I'm pretty sure they all have to be at infinity and more or less, because that's how the math works when you're not paying any more principle. Where do you see the risk there? I'm concerned about maybe 2025 and people who bought their homes in 2020 and took out a variable rate mortgage and rates were effectively zero. So they were fine, but now they're paying no principle and their interest only, and if anything, their principle might actually be going higher. They're not at risk of a payment shock near term because they likely would've paid down enough principle in the meantime to not get that payment shock.

But when they have to refinance, they might be in store for a surprise. Does that worry you from a bank credit perspective? And does that worry you from maybe more macro perspective, even though I know that's not your wheelhouse, but I'm going to ask anyways.

Furaz Ahmad:

Yeah, I mean that's a really good question. I think we take a step back. When people were thinking about what would be the impact of higher rates, most people thought the consumer would break first. Right. And so I think when you look at the consumer in Canada specifically, the biggest issue is the mortgage issue. And so you have essentially a fifth of the market refinance or renewing every year at higher rates. And so I think the big issue is, or the big risk is the longer this higher rate environment extends, the bigger issue it becomes for the banks, for the system in general. And so we've seen essentially one year of high rates likely see another year of relatively high rates, DBD.

Ben Reitzes:

Not if we keep going like today. We'll see.

Furaz Ahmad:

Yeah, but I think the banks are being very accommodated right now. And so I think that's their policy and rightfully so to protect consumers, to protect their own balance sheets because if they aren't, they would force people into foreclosures, bankruptcies. And that's not something that they would want. And in particular because if the person is making their payments but now they have to refinance at a rate that's two to three times higher, then that would be tough for anybody. And so I think they're thinking long term as they should be. And so I think over the next year or two we'll likely see the banks kind of hit the limit of what they're allowed to do from a regulatory standpoint, whether it be adding payments to principal where people can't meet principal payments on an ongoing basis, taking interest only payments on a longer term basis while they can. And so I think they're going to start to get flexible. They already have from what I've heard as well. So I think that'll continue.

Ben Reitzes:

I've heard the exact same thing. I mean everyone's doing their best to make sure consumers can cope with where we are, but it is, it's kind of like a looming dark cloud in the background or I don't know how dark it necessarily needs to be. If you really, I mean, really think about it, 2020 to 2025, you got five years of income growth in there as well, which has been really strong over the past year and probably continues through most of this year if things don't go worthy pair shape near term, and so that compounded income growth does make a difference. And so that'll provide some cushion, I think for a lot of people and payments, some people have opted already to increase their payments, which is I think notable. And so it's kind of like a medium term headwind for Canada. And I can see us maybe underperforming a little bit relative to the US from a broader macro perspective because of this, but it doesn't have to be a huge negative per se.

And really it's only if rates can stay up here. And I think the past week has shown us that that will be really hard to do over a long period of time. That being said, I am quite concerned that there is kind of a scenario where the Fed backs off a bit here, the bank backs off a bit here, and whether that's rate cuts are just not moving on rates for the Fed and inflation stays sticky. Yesterday's USCPR report that all the core metrics were higher on a three month annualized basis. All of them. Pick anyone you want. They're all up. That's not good. That's not the momentum they want to see. And so it doesn't look as though inflation's been broken yet. Maybe if this morphs into something worse, this financial crisis morphs into something worse that drags down inflation. Oil was down at some point today, 7%.

So that'll help. I'm not sure how much it helps core, but it's got to be at least a little bit of a drag on that front. So I'm worried if they back off and inflation stays high, they'll be a lot more work to be done. And that might mean higher rates at the end of the day and more inflation, longer inflation for all of us. But that that's probably a conversation for another day. So I think at this point, we'll leave it there. I mean given we're not allowed to say specific names here, we're going to quasi skip the trade idea part and given market volatility, hard to really pick out an amazing trade idea at this point. But I think it's worth highlighting, at least Canada, US spreads at this point. If you look at 10 year and 30 year spreads, we've had huge volatility, but we're not all that far from the extremes.

And if Canada has another bout of out performance, we're getting smashed today, but if we do have another bout of out performance, that is definitely worth fading in 10s. Somewhere in the 90s, maybe you get to 90 through the US. You definitely want to do that and longs 90 plus, 90 to a 100, I think you want to be fading those moves. So something at least to keep in mind, lots of volatility that may provide those opportunities to fade those moves. And other than that, good luck everybody out there. It has been an interesting week and I'm sure we're not done yet. And Furaz, thanks for coming on.

Furaz Ahmad:

Thanks 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 4:

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