More to Come: Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Sam Buckley, head of BMO's Government in Canada Trading Desk. This week's episode is titled More to Come. I'm Ben Reitzes, and you're listening to Views from the North. Each episode I'll be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep the 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. Sam, welcome back. I think the last time you were on was January when the Bank had just paused, and now they've just hiked, so very convenient.

Sam Buckley:

Thanks a lot for having me back, Ben. Yeah, a lot's changed from January to March and then from March to June again. It feels like we've been around the sun a couple times since then.

Ben Reitzes:

Lots has happened for sure, and the hiccup in the U.S. on the regional banking side clearly made some waves, but that's past now and we're back to rate hikes. The Bank lifted rates 25 bps in June, and we're expecting another 25 basis points in July. A few reasons for that, or one, I guess. Firstly I should say it is still data dependent. We get CPI next week. There's the business outlook survey still to come also next week and then there's another jobs report, and we get all that before the Bank. If it's uniformly bad data, that could change things, but I'm skeptical of that at the moment. I'm getting a pretty decent reading for CPI at the moment. We'll see if that changes, but my preliminary forecast is pretty solid, especially on the core front. That just reinforces the bias for further hikes.

This morning's retail sales report was pretty strong. Even if the volumes were not huge, the fact that consumers are still willing to shell out money, even if it's for not necessarily more stuff, that just signifies how strong the consumer backdrop is at the moment. That is one of the things that the Bank had highlighted in their policy statement and in the minutes that we got this afternoon. It's Wednesday the 21st at 4:30 at the moment. We got the minutes earlier this afternoon, and they highlighted consumer spending strength and housing strength and just broader economic resilience. We don't see any signs that that's faded at all. Sam was with a client yesterday on a rooftop patio bar type thing at a hotel.

Sam Buckley:

At 2:30 in the afternoon.

Ben Reitzes:

On a Tuesday.

Sam Buckley:

On a Tuesday, and it could not have been more busy. Yeah, things are good, at least in Toronto. At least in this downtown core, things are good. There's a couple restaurants I've been to in the past few weeks on a Monday and Tuesday, and completely booked up. Yeah, and the rooftop patio yesterday, that was all booked up too. Yeah, I think the Bank of Canada's obviously seen something, and the data's been quite resilient. Housing's been very resilient too. I mean, you can't really fault them for hiking again or hiking again in the future. I think we have almost two more hikes priced in by the end of the year, and I think it's going to take a catalyst to change that narrative from happening rather than something to change to make the market pricing hike.

Yeah, I think that right now, in the market anyway, the biggest thing for us would be positioning. I don't think anyone's really expected this, especially after the regional banking crisis that Ben mentioned earlier. I don't think anyone really anticipated the Bank of Canada restarting after the pause after this. I think a lot of accounts and people loaded into steepeners, and this continued bear flattening has not let up at all, especially with this morning, the UK having higher CPI numbers as well. The candidate curve is quite inverted relative to the other developed markets.

That being said, it's still a pain trade until we get a catalyst to change that, whether it's monetary policy. Well, it's only going to be monetary policy actually that's really going to change that, because supply doesn't seem to do anything. I think until we get that catalyst to change the Bank's narrative, I don't see the curve steepening at all really, anytime soon. There's just too many people in steepeners. I think that's the biggest thing that has been taken away since the Bank's surprise hike, which wasn't really a surprise because it was 50/50, but you would never have guessed that by the market reaction. Clearly positioning was an issue there, and it hasn't let up at all.

I think today we hit the high yield in Canadian 2s, where long bonds really haven't moved all that much at all. I think that as we get to these higher yield levels, especially if we keep drifting higher in yield, which so with the algos having control of the market a little bit here, it seems like we're going to keep getting higher yields again unless we see a catalyst to change that. That to me just means more picking away further up the curve from insurance pension, other asset managers that have LDI mandates, and then 2s will continue to drift higher in yield until something changes.

Ben Reitzes:

You mentioned catalyst, and that's something I've been saying for a few weeks now, just a lack of a catalyst to change that narrative, and it's hard to see one. I mean, go back to the start of the year, and the catalyst that it took to drive rate cut expectations was the regional banking crisis, which I'm pretty sure nobody saw coming at that time. You'll need something like that at the moment and in the near term at least to drive any real material steeping in the curve. If things just evolve and then there's no real surprise negative shock, we probably continue to grind flatter. That's going to probably cause, again, as you mentioned, continued pain in the market, and that's probably the most likely path forward.

We are extremely inverted, so I think a big move here is probably not quite as likely, but again, there just isn't that big catalyst for steepening. We're going to have to sit here and wait, and maybe the Bank of Canada hikes us into recession. Maybe the Fed does the same thing in the U.S. That's not going to happen imminently, though. If they hike again 25 bps in July, that puts us at 5%. That's a big number. I think part of the reason why everyone's been so skeptical the Bank could continue is because they were skeptical in the first place the Bank could get to 4%, or even 3% if you go back a year or two, and now at 5%, still skeptical.

The reality is if you look at the numbers, and just looking by mortgages, if you think about it this way, the most rate-sensitive part of the economy should be housing and people who have mortgages. If in any given year only 20% of mortgages roll over and only about a third of households even have mortgages ... a little bit more than that, but let's just call it a third ... you're only impacting a very small share of the population in any given year, and it takes time for all this to pass through, to have a large enough impact when you have so much money sloshing around, when you have wage growth as strong as it is, when you still have some savings in people's bank accounts from the pandemic and just an appetite to spend.

People are still to some extent revenge spending. Maybe not to the extent they were, but it's still there. There's still strength in travel spending. There's still strength in restaurant and entertainment and recreation and all that. That's been pretty consistent and hasn't faded hugely yet. As long as that's the case, rates are going to take time to have an impact. If the Bank really wants to slow the economy and really wants to slow inflation fast, the only way to do that is to continue to jack rates higher, so 25 in July makes sense. After that, I don't know.

I personally fear for what will come in 2024-2025 for all those mortgages that do roll over. I just feel bad for folks that have renewals coming. I don't know if the Bank feels that way, but I do. I think that risk is there, but I think at the same time, maybe the Bank just hikes and then they leave the door open, clearly. Instead of pulling a January and pausing or conditional pausing, they just leave it wide open and the market continues to price something every meeting, but they just don't ever go.

You eliminate the risk that people are like, "Oh, well, the Bank's done. Let's jump right back into the housing market." If you get rid of that dynamic, maybe, maybe, maybe that buys them a little bit more time to wait versus what they've done in January, and seeing housing mounts back and seeing consumption stay strong and all that. I don't know. I guess we'll have to go to more rooftop patio bar, poolside, swimsuit-clad people and places, to see what goes on there.

Ben Reitzes:

We talked about the curve. I mean, do you think it can go more inverted? 2s/10s is at neg 125. 10s/30s is minus 16, 17, give or take. 5s/10s is minus 34.5, something like that.

Ben Reitzes:

35, yeah. I mean, am I right? Do you agree with me that if we flatten more, it's probably a grind, it's not going to be a huge move? Because we do have two more hikes almost priced in at this point.

Ben Reitzes:

Yup. It's hard to keep going from extremes.

Sam Buckley:

Yeah. We're starting to see accounts fade this a lot more than we have, I would say, in the past couple months, especially in 10s bonds. Minus 20 has been the resistance level there. I think it's almost hit it twice, once a year ago and then almost once a little while ago, so I could see more people starting to fade it. That being said, we do have what's shaping up to be an okay month, which would be supportive of the long end especially. Also, there's a number of accounts that will have to do their June index rebalancings at the end of the month. Some international accounts do that, so that will also be very supportive, I would say, at the long end.

That being said, I think you're also getting to the point we talked about where you're seeing a decent amount of accounts line up to start to sell. Can we go flatter? Yeah, absolutely, but I do agree it's not going to be a shock where it's 10 basis points, knee-jerk reactions, like it was when the Bank hiked. I think it'll be a slow grind, just based off of flows and the summer drift. Someone that I used to work for always said that summertime causes the most pain for the most people, due to a lack of liquidity. I think the most pain for the most people is still probably a flatter curve. I think that it could be a slow grind, barring the advent of that catalyst that we talked about.

Back to the Bank, I think you mentioned whether or not the Bank cares about hurting the renewal people. I think the one thing that the Bank is very aware of is how much housing's actually ramped up pricewise and how much wealth has been created from that. No other people are spending that wealth. Creation or not, they still have, I would say, a decent amount of cushion on that asset that they bought, whenever they bought it. At this point, it's higher. I think the Bank is also aware of that. It's feeling bad for people who bought Apple 10 years ago.

Ben Reitzes:

I don't feel bad for them.

Sam Buckley:

Yeah, exactly. Anyway, I think that the Bank is aware of that, and I think that there's a little bit of not a lack of hesitation to go. I think it's still front-page-of-the-paper risk, and I think that inflation is hurting the most vulnerable of our population and I think they're very aware of that. I think they're going to do what they can to help that segment of the population. If, like you said, it's a small amount of people every year percentagewise in the population that these hikes are really affecting, I think they're probably going to be okay with that risk/reward to get inflation under control, and spending under control.

You go everywhere, all the time people are spending money, whether it's restaurants, whether it's stores, whether it's entertainment events. I mean, look what the City of Toronto was doing when the Leafs were in the playoffs. It feels like ages ago now, but everything was happening. I don't think there'll be a huge hesitation on their part until they actually start to see some cracks, which we haven't seen any cracks really.

Ben Reitzes:

No, there have not been, not many. There's occasional things that come up, like insolvencies rose a lot in March, but then they fell back in April. Maybe a false sign there and nothing consistent, I guess would be the way to put it. Job growth has slowed, but if you look at the last month, the details were not nearly as bad as the headline suggests. All the losses were in youth and really just a lackluster summer job market, whereas the core of the workforce 25-to-54 saw really good job gains. We'll see what the next job report brings but that was not a particularly soft reading, despite what the headline suggests. Things have held in pretty good.

Something the Bank mentioned in the minutes is that Q1 growth beat their forecast, and there it looks as though the way the second quarter's shaping up, that might also beat their forecast. The Bank's models and their inflation forecast is driven by how much output gap they have, how large the positive output gap is, and if growth is beating their forecast, it's going to be more positive than they have in their forecast, which means inflation is higher in turn. They need to see growth consistently slow and be at or below their forecast for them to be comfortable with staying on hold and/or eventually pulling rates down. That's well down the road at this point, it seems.

We'll see how the numbers evolve, but things have been pretty solid. We get April GDP next week, and the flash there was really strong. We'll see if that holds or not that. That could determine whether the Bank goes or not, but we'll see. We also get inflation next week. Again, my estimate is pretty high. The year-over-year comes down a full percentage point, but the core numbers, at the moment on a three-month annualized basis, I have them accelerating, and the short-term core CPI metrics were specifically mentioned in the minutes as being an issue for the Bank. If they go back above 4%, I can't imagine that'll make them all that comfortable. I mean, it's pretty short-term, but still they won't like that one bit.

Sam Buckley:

Ben, I've got a question for you.

Ben Reitzes:

Sure.

Sam Buckley:

A lot has been made about the Canada growth story and Canada inflation story. A lot of it comes back to, in some people's arguments, immigration. What's your take on that?

Ben Reitzes:

I think it's a good argument, and I don't know if there's enough research done on this. I'm not even sure how to go about it at this point, but one of the things that we talk about when I talk to my colleagues in economics is how immigration impacts things on both the supply side and the demand side. The thesis on the government side, on the policymaker side, is we need more people to come into the country because domestic population growth is slowing, which it is, and we need more people to help grow the economy, to help fill the gaps in the labor force and the job market and all that. Yeah, definitely true.

However, when you bring people into the country, the day they walk through the door or onto the soil, whatever you want to say, they need a house. They need somewhere to live, be it a house, a condo, doesn't really matter. They need furniture, they need clothes, they need services, they need a doctor, they need a car or access to transit. They need every service that Canada provides. Those things are needed pretty much right up front. The demand side I think has a much more immediate impact than the supply side. Over time, maybe they come with a job and they contribute to supply pretty much right away, but if it's a whole family of people, they're demanding a lot more than that one person is supplying. Even on the supply side, I'd argue it's a longer-term thing that you get growth from.

The timing mismatch on supply and demand tells you that when you really open the floodgates on immigration like we have, you have the potential to unleash a little bit more demand than you think. I think that that's part of what's going on. I think just the lagged impact of rate hikes is also a big part of this, but housing, for example, is probably the best point where immigration flows are pretty clear, in that there is that underlying bid there that will not quit no matter where rates are, because there's just too many people. Prices may be off the highs, but they're not far off the highs.

All that we lost with 400-plus basis points of rate hikes was just the froth that was there, and prices are still expensive from a long-term perspective, and affordability is still pretty bad in the major cities. There are a few aspects there maybe worthy of further investigation. I believe the Bank of Canada will put something out that's meaningful on this in the next MPR. We'll find out in a few weeks.

Sam Buckley:

What you're suggesting is this could be a potential perfect storm of lagged effects of the hikes and a flood of immigration all at the same time boosting demand and GDP, only to see it lag in the next 12 to 24 months potentially?

Ben Reitzes:

Well, if immigration stays high, then that's a persistent positive, but you're just effectively creating more pain for the people that are exposed to rates, and you're not going to be able to slow the immigration side of demand. That part won't go away. It has the potential to create problems, yeah, for sure, and maybe unintended consequences of policymakers. I don't know, but again, very much worthy of further investigation here. Immigration's essential for Canada for obvious reasons, but the pace at which we can absorb people and bring them in without causing fluctuations on the economy and on inflation and maybe overwhelming our ability to satiate demand is, I mean, an open question.

Sam Buckley:

Yeah. Yeah, it's going to be interesting. I'm sure the next six months will be just as exciting as the last six months.

Ben Reitzes:

How do you think the second half evolves from a rate perspective? Let's say they hike in July or September. Do you think they're done after that?

Sam Buckley:

I mean, I thought they were done in January, I think, when we had this last conversation, but yeah. I mean, I think they're going to be patient and watch the data. I think they're just going to keep watching the data. I don't think there's any reason for them to say they're done. Like you suggested earlier, I don't think they do a conditional pause after they go in July. I think they're going to be data-dependent, and I think they'll continue to be data-dependent as long as the data's coming in the way it's coming in.

Ben Reitzes:

Okay, fair enough.

Sam Buckley:

That just creates a lot of uncertainty, and I'd say the last few weeks has created that uncertainty in the market too. Just now after the Bank, you're starting to see people fade the flattening. I'd say there was two weeks there where accounts were pretty quiet, other than what they had to do from a day-to-day perspective. The general theme, I would say, has been quieter. I think it just creates more uncertainty in the market, which creates more volatility, to be honest.

Ben Reitzes:

Uncertainty and volatility, my two favorite things. I think that's going to be with us for years, years and years and years. As long as inflation's a problem, it's going to create uncertainty on the policy front, which then creates volatility in markets, because there's two ways you can go. Higher rates will also help with that volatility as well, I think.

Sam Buckley:

When I first started at BMO, call it a year ago, terminal was a big topic. I don't think I'd heard the word terminal mentioned so often in my entire career as I did probably in the first week when I started.

Ben Reitzes:

You know what that means? It means he was sitting too close to me.

Sam Buckley:

Yes, exactly. I think then we were talking terminal 4%, maybe 4.25, probably 4%. Now we're talking 5.0, maybe 5.25. Where is it now?

Ben Reitzes:

If I only knew, I probably wouldn't be here. I'd own my own island. Again, 5% seems like a big number to me. As long as they keep the door open to more, I think that gives them a little bit of license to pause.

Sam Buckley:

Yep, without saying pause.

Ben Reitzes:

Without telling you, yeah, exactly. If the Fed's also close to done, which they look like they are ... they're on an every-other-meeting profile here, and let's say they go twice more ... it's hard to see the Bank getting far north of 5%. Maybe it's 5.0, 5.25, but again, I just worry about the lagged impact of hikes, but maybe I'm wrong. Maybe the compounded growth rate of wages over whatever, the five-year term of all these folks that have mortgages, maybe that's enough to overwhelm the payment shock on a lot of the mortgages and it's not that much of an issue.

Or maybe I just don't know. I don't what all these people at bars do on a Tuesday afternoon where I've gone wrong in my life, and maybe there's just more money in this country than I think there is. All the QE globally just created a lot more wealth than I think and than everyone thinks, and we're much more resilient than it appears.

Sam Buckley:

I've been saying that for the past 10 years, looking at Toronto real estate.

Ben Reitzes:

Exactly.

Sam Buckley:

There's a lot more money in this country than you think. I think that's what the market and the Bank of Canada's grappling with right now, trying to figure out where the equilibrium and all this is.

Ben Reitzes:

I don't know what the answer is. I don't know if there is an answer, not an easy one. Terminal will be whatever. It doesn't really matter. I guess my question would be I don't really care how high rates go per se, but where do they end up when they start cutting again? How low do they end up going? Are we down to 1.0 or 2.0 or 3.0, or is it higher than that? Is it 3.5% or something? If rates get all the way up to 5.5, let's say, or even 6.0, go crazy, can they get below 3.0 on the other side of things? What kind of deep recession do you need to get there? Probably a pretty big one, I would think.

Given the trajectory of things right now, that doesn't seem particularly likely, not without some crisis. I don't see a big imbalance in the economy right now. You can go like the tech bubble, tech obviously was that imbalance there, and you knew that it was an imbalance. You just didn't know when it was going to go bad. Same with U.S. housing. You knew it was a problem, you just didn't know when it was going to go bad. The pandemic was a random event, whatever.

Now, what is it? What's the big imbalance in the economy? I see one. The only thing I see that's meaningful is the U.S. fiscal situation, but I don't think that they're going to fix that anytime soon. You're not going to go from a 7% of GDP deficit to 4% overnight or 3%, and cut all that growth there. What else is going to cause it? I don't know. Maybe it's a banking crisis, maybe it's something else. We'll see. That's why they're black swans, I guess, because I'm not supposed to know.

Sam Buckley:

You don't see them coming.

Ben Reitzes:

That's exactly it.

Sam Buckley:

Okay.

Ben Reitzes:

All right, let's wrap things up here. What's your favorite trade idea at the moment? If you have more than one, that's okay.

Sam Buckley:

My favorite trade idea right now is not fading the flattening.

Ben Reitzes:

Would you have flattening on, though?

Sam Buckley:

Into month end it could see some flattening. I don't mind 10s bonds flattening into month end. 2s/10s, probably not, but 10s bonds further the curve at these yield levels and into the buying that I think we'll see at month end. I don't mind 10s bonds flattening. Again, I think until we get a catalyst here, I think it's just going to be the pain trade of the summer. 10s bonds, I don't mind.

Ben Reitzes:

Two extensions to that. One, how's that 10s/30s Canada/US box? We're at like 23 or 24 today. I think it's 24.

Sam Buckley:

Yep. Yeah, I do personally think we retest that 30 level that we got to after the Bank hiked, so I could see us floating back up there. Then again, I think what we talked about around June 1, Ben and I, at that point you're maybe risking 10 to make 30 on that. I don't think that's a terrible trade from that. If we do get back up there, I don't mind that.

Ben Reitzes:

What about Canada and the U.S., then? Also, just any pick any point on the curve. I know you like the long end, so you can go there.

Sam Buckley:

Yeah, yeah. I mean, again, I think for the summer, if the theme is going to be a lack of catalyst, then the algos control the market, at least in Canada they do, so cheaper Canada versus U.S. Again, I don't mind being a little bit on the long end into month end versus the U.S., but aside from that, I just think the algos are going to drag Canada cheaper versus the U.S. if we don't get that catalyst.

Ben Reitzes:

All right. Sam, thanks for coming on the show. Much appreciated, and I'll have you on again in less than six months, I hope.

Sam Buckley:

Thanks a lot for having me, 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.