Managing Your Liquidity in a Rising Rate Environment

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Johanna Skoog:

Clients and colleagues, welcome to the latest edition of NextGen Treasury. My name is Johanna Skoog, I'm the head of I&CB US TPS and I'm your host today. With this series, we aim to deliver great content and ideas on topics that are timely and most relevant to you. In previous sessions, we discussed the latest tips on how to minimize your exposure to fraud with expert Larry Zelvin, and last year, expert Jim Santoro spoke about balancing the liquidity scales.

Speaking of liquidity, today we're bringing back the liquidity conversation. Over the course of this year, nearly every major economy has jammed on the breaks. In the past five decades, policy has never tilted so overwhelmingly towards rate increases. In North America, the Federal Reserve and the Bank of Canada have raised interest rates six times this year, citing persistent inflation. We are expecting this trend to continue into F23. What does this mean for you? How you manage your liquidity during this time is very important.

With rising interest rates and interest market volatility, it will become more difficult to maximize liquidity, minimize operational risk, and achieve optimal returns and palatable borrowing costs. If you've been keeping an eye out on the rising rates, you're not alone. Managing liquidity in this volatile time has been one of our most asked-about topics. To help put things into perspective and to answer some of your questions, I'm joined today by two expert speakers. They will provide their thoughts and unique perspectives on liquidity management and we'll follow that up by a panel discussion where they'll answer your questions. A quick introduction of our experts today, and we'll dive right into it.

First, we have Jennifer Lee, BMO senior economist. She is known for her analysis on the US economy, as well as her commentary, analyzing financial market and economic activity in Europe and Japan. Welcome, Jennifer. We're joined by Ben Lambert, managing director and head of Liquidity Solutions at BMO Capital Markets. Ben has deep expertise in partnering with clients to deliver liquidity solutions across their working capital, reserve, and strategic cash. Welcome, Ben. Now let's get into it. Jennifer, over to you for your views on the economy.

Jennifer Lee:

Thank you very much. I thought I'd start off with some positive news, which I feel like I haven't done in ages. Are you ready for this? Here we go. I haven't heard any of the major central bankers use the word "front load" in a few months. There we go. There's your good news. I'm going to do my mic drop now. Of course, maybe after like what, 475 basis point hikes in a row, it's hardly frontloading anymore. If it's considered frontloading, I think we would've been have a bigger problem, I guess, on our hands.

Now, of course, it doesn't mean that rates are headed the other way, there's going to be higher for longer and rates are probably going to be staying elevated for some time, meaning that in the US, we're probably going to be living with a Fed funds rate in the range of 4.75% to 5% for a while, like about a year or so. The reason behind that is because the US economy, even after like 375 basis points of rate hikes remains very, very resilient. I have to say, I've been pretty surprised by the data, just the fact that they've just been managing to hold up after all that tightening.

Now, not every single data release obviously has been doing so, but it's still pretty broad-based. Now, most recently we just got the latest real GDP reading for the third quarter and it was revised higher to 2.9% annualized, and that was higher than the first estimate. We saw broad base gains in consumer spending and business investment and exports but of course, there's some offset from housing and from imports as well. Since then, the handoff to the fourth quarter, we're still seeing a pretty decent passover. Consumer spending is still rising, albeit at a slower pace, but still on the rise.

We've got evidence of that from the October retail sales report. Business investment in machinery equipment, it's still growing and trade looks like it was up until October, it was still adding to GDP growth, but we saw a pretty big deficit in October. It looks like we can start seeing trade subtracting from growth. In Canada earlier this week, we got the third quarter GDP numbers finally, headline was very solid up 2.9% annualized, but the details were not solid, consumer spending was down, but that was okay because that allowed consumers to soak away some of that hard-earned money for a rainy day, and so that boosted up the savings rate a little bit.

We all know that having some savings put away is never a bad thing. Housing was still there and there's probably more of that to where that came from. Net exports and business investments also boosted the headline as did inventories. Now, for all of 2022, we did lift Canada's GDP growth rate to about 3.5%. Originally, we had about 3.3%. For the US, we're looking at a number just under 2%, maybe about 1.9%.

We still continue to expect a downturn in the first half of 2023, which I guess is just right around the corner. Then a modest recovery in the second half, which basically works out to zero growth, netting out to zero growth, so it's almost going to be a write-off for 2023, then we're going to get some rebound in 2024, in the neighborhood of about maybe 1.5% or so for both countries. Now, here, I feel like I should also mention our global growth forecast because we are all still getting that question. Do you all see a global recession coming in the next year or so? Right now, the answer is no, not quite, but it's pretty close.

Right now, I should say, we started off the year looking at 4.5% growth for 2022 and 4% for 2023, which feels like the good old days at this point, and of course, we had the Russian-Ukraine war break out, the lockdowns and restrictions in China, and of course, the uber-hawkish talk from the Fed. Now we are looking at 3.1% growth for 2022, 2.3% for 2023. For 2023, aside from the pandemic and the great financial crisis, that is the slowest pace in about three decades. Now, there's no hard and fast rule about what specific number it would be that would constitute a global recession. By definition, it would be just an extended period of economic decline around the world.

Here at BMO economics, we look at a numbers sort of in the 2%-ish range, we're going to give a low 2s. Given our call for 2.3% next year, we're pretty close. I don't think it's going to take too much to tip us over into that recession category or recession camp. By the way, a number of those big thing takes, the global thing takes have also been weighing in on this whole concept. The IMF in October said that the, "worst is yet to come," and they marked down their forecasts as well, but they didn't call for an outright recession around the world, but they did say that some countries will feel more of a recession than other countries.

They also mentioned, not in October, but a little while before that, they talked about inflation and how it's been stubborn and more broad-based than anyone would have thought it would be. They encouraged central banks to be equally as stubborn in fighting it. We all know what that means. It's basically means that you would require more interest rate hikes. The World Bank, by the way, had a different angle. They agreed with the view on inflation, but then they warned the devastating consequences to the global economy if central bankers raised rates too quickly and is too aggressively.

Anyways, regardless, there's going to be pain everywhere. Some countries and some regions will suffer more than others, and they have their own challenges. I'm thinking China with its COVID lockdown and these restrictions and now it's protests, which look like they might be hiding some of their desired effects. Of course, with Europe, I don't know where to begin with that, you've got energy crisis in Russia and all that. Probably recessions there for sure.

Getting back to North America, the reason why we are only looking for a mild recession, goes back to the whole labor market, just the fact that it remains very, very tight, not as much as it once was, but I will still say this that, if you're a job hunter, it is still the best time to be looking for a job, and for those who are trying to hire, this is still the worst time to be looking for workers. You don't have to look any further than the job vacancies or the job openings data. Very few people, I remember back in the day that used to look at the US JOLTS report, which is the job openings and labor turnover survey, and now we are really scrutinizing it, even as much as the monthly nonfarm payroll report.

Now our last check, we just got the October report. It still shows that for 16 months in a row, there have been over 10 million job openings out there which outnumber unemployment by a factor of almost two. In other words, there are nearly two job openings for every unemployed American. In Canada, there are nearly a million job vacancies out there, which is a near record, and that is almost equal to the number of unemployed Canadians. Until that less up, we will probably continue to see upward pressure on wages, and that in turn would mean upward pressure on inflation.

Now there has been some encouraging news on the inflation front. We have the October US CPI report which caused a lot of hoopla for lack of a better word and I'm so of being too technical there, but it did come in well below expected. The core reading in particular was up only 0.3% month to month which is the smallest increase in over a year. The year-over-year trend slowed from 6.6% in September, which was a 40-year high to 6.3%. Then a week later, we got the Canadian CPI numbers for October and it didn't deteriorate. It was steady at 6.9% and they kept putting some distance between itself and that 40-year high of 8.1% back in June.

The average of the cores though, were still quite steady at 5.4% which isn't great, but at least it didn't get worse. Because central bankers they've been burned before, I think it's totally understandable that they don't want to be too trigger-happy. Pretty sure, the Fed Chair Powell back in August was saying that the cost of doing too little is greater than the cost of doing too much. He's been saying that up until recently and other members of the FOMC are also echoing his words such as the Cleveland Feds, Loretta Mester.

What does this mean for the Fed and the Bank of Canada? Here are our calls. The Fed after 375 basis points of rate hikes, we continue to look for another 100 basis points to come in the next three meetings or so. We're looking for 50 basis points in December and judging by Fed Chair Powell's comments on Wednesday that's supporting that view. For another 25 beeps in February and 25 beeps again in March, which will land us at 4.875% or in the 4.75 to 5% range.

For the Bank of Canada, we are looking for two more rate hikes, about 75 basis points. This follows 350 bps of hikes. Maybe another 50 bps in December to 4.25% and another 25 basis points to 4.5% in January.

Once they reach terminal, they'll hold and assess the landscape because we all know there's a lag response to the policy actions, but there is a risk that rates will be higher than what we have penciled in. What is next? I'm going to shamelessly borrow from ECB President Lagarde comments. I'm going to semi-quote her, but when she says, "Everything is data dependent and decisions will be made on a meeting by meeting basis," so that's a great quote to use but for sure, we got to keep an eye on the data on oil prices, for example.

Because if oil, if it continues to decline and it's got to stay there for a few days, by the way, it's got to stay there for more than a few days, then that can actually ease pressure on other costs like on transportation. That'll help the overall inflation story. Of course, it all comes back down to core and just making sure core CPI heads back south towards that 2% mark. Remember that a slower pace of rate hikes does not mean cutting. It just means 50 instead of 75 or 25 instead of 50. If you get weaker economic growth, if you get weaker job growth, and less spending, that will help the decision to slow things down a bit.

Slow growth not how to do it. That's what makes this whole situation so unique is that bad news is good, good news is bad and unfortunately, that's the way of the world these days. I think that covers my comments. Back to you.

Johanna:

Thank you, Jennifer, for your comments. It was very insightful. Now, we'll turn over to Ben for his commentary on liquidity with clients.

Ben Lambert:

Good afternoon everyone, and thank you very much, Johanna, for hosting this session and, Jennifer, for sharing the good news, bad news story. Obviously still a lot of caution, still a lot of uncertainty as we perfectly describe Jennifer. As we're facing a rising rate environment which is at the end of it much more aggressive that anyone's initial forecast, as we look back earlier this year. Obviously, we talked to clients on a daily basis and we actually have to admit we see a lot of stress and almost I would say rate hike fatigue at this point.

On the one hand, we have clients analyzing all the economic data and the talking points and I would say juggling between the dovish and hawkish comments that comes day after day, whether it's the GDP data one day or Chair Powell comments yesterday. On the other end, we have clients that are still trying to make sense of all this and still don't know really what to do with our cash as they approach us. Whether you sit on one end of the spectrum, on the other side, or in the middle, it's perfectly fine. It's perfectly normal. I would say do not worry, there are solutions to accommodate everyone and help navigate this rate environment.

One thing I'll add is let's remember that we probably have not seen this pace of rising rate environment in quite a while. On my hand, I've been almost 20 years in banking, tenancy and liquidity since some prime sovereign financial crisis. I have to say the rate environment that we deal with at the moment is probably one of the most challenging I've had and the most difficult to navigate I've seen.

I would say speaking under Jennifer's control, I'm not sure ever been in such a situation. I think that, Jennifer, correct me if I'm wrong, but really last time, we came out of a zero rate environment, that we've done over the past 12 months. The Fed was not fighting real inflation, but reproducing accommodation. Really a new territory that we've been progressing through, so far, a difficult environment to deal with.

I would say, over the next part of this session, we'll try to make a bit of sense of what's going on, and look how to best navigate at these times when it come to liquidity management.

There's three main things on that purpose I would like to talk about today. The first one is the impact of this rising rate environment on our corporate liquidity market. What we've witnessed after 12-month now, is that this space of rate hike, this rising rate environment, has fully shifted the market from what we call diversification to value. We've witnessed that dynamic both across the client and bank perspective. I would say, let's look at, challenge you first. You're probably sitting and listening to the sessions, like, "Oh yes, that sounds familiar." Let's take a step back.

During the pandemic, we saw big influx of cash deposits. On the corporate treasury side, clients were uncertain about the cash reserve they would need to maintain given the uncertainty linked to the health, the geopolitical environment, as we exited the pandemic, and plan, grow on their facility and committed to cash, and keep those as reserves along that side. Now, as we entered into '21 and early '22, we saw a bit of normalization that happened on the fund behavior side. Clients started to deploy cash for CapEx, debt repayments.

Obviously, you're paying debt as interest were rising, and this was becoming more expensive. We saw a bit of a shift of priorities for clients, and also a shift in appetites, when it comes to going after a yield, and after value, only focusing for diversification across our bond group, and capital preservation over the previous month. Now let's take the bank perspective for a second, and this is what's on the slide, and which could be able to illustrate the point which I'm making. Clients who are coming to banks with cash in hands, really not focus on the yield during the pandemic.

As I mentioned, we are looking to place, and put cash, to put on their bank's partners' balance sheet. That's the peak that you see on the left side of the chart, during the pandemic period. As we started to exit the pandemic, banks started to put caps and limits on balances they could accommodate, on pricing potentially as well, to make sure they could service all their clients, and keep capacity on their balance sheets, on the go-forward basis.

Now, from the bank perspective, we started to see normalization of balance sheet behavior as well. We saw less risk on balance sheet with a rebalancing of inflows between loans extended and deposit capture, which is that middle inflation point you see on the slide, as we exited the pandemic. If you look closely, you'll see that over the last couple of quarters, we start seeing loan growth, and loan being sent to clients outpacing the deposit collection.

What does that mean from a client point of view? It means that banks, as they try to self-fund this loan growth, and this new loan appetite, this new normal, we will have appetite to capture deposit and extend value to collect those deposits. I would say, good news, banks are still here for clients, they were here during the pandemic, they're still here after the pandemic. Now, even better news, is that there is value associated with deposits, and some banks, to support their loan growth, will go after their value.

On the one hand, clients, open for yield, some banks open to support their loan growth and provide value. Conditions were created to shift from that diversification angle to the value proposition that we look at at the moment. First thing, shifted from diversification to value. The second thing I'd like to mention, is going to help us navigate this environment, is that we have not to go back to the discipline of reviewing liquidity management strategies. What does it mean? It means we will need to go back to the old practice of analyzing cash flows, where cash flows coming from, and where they need to go.

The way I look at it and is the second slide when I look at the moment, and the way we like to look at it, and the way we recommend to look at it is to surrogate the cash into three different buckets. First bucket, operational cash where you place your working capital cash, day-to-day, immediate access, which is the cash you need to deliver for payments, collection, payrolls, financing. A second bucket, which is more the reserve cash which may not be required beyond a month. Generally, for longer foreseeable corporate events, corporate needs, dividend payments, debt repayments, bonus payments, so all that cash within one to six month that you can allocate along to your cash for forecasting.

The last bucket is what we call the strategic cash, which is long-term cash that is really seldom touched that you use for acquisitions or large CapEx decisions, so really like cash that you will not touch six month and beyond. This old practice that I describe as some real users, and when I say old is not related to any recent complacency per se. It's just like that during the past couple years, the discipline was not as much required because of the low-rate environment. Why segregate cash and put some cash to work when the rest are close to a zero or close to zero and the natural solution where to keep fund overnight and fully liquid. That's what we had witnessed until client practice of the past few years.

Now that the environment has shifted and that there's value to capture, we need to go back to this practice and reallocate cash across the different buckets to really identify which class could be put to work and which cash need to stay overnight to keep the daily liquidity funding. On that topic, and to expand a little bit, so I mentioned reviewing liquidity management strategies. Now the third theme I'd like to introduce is to stay nimble and adjust investment policy, so we mentioned the value we can capture. We mentioned the need to be disciplined and really segregate cash accordingly based on needs and based on appetites.

To capture that value that some product to consider and to be able to secure those products and place [unintelligible 00:22:22] solutions, we need really encourage our clients to review and adjust their investment policy. The message really is to stay flexible, to stay nimble, to go after the value I just described, and really fit that value against the need to access the funds, so the liquidity needs, the yield appetite, and obviously, the risk appetites.

Focus on capital preservation is still a key focus at the moment for clients, but some clients may be able to take a bit of principal risk and we look at some of the products that we could consider across the different buckets of cash. We just talked about, so when it comes to operating cash and read that the daily cash we need to get access to. A couple of products that clients and you probably have been leveraging historically or still leveraging today is the current account or if you're in the US, the ECR account, so earning credit value where whereby the deposit you place in your account enables you to offset fees linked to your cash management services and treasury payment services.

With the rate hike environment that ECR, we should have seen a little bump, and you should have got a benefits in offsetting more fees in that environment. If you are sweeping that excess cash, that reserve cash to money market fund, at the moment, you will also see an uptick in your daily yields from the [unintelligible 00:23:59] funds that your funds could be placed with. Now, in this rising world environment that money market funds may have a bit of a lag, and it's mainly linked to the interesting value that those funds carry.

Usually those money market funds, 70% invested overnight and there's some TBIs and some tariffs in there, so by the time they catch up on the rate hike, you see a bit of a lag of yield pickup. More importantly, if you have an interest-bearing account or money market deposit account or a treasury management account in Canada, the rate hike should have translated in the return you get on your bank deposits,

Sometimes for some banks where we are described earlier, have self-funding appetite and are looking to support that long growth, the return you'll get on your account would supersede or may supersede the return you may get on the overnight money market funds or other instruments of that nature. Really for you to better appreciate and understand this dynamic, we encourage you to stay close to your corporate banker or liquidity specialist truly appreciate the value you could capture by looking at bank deposits in a closer manner based on the former banks obviously you deal with.

To echo that, you really need to check investment policy to potential rebalance portfolio, look at bank deposit appetite based on the value that you could extract from the rising rate environment. That was more for the operating cash, the overnight cash that we could access. Now, let's look really quick at the reserve cash and that term deposit, notice deposit product buckets, which is part of this one to six-month bucket of cash that we could leverage.

Actually, we've seen a lot of cash inflows and a lot of cash from clients deploying into that segment over the past month. Clients were able to segregate cash in that bucket, were able to lock in yield, and create a lot of value for the cash portfolio and the excess cash as they lock in the property of rate hikes. Just a reminder, term deposits, we're locking the funds and get access to the funds [unintelligible 00:26:12] with your interest, and the real value of the term deposit is that you lock in the probability that the Fed will hike in such a way.

At the moment there's a lot of value on the curve, both short-term or long-term between 1 month and 12 months. We see clients playing along the curve and locking yields and getting more value for their buck as we call it. The beauty of the product as well is as clients are disciplined or can provide transparency on the core events, it's natural to tie the material investment to their set up or events, whether it's a debt repayment or dividend payment, or tax payment per se.

Now let's look at the last bucket, the strategy cash where plans can place cash long-term, so six months to one year. We could leverage the same product or beyond one year by the way, and we could leverage the same product on the term side. We also saw a lot of appetite for clients on that tenor, which less than the three to six month given the nature of the portfolio that they have. We started seeing now clients being even more sophisticated in anticipating potential rate cuts in '24. We heard Jennifer mentioning that some clients are starting with the R-word, so I'll say it because he said it as a recession.

We start seeing some limited clients starting to hedge against the rate cuts and going really long term, two, three year to locking the yield today and protect against rate cuts. Other products to consider if principal risk could be part of the equation of your daily cash management, that's something we have to say, we have not seen too much, we haven't seen a lot of risk profile transitioning to that service background. Actually, we have seen the opposite. We have seen clients who are investing strictly in treasuries going to more fixed-value product whether it's money market or [unintelligible 00:28:17] funds or bank deposits.

Because the volatility of the online treasury market at once was such that there was a bit of principal risk that could have been created if they were to sell the security before maturity. A lot of dynamics at play across a product set and really need to stay flexible based on where the value sits at the moment across the different cash buckets. Obviously, we're here to help you review those investment policy, review those liquidity management strategies and unlock the value that we see right now in the market.

Three main things to summarize, the liquid market has shifted its value capture. To capture that value, the second thing, we encourage all our clients to review their investment options and separate their cash accordingly. Three is to stay flexible in terms of investment policy, to go after those products and rebalance the need to access funds, the risk appetite, and the yield appetite to really go and unlock that value. I said a lot here.

Johanna:

Great. Thanks, Ben. Thanks, Jennifer. With that, I think we'd like to close out today's session and I would like to thank Jennifer and Ben for their insightful comments and our audience of financial professionals for joining us. From my point of view, I'd like our audience to think about these takeaways, the importance of following the news and staying informed. Stay close to your liquidity advisor, making sure your company liquidity policy is updated and developing scenario planning and preparation for, what if. Soon after this session, you'll receive an email containing a survey seeking feedback from today's session, a link to today's liquidity recording, and a link to submit for CTP credit. Thank you so much for joining us. Chat soon.

Disclosure:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy, or security. This presentation may contain forward looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary. This presentation is for general information purposes only, and does not constitute investment, legal, or tax advice, and is not intended as an endorsement of any specific investment, product, or service. Individual investors should consult with an investment, tax, and/or legal professional about their personal situation. Past performance is not indicative of future results.