Tough Talk: Views from the North

Speaker 1:

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Today, we have a special episode from BMO's Views from the North podcast that recently aired. Views from the North features BMO’s Canadian Rates Strategist, Ben Reitzes, who hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. Today, Ben is joined by Chris D’Onofrio, a trader on BMO’s Canadian swap trading desk, to discuss the outlook for monetary policy after the recent Bank of Canada minutes, swap spreads, an update on the shift from CDOR to CORRA, and his favorite trade ideas.

Ben Reitzes:                       Welcome to View From the North, a Canadian rates and macro podcast. This week, I'm joined by Chris D'Onofrio from BMO's Canadian Swap Trading Desk. This week's episode is titled Tough Talk. 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 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.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated. Chris, welcome back to the show. I think it's your second appearance.

Chris D’Onofrio:                Yeah, second time. Thanks for having me back. Good to be here.

Ben Reitzes:                       It's also our 50th episode.

Chris D’Onofrio:                Oh, congratulations.

Ben Reitzes:                       Thank you. Thank you for everyone out there who's still listening to me ramble on about all this Canadian macro and rates talk. It's Wednesday at 4:40, April 26th. And we had the minutes or what Canada calls the summary of policy deliberations. Can't just call them minutes. That'd be too simple. From the Bank of Canada this afternoon, they were out earlier. And they kept the same tone as what we heard from the bank a few weeks ago, just effectively that the bank considered raising rates at the last meeting. They chose not to. Patience is the way to go for now. I think it's pretty clear why if you really read through the whole thing.

                                                It seems quite evident that until there's a real reason that they'd have to push rates even higher, I think that they're more than happy to sit on the sidelines, but the tough talk continues. And I think that's probably the bottom line. And the market isn't really buying that. There's 35 basis points or so of rate cuts priced by the end of the year. We've had as much as 50 or more at some points, and then further cuts in 2024. Is that appropriate, Chris.

Chris D’Onofrio:                Yeah. I mean, you jumped right into exactly what I wanted to talk about. The imminence is the thing I have the problem with. So is there validity to having cuts priced in at some point at some point in the next year? Probably, or at least some probability mass assigned to that some point in the next year. Yeah, that's fair. But like you said, the way the short, very, very, ultra-short end of the curve looks right now is you've got about a half a cut in each meeting starting at September. And then as you go towards the beginning of 2024, you get into a full cut per meeting, which is ...

                                                I mean, it's not impossible, but it doesn't seem very likely at this point. I mean, as you said, today just gave us more evidence of the same thing. We are on hold. We considered raising, not considered cutting, considered raising, and that still may happen. Right? And probably not, I agree with you that we're probably on hold for a very long time. But in no way, shape, or form to do say we considered cutting, we're concerned about a recession, blah, blah, blah, et cetera. And I think a big reason as to why, and we actually saw this flows wise with some of the OIS that some of the American guys were trading was the reason that the curve kind of looks like that I think is just because of the US. People think the risk return on betting on cuts in Canada against to converge with cuts in the US is too good to pass on basically. So we've got from having no cuts to, as you said, almost two full cuts priced in, purely because maybe something will blow up in the US again, and maybe the Fed will have to be cutting at the end of the year.

                                                But that's not a made in Canada Canadian problem. Right? Just because a regional bank blows up in the US doesn't mean, oh, my gosh, all of a sudden we need to price in 25, or 50, or 75, or however many basis points of cuts in the next six months.

Ben Reitzes:                       That being said, and I agree for the most part on its own, idiosyncratically, if Canada lived in its own world, then cuts would probably be a ways away. But we are seeing signs of the economy softening, so we'll see where things pan out over the next few months. But does it make any sense for meaningfully more cuts to be priced into the US and Canada. And so we're due next week to hear from the Fed, and they're likely to raise rates another 25 basis points, pushing policy rates above 5%, while the bank stays on hold at 450. So Fed funds will be 58 basis points, give or take, above overnight rates in Canada. Does it make any sense for Fed funds to be trading through Canadian rates in the middle of 2024? Which would mean the bank would have to lag the Fed on rate cuts by 75 basis points, give or take. Does that make any sense? Is that a reasonable outcome?

Chris D’Onofrio:                It's an outcome, whether it's reasonable or not is another question. Do I think 75 is a serious number? No, probably not. At some point, maybe, there may be a lag of ... There's a stretch of a couple of months there where we do reach that point in a more steady state. A year from now, I would think probably not. So if you're talking about the one year, one year cross market trade, which a lot of people are poking around on right now, then yes, I think that probably is the right trade. But I do think for at least a period of time, the US has to big time lead the way. Right? If this is a blowup recession induced cutting cycle in the US that starts with the US, my thinking would be that gap gets a lot wider before it narrows back to something that we think is probably reasonable, whether it's 25 basis points, or 50 basis points, or however the disparity between Canada and the US should be at some point next year into this hypothetical cutting cycle.

Ben Reitzes:                       But there was lots of talk, or a decent amount at least, of discussion by the bank in the minutes about the regional banking stress in the US. So I mean, it is something they are very much concerned about, they're cognizant of, as much as any stress generated by the US or emanating from the US could be the driver of any kind of downturn that there's a knock-on effect on Canada. I think that's undeniable.

Chris D’Onofrio:                Yeah.

Ben Reitzes:                       And even if it takes some time to manifest itself, the bank will have a hard time ignoring, especially if the Fed is cutting, if the bank holds policy, the Canadian dollar is going to go bananas strong, which I mean, as a tourist occasionally to the US, I'm totally okay with. I was in California last week. I would love for those bills to come down if that were to happen in the next couple of days. I need to pay those pretty soon. But outside of that angle, I don't think the bank's going to want to see that much Canadian dollar strength at the end of the day, especially in an environment of the global economy likely weakening. And that's exactly what they don't want to see, unless Canada from some reason is somewhat immune to that, but I have trouble believing that.

Chris D’Onofrio:                Yeah. As I said, I think it's not even a long-term view. It's more of a medium-term view. You're absolutely right. That bleeds into Canada no matter what. We don't exist in a vacuum. We are in many ways second to the US, and that's fine. But I just think the urgency with which this situation might unfold in the US would lead to that gap widening before it narrows.

Ben Reitzes:                       Okay. So first order move, whereas the market isn't really priced that way, but yeah, okay. Got you. I could see that. That makes sense. And so those trades may not work-

Chris D’Onofrio:                Immediately.

Ben Reitzes:                       On that first order move.

Chris D’Onofrio:                Yeah, yeah. But eventually, yes, depends how deep your pockets are I guess.

Ben Reitzes:                       In the meantime, you'll be well offside.

Chris D’Onofrio:                Yeah.

Ben Reitzes:                       Okay. I mean, that does make some sense. So the other side of things is the housing angle in Canada. There's a reasonable argument to be made that the bank doesn't really want to push rates lower and strengthen housing at all. That's one area where Canada is more vulnerable and the longer rates can stay higher and continue to push froth out of that market, the better off they are, and really, the financial system is. The little bit more stability there over time, I think, if they can refrain from lighting a fire under housing again. I don't know if you need to buy a house, so maybe you have a different opinion.

Chris D’Onofrio:                Hopefully. We'll see if that June September steepener pays off by the end of the year, and maybe.

Ben Reitzes:                       But no, that's actually a good something I'd like to pick your brain on because we haven't seen much of an impact in the housing data as of yet. We've seen a bit of an impact, but it's not material enough to where-

Chris D’Onofrio:                It's bottoming.

Ben Reitzes:                       It's bottoming. So two weeks ago or three weeks ago, can't remember the date, timing anymore. Views from the North was with Rob Kavcic, and the numbers since then have been pretty similar, that it looks as though housing is bottoming. Mortgage rates have stopped going up. Five year rates are off the highs. They're not well down, but they're off the highs. And I think all you need is almost just a little bit of confidence that rates aren't going to keep going up anymore. And then everybody was kind of waiting on the sidelines, unsure. Well, is my mortgage rate going to keep going up? Do I want to pay that much more? I just need some certainty in my life, and it seems as though that's helped bring in some buyers. At the same time, supply has been just nonexistent. And so really, a lack of supply and buyers being a little bit more willing, I'm not going to say en masse at all because sales are still pretty low, but prices have firmed up a little bit. Things look a little bit better. We may still get supply may still pick up, and that may weigh on prices again. But for now, things are tightening.

Chris D’Onofrio:                Right.

Ben Reitzes:                       I'm not going to say they're going to stay that way per se, but it looks as though we might be maybe at least kind of trudging along the bottom for housing. So prices, I'm not going to say they've hit the bottom, but it's certainly possible.

Chris D’Onofrio:                Yeah. They're not at a cause for concern point as of yet.

Ben Reitzes:                       Oh, definitely not. If anything, I almost want them to fall a little bit further to be a little bit more comfortable with valuations. They're still relatively rich. You've only effectively worked off the froth. We're not cheap. And that's just because supply isn't there.

Chris D’Onofrio:                Right.

Ben Reitzes:                       And when supply's not ... Supply and demand, so no supply, prices stay high. It really is that simple. No forced selling yet, and I don't know what brings that around, but maybe the economy weakens enough and you get some unemployment, and that drives a little bit of weakness in that market. We're not there yet. Job growth has remained pretty strong. Unemployment's still really low. But some small cracks, you can see January GDP was really strong, February, we'll find out at the end of this week, but not quite as good. March, very mixed, so home sales were up in March, but manufacturing was down, but retail sales were down and wholesale trade was down, but manufacturing was up. And so you get a really mixed bag on things. And so there's no clear direction yet on the macro economy. But if it were to crack, that's not going to be a good thing for housing. Then you get that supply come back and prices go back down, all that kind of stuff. So we're not there, we'll see where we end up.

                                                But all that stuff are factors that the bank needs to take into account when they're setting policy. And so I guess something to think about when looking at those Canada US differentials, for sure.

Chris D’Onofrio:                Yeah. That's a good point.

Ben Reitzes:                       Given the bank's kind of continued hawkish tone at least, or whatever you want to call it.

Chris D’Onofrio:                Or firm tone, let's say.

Ben Reitzes:                       Firm tone, sure. Tough talk on rates and inflation. How soon do you think they can soften that? How soon can they start to sound a little bit more dovish? When can they back off, at least a little bit? To sound, call it more neutral or more balanced two-way, instead at the end of the statement, and in the minutes, telling us that they're considering raising rates. They're comfortably on hold or something along those lines.

Chris D’Onofrio:                Yeah. I think an important consideration there is: Do they or do they not care what the market thinks? Because I feel like pretty soon after they start making that transition to not necessarily a pivot to cutting, but to, okay, we're done, we're good to go. Things look good. The market will probably just blast off in pricing another 75 basis points of cuts and everything else. Right? So if that is a consideration, I would say that they probably need to wait until something more like Q3 of this year to get to the point. I mean, of course to your point earlier, unless the cracks tend to widen and something goes wrong, to take that stance and to say, back off a little bit, not walking it back, but we don't need to tap the market on the nose every time it gets ahead of itself here.

                                                If that's not a concern, it could be maybe not the next meeting, but probably as soon as July, I would say, if things remain the way they are. I don't see a reason for them to not say, "Okay, well, look at our history over the last three meetings. We've been on hold." Maybe the first two of them considered raising rates, but last time, didn't even consider it because growth is slowing the way we intended it to slow, et cetera, et cetera. And the US remains a concern. We don't want an incredibly strong dollar, all the main arguments that you pointed out before. And I really don't know if the answer to that question is: Do they or do they not care whether the market gets ahead of itself or not? But I think those are kind of the two scenarios in which I see them approaching that.

Ben Reitzes:                       I'm not sure I know the answer to that either. I mean, I guess it depends on what mortgage rates do. I think that's where they start to care, and if five year yields start to dipping up and-

Chris D’Onofrio:                Yeah. That's a good point.

Ben Reitzes:                       Credit spreads tight enough, and that drives mortgage yields down, mortgage rates down. Then they start to get concerned, but otherwise, for market prices cuts, I don't think they're a huge fan of the market going on its own way. But they tend not to push back too hard, and I like that July timing. We'll know where inflation is by then. We'll be at that maybe 3% mark by then that the bank's forecasting. And we're close. We don't have inflation continuing to fall for the second half of the year. It's kind of just stuck around 3%. But we'll be at that 3% mark, and that's as hard as it might be to get from three to two, three's a lot closer to two than where we are today.

Chris D’Onofrio:                Three is better than six.

Ben Reitzes:                       Three's better than six. It's better than five. It's better than four. And directionally, it's probably at least where they want to be going, and the economy will likely be softer by then. And then we won't really have a great idea of if the economy softened enough I think until that meeting, June is too close, so we're still a ways to go on that front. Let's change gears a little bit here and talk about stuff that you know better than I do.

Chris D’Onofrio:                Sure.

Ben Reitzes:                       That's why I brought you here.

Chris D’Onofrio:                Sure.

Ben Reitzes:                       Soft spreads.

Chris D’Onofrio:                Yeah. That curve has been all messed up for the last couple of weeks for sure.

Ben Reitzes:                       Where are the opportunities there? And why is the curve the way that it is?

Chris D’Onofrio:                Well, there's a couple of things. So over the last few months, we've seen a shift in the kind of domestic real money flow crowd, to where most of the people that matter in our market have been paying the front end, paying twos, paying threes, possibly paying fours against things further out, which has been a shift because most of last year, that flow was dominated by pretty much receiving fives and sixes and sevens, and that was pretty much all they did. So that's kind of distorted the curve a bit. Mind you, as I speak today, it started to correct a little bit today and yesterday. But that's distorted the curve over the last couple of months to the point where twos and threes are very, very stretched compared to where they were and compared to the rest of the curve.

                                                And I think this is pretty evident if you look at the curve in forward space. I mean, you and I have talked about this trade before, but if you look at kind of the one year gaps going beyond one year, one year, so if you look at two year, one year versus three year, one year, and that's in spot stating terms, basically twos, threes, fours. But if you look at that over the last couple of weeks, it's been crazy inverted to the point where it's 30 basis points inverted, 35 basis points inverted. I think it got to 40 basis points inverted recently, which if you believe that we're at the end of a hiking cycle, and that the beginning, well, maybe not for six months or 12 months, but going into a cutting cycle, then that curve should be entirely closer to flat than it is at the moment. So, I mean is that a reflection of the macroeconomics people are pricing into the Canadian swap curve? No, probably not. It's a reflection of where twos and threes and fours have been trading just because of this idiosyncratic flow.

                                                But it's I think an opportunity and remains an opportunity today, although it's corrected a little bit. And that's something that we've seen people start to express as well, whether it's in the form of twos, threes, fives, or two, three, four, or two, one, three, one, two, one, three, two, all that fun stuff.

Ben Reitzes:                       Why is that flow going to subside? So if mortgage rates, so the mortgage rate curve is upward sloping, people expect rates to fall over the coming years, including Main Street, thinks rates will not stay up here for a long period of time. Why are people going to stop taking out one, two, three year mortgages and start taking out five year mortgages? Because that's what drives a lot of that pay flow is where those mortgages are originated. And near-term, for the next six months for sure, until the bank really changes its tone and even then I suspect that'll be longer than that. Why is that flow going to subside? It just doesn't make a lot of sense.

Chris D’Onofrio:                No, no, no. Yeah, I agree with you on that front. I don't think the flow subsides. I think it remains. What I think happens is people who have some view in Canada, whether it's they want to steepen two, fives, for example. Instead of twos, fives, maybe they do it in threes, fives, or maybe they do it in two year, one year, versus three year, two year, or something. And they express it that way just because you get a kicker from, these spreads are pretty rich versus these spreads, and so when I express this in swap space, I get the added advantage of pushing the market back into place with the way I'm expressing my view.

                                                I think you absolutely have a point. Looking at mortgage rates today, I don't think five year fixed is inverted nearly enough to five year variable for people to start doing that. I don't think the natural flow will switch anytime soon, but I think if this becomes more of the norm, I think people will understand that and people will realize where the spread curve ought to be, including those people who maybe have this flow and are hedging it as well, and may choose to receive the four year point instead of the three year point, for instance, just because that spread switch has gotten so out of control or whatever. And I think that's how kind of this normalizes. I don't think it's more, like I said, I don't think it's more of a reflection of the macroeconomics of mortgages in Canada are going. I think it's more of people needing to take advantage of this. That's depressing.

Ben Reitzes:                       That's the best point on the ... That's the best way to express the steepener.

Chris D’Onofrio:                Yeah, yeah.

Ben Reitzes:                       That makes sense.

Chris D’Onofrio:                That's how I'm thinking about it right now.

Ben Reitzes:                       That makes sense.

Chris D’Onofrio:                For sure.

Ben Reitzes:                       This is a good segue I think for you to give us an update on the transition, or how it's going, or where we are in the transition from CDOR to CORRA because I think we're well on our way at this point.

Chris D’Onofrio:                Yeah, yeah, definitely. It's been what, four months now? More than four months, just over four months. Yeah. It was a bit of a slow start, but I will say, I mean, as I was saying I think last time that you had me on the show here, it's been better than what I saw unfold in the LIBOR to SOFR transition. Canada has maybe taken a lesson or two from the US, and it's been quicker. I mean, it's been four months and we've seen a lot, especially in the last month, a lot of the real money community, whether it's domestic or foreign, switch to maybe not completely CORRA risk, but at least most of the new risk, if they can do it in CORRA, they will do it in CORRA. And then the inter-bank, I would say it's not 100%, but it's probably something like 70% of the prices out there and 70% of the stuff that's going through is in spreads and in rates, and in flies, et cetera, is going to be CORRA based. And I think that's great.

                                                That's what regulators want. That's what the banks want. And that's what hopefully the client want. And I think people are starting to realize that the liquidity is definitively better now and going to remain better on the CORRA side of things than it is on the CDOR side of things.

Ben Reitzes:                       I think it's worth highlighting that the Bank of Canada, they put out a weekly update on this transition. And over half of trades on a DV01 basis were in CORRA versus CDOR over the past couple weeks, so that is clearly the trend. I think it's still a challenge on the future side of things, backs are still dominant versus the CORRA futures, but it's slowly building. Open interest is building on the CORRA side and then pulling back a bit on the backside, so we will get there. But there's definitely progress there, so anybody out there who dabbles in these markets, I think you got to look at CORRA now, and especially for anything new, that's how you want to play this. I mean, fundamentally, it's no different.

Chris D’Onofrio:                Yeah, absolutely. And I think the time is becoming very, very ripe for portfolio transitions as well. Right? Even if, like you said, people are doing all their new risk in CORRA, they might have a bunch of legacy CDOR risk. And now is the time where we're starting to see a lot of big 01s go through of like, "Okay, we have this portfolio that we've had for the past 10 years, there's a bunch of CDOR in it. We need to put through 500K, or a million in in 01 of CDOR/OIS basis to transition our whole portfolio. Let's get it done now." And I think now is becoming the best time. This is where we're seeing big, big 01s in the inter-bank cross in that basis. And it's trading at, by Canadian standards, a relatively liquid bid offer, so I think it's pretty good. So for folks out there wondering what the time is to transition their portfolio, I think it's upon us over the next couple of months here.

Ben Reitzes:                       Best part about your statement was by Canadian standards.

Chris D’Onofrio:                Yeah, yeah, exactly. You got to give a caveat.

Ben Reitzes:                       All right. Let's wrap things up. What are your two favorite trade ideas? Because I know you have two, because one of them is going to have to be OIS and one of them is going to be cross market.

Chris D’Onofrio:                Definitely. I mean, yeah. So I think just kind of repeating I guess myself a little bit here, in the very front of the curve in the OIS space, I think the very beginning of the cuts is worth fading right now, so there's about a 50% chance of a cut priced into September meeting, which I think is very much too early. So whether it's July, September, July, October, something like that, steepening that meeting switch is I think a pretty good risk return at this point, and that will trade naturally short. And given how much we rallied recently, I think that's probably a good thing. Further out on the curve, we've already talked about two year, three year, one year. That's also a pretty high risk return right now.

                                                Cross market, I think in the US, it's about flat. So if you think Canada will steepen at all whatsoever, what the spread curve will normalize, you can pick up 10 to 20 to however many basis points for those things to converge. I think the long-run average over the last two years has been something like 12 basis points, Canada is inverted to the US, so that's a pretty good one. My third trade that I think is more of a longer term trade is the one that you talked about, the kind of one year versus one year, one year cross market. I don't know when the time to put that on is. I don't know if it's now. Like I said, I think it probably gets a little more exacerbated before it gets better. But I think if you've got deep pockets and a long-term view, I think that's probably the right trade to do.

Ben Reitzes:                       All right, cool. Well, thank you for coming on to episode number 50. And thanks to our listener out there, and hope you tune in again soon. And thanks for coming in, Chris.

Chris D’Onofrio:                Yeah. Thanks again for having me.

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.