Provincially Speaking - Views from the North

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Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Robert Kavcic, a senior economist from BMO's Economics team and Jordan Sugar, BMO's Provincial Bond Trader. This episode is titled Provincially Speaking.

I'm Ben Reitzes and welcome to Views from the North. Each episode I will be joined by members of BMO's thick 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.reitzes@bmo.com. Your input is valued and greatly appreciated.

Gentlemen, welcome to the show. I don't think I've had you both on before. I've tried to do this for a few weeks. I'm happy that it worked out. We get the trading side of things and the fundamental side of things, and so anyone that's interested in the provinces should be a very keen listener this week.

Jordan Sugar:

It's good to be here, Ben.

Robert Kavcic:

Thank you Ben.

Ben Reitzes:

All right. Kick things off here. I'm going to do the least amount of talking I think I've ever done on one of my podcasts. But let's start off just Sugar, let's start with you, Jordan. I call him Sugar lovingly because that's what we do here. How is the provincial market trading at the moment? Where are spreads from a historical perspective? Are we rich? Are we cheap? Where are we right now? Just big picture.

Jordan Sugar:

I would say right now we're in the middle of the range here. We've been as wide... Let's say, just talking longs, we've been as wide as 104 and we've been as tight as 92 and we're right now at the time in that 97 range or so. We've had some good news come out from the provinces, but that seems to have all but been priced in. And right now the topic is the December coupon flow that we have coming out up next week.

Ben Reitzes:

Before we get to the December coupon flows because that's a big conversation topic, let's touch on the fundamentals importantly. Let's do more than touch, get deep in the fundamentals here. Rob, we just had the fiscal updates from all the provinces. Where do things stand at the moment and how are things going to look six months from now or maybe a year from now?

Robert Kavcic:

Well, things look very good right now. We got public accounts through the summer for last year. Combined, the provinces overall are balanced in a small surplus. We're probably looking at a small surplus for this fiscal year as well. We all know following the group that we've gone through this two year period where it's just been constant upside surprises. Because provinces came out with what proved to be much too bearish economic outlooks and not nearly enough of a building for inflation and revenue gains. So that helped really close out the deficits very quickly.

The trick is going to be when we go to next fiscal year, most provinces, if you look at their most recent medium term fiscal outlooks, we're still leaning on economic outlooks that now actually look too optimistic. We've probably reached the point where we're starting to flip over from upside surprises to maybe relative to what's on the books right now, maybe downside surprises into next fiscal year and next budget season.

Ben Reitzes:

BMO, we have a recession in our forecast for the first half next of year and maybe that gets pushed to the middle of next year. Not even sure that matters all that much at the end of the day here. But when looking at the growth profiles that we have and that the provinces have, real growth is probably going to disappoint relative to where they are. But is nominal growth going to disappoint and isn't that what matters at the end of the day for revenues?

Robert Kavcic:

Yeah, it's a bit of both. Real growth will disappoint, nominal growth probably comes about in line with some of the medium-term outlooks that we're seeing now. Maybe a touch better, depends how sticky inflation and the deflators are. We've been on the high side of inflation all along. I'll lean to the positive side on that front, but on net, maybe a little bit of downside versus the medium-term plans that were put in place most recently, as a group overall. Obviously, there are some nuance maybe below the surface.

Ben Reitzes:

We've heard it from a lot of the provinces over the past months really, that have come out with inflation payments to some extent, inflation support payments, I think pretty much every province has done something at this point. What's the total fiscal impact of that so far and do you think we'll get more? Is that going to be on the table again for budget season next year or are those downside risks to growth going to materialize and they'll just have less room to spend at that time?

Robert Kavcic:

Direct answer to your question, we have $11 billion or so of direct payments from the provinces to the households to fight inflation. I know we laugh about it because what's more inflationary than just sending money to people? But regardless of the policy choice, it's about $11 billion. It's like 0.4% of GDP. There's definitely some incremental stimulus coming from the provinces. Everybody has done something that has directly given money to households. Now, some provinces might call it something different. Ontario gave out payments to households with kids as an education support payment. Wasn't under the banner of inflation support but it was still basically free money. Most others have done something similar.

What we're going to see next year, it's hard to say because everybody's in a very strong fiscal position now relative to where they were two years ago, there's a lot of room to work with. Alberta's one that has an election coming up and that's always important because if you look at what Quebec did over the last 12 months, they rolled out a ton of stimulus in advance of their election. Ontario's budget last year was pre-election, that's where you get most of the big spending. The big three provinces are past that cycle, so we might not see as much there. But Alberta's going into that cycle and they have a ton of money and they have an election coming up that might be more closely fought than maybe would've thought a while ago. And even just within the last couple of days they've started to push some of that out, another $2 billion directly to people's bank accounts.

Ben Reitzes:

That was going to be my next question, on elections and what's coming up on that front and clearly it matters because everybody likes free money.

Rob, you laid out how the fiscal news has been pretty good over the past number of months, really year or so, almost always surprising on the high side on the better than expected side. Jordan, have we seen markets react to this? Is fully priced in? Are we done pricing the upside? And maybe the fact that the next surprises are probably going to lean to maybe the softer side, we'll see, or flat to softer? Is that what's coming next for spreads?

Jordan Sugar:

We've seen all the news all but priced in. We've seen spreads for Alberta, BC, Manitoba, Saskatchewan, all stall out here. Clients are definitely playing it cautiously, they're involved in new issues. The secondary markets are a little bit quieter. Anytime that clients need to sell anything, it seems to be that those provinces are the candidates as a duration tool. Like I said, they're involved in the new issues but the news definitely seems to be priced in and the flight to quality during this time, with the choppy markets, clients would rather stand, it seems Ontario, Quebec and less so even with Alberta trading flat or slightly through Ontario, it seems that it doesn't even matter if Alberta would achievement up another basis point or two. Clients really want to see the pathway for more rate hikes and where we sit into the end of this year and the beginning of the new calendar year.

Ben Reitzes:

Given where we are now, Ontario longs traded as wide as 104 and a half give or take. There isn't that much upside to spreads though, crisis spreads and in crisis times long spreads widened out to 120-ish. 15 basis points from the wides, which is not a huge move, especially if you consider the carry pickup on longs relative to shorter duration bonds. Shouldn't there be limited downside or limited room for spreads to widen from here given where we are? Even if clients are, or maybe especially if clients are cautious at this point, the risk is maybe that things end up maybe a little better than expected and risk does a bit better, like the way we've seen over the past couple weeks generally and spreads come tightening in.

Jordan Sugar:

I know, I do think over the short-term and medium-term spreads, spreads are cheap here and there is upside. I think anytime we've seen inflation, miss a little bit. We definitely see the rally in the markets and provies move almost one for one or even move one for one with the broader market and there is demand for credit more globally and that has been constructive in general for spreads.

Ben Reitzes:

We've also seen good buying of the long, and generally going into December one, two flows. That's been a big theme here for the week. And we'll surely continue for the next week or so given it is November 23rd at 2:25 and we're missing some of the Canada soccer game-

Jordan Sugar:

As we speak here. I would also add that we've seen the Ontario 10s-30s credit box flatten from the wides of the steep level of 24, 25 right down to where we are right now at around 18 and a half, or so. And it feels like it still has more flattening in it. I do think it stalls out in that mid-teens. I know clients and myself, a couple of us on the desk talk about the plus eight or plus nine level a few years ago. But I think it's important to note that the Bank of Canada still owns a lot of the five to 10 year or stuff that's rolled down the curve now, maybe the four to seven year stuff that is, for lack of a better term, locked up. And I think that does keep the credit box on the steeper end and I don't think it gets back to those flat levels from five or six years ago.

Ben Reitzes:

But if the Canada curve re-steepens and at some point that is going to happen, shouldn't we expect those credit boxes to flatten. I'm talking more 5s-10s but 10s-30s as well? But 5s-10s is pretty steep historically, and 5s-10s itself, as is Canada is quite inverted, when that moves back in deposit territory, we should see some flattening in that box now.

Jordan Sugar:

Yeah, we should theoretically as a Canada curve we should see the box flatten. It's very directional right now, almost regardless of what the Canada curves doing, but if it gets back to plus nine, I'll sell you something.

Ben Reitzes:

I think as a low beta way to have a steepener on, that credit box flattener is a good trade for 2023 because timing the bigger curve, steeper is going to be really hard, but you can sit in that box and patiently wait and honestly you're really not going to be that far offside. It's not going to steepen materially from here. That I think is a good trade.

Rob, Jordan talked about Alberta trading slightly back or right on top of Ontario, they just announced a 2.4 billion inflation support payment. Again, I don't understand how payments support... They actually do support inflation, they don't support the people. What are your thoughts on Alberta here? If they're rolling out $2.5 ish billion in spending just days before their fiscal update, that suggests to me, and we'll see and I could very well be wrong, but that they have lots of money to burn there and they'll probably blow through whatever number they had put out there earlier. Is Alberta buyer? Should they be richer?

Robert Kavcic:

I still like it. Keep in mind $2 billion, we're coming off a 13 billion surplus, there's a lot to work with there. Oil is backed off, but even around the $80 level, we're still looking at pretty good upside over the course of the next couple years, if this is where we trade. And then I think fundamentally, the other part of this is we look across the country in 2023 and you say, "Okay, who's most exposed to the downturn and to what's going on in something like real estate? BC, Ontario, maybe a little bit lesser extent Quebec, who's at the very bottom of the list? I would say it's probably Alberta in terms of who has the least exposure to just the nature of this economic cycle that we're dealing with.

The housing market there was not even correcting, Calgary house prices have flattened out, you're off like 25% in Ontario. Calgary's not just going sideways. That speaks to relative economic performance. I don't know, I think trading in line, and you guys know, you follow the spread in the trading more than I do, but trading in line with Ontario seems a little bit cheap to me over the course of the next couple years. I still fundamentally like the story.

Ben Reitzes:

I have to agree, I'm bullish on oil. I've made that well-known already and I continue to be. Unless you have oil coming back down to 60 or lower, things should look pretty good for Alberta, you should see pretty sizable surpluses for a while and that should cut their net debt substantially. There are few, if any new issues coming. They just came in with a long bond and that's their probably only one for at least a year or so, assuming no major shocks or anything like that. And that wasn't even for them, that was for municipal funding.

Once you start to get flows back into fixed income generally, and you start to see more index buying broad across names across the curve and you start to see that demand pick up for Alberta and other names, and especially Alberta though, and there are no more bonds to buy, that's when I think Alberta really starts to scream in. And so it's like when you really think rates have topped, and maybe they already have, and then buyers come back to fixed income, that's when Alberta probably does meaningfully better. And that I think there's a decent chance that's the 2023 story I think. Now would be a time to start at least picking away at the name as it should be attractive here.

We know that you like Alberta, Rob, any other provinces that stand out as fundamentally strong at the moment? On a relative basis because we know they're all in pretty good shape. And going forward through 2023, we have recession, you already mentioned Ontario, BC, to a lesser extent Quebec getting hit hardest by the real estate correction. Anyone else out there stand out as we're beginning... Hurt more? Or maybe Ontario or in Quebec or BC, maybe those are the standouts for other reasons and that's why you like them?

Robert Kavcic:

Ontario's a weird one because yes, they're most sensitive to this downturn I think. But through this whole pandemic, we've been talking amongst ourselves or we've been writing stuff too, this entire time it seems like Ontario wants to set the bar really low and just make everything look a lot worse than it really is. And until they prove otherwise, I'm going to keep thinking that. And in their last fiscal update, they came out with a 13 billion deficit off a 2 billion surplus last fiscal year. And numbers came out I thought, "What? Why again?"

And we scratch all the surface, we figure out where the money's moving, but there's a lot of contingency built in there and they're probably still soft peddling the economic outlook for this current fiscal year still. Again, once this fiscal year actually wraps up, I think these numbers are going to look at least a few steps better than they have on paper right now. Until they show me otherwise, I'm going to just continue to assume that they keep beating these targets that they have on paper. And Ontario's probably, with the exception of the oil producing provinces that always swing all over the place, Ontario's the one that has been just beating by the most persistently over the last couple years.

Ben Reitzes:

Is there risk from all the union negotiations that we're seeing, that that might drive up their wage bill substantially and eat away at some of the likely improvements that we're going to get on the numbers they've tossed out there?

Robert Kavcic:

That's a good point. We talked about some of the stimulus programs and stuff earlier, but we should come on the spending side. But that's the other issue on the spending side that everyone's going to have to deal with for realistically a number of years going forward. Ontario's in the headlines right now because we're in the middle of it. But BC already went through this and set the precedent with pretty solid wage increases. And so the question is on a relative basis, is Ontario alone in this? No, they're not. Everybody is looking at very similar inflation rates across the country and is going to see similar upward pressure on wages in the public sector. Maybe there's some degree of upward pressure that's a little bit higher in a place like Ontario where wages in the public sector have been suppressed for a long time because of some of the past bills and stuff like that. But they're not alone, that's the message. They're not alone. Everybody has pretty significant inflation and wage pressure coming down the pipeline.

Ben Reitzes:

Contract timing matters also when they come due. That's a factor as well. If you had to pick your top four provinces, what would they be, one to four? Even though it is like one A, B, C, D, but let's go one to four just to make things simple.

Robert Kavcic:

As we're talking here, I think Alberta stands out and they're on the top of the list and then you have to go a few notches down to maybe find somebody like Saskatchewan. Fundamentally, yes, were benefiting from the energy price backdrop and no housing exposure and all that kind of stuff, but fundamentally they just don't carry the same economic strength and sustainability as Alberta. You got to go down a couple steps to get to Sasky. I don't want to call Ontario a favorite because of what we're seeing in housing and stuff like that, but just in terms of fiscal momentum, they have persistently beating to the upside and there's probably some more room at least in the very near term. And then Quebec's been my favorite for probably, I don't know, five, seven years, since 2015 or 2016. I don't want to toss them off the list yet, but let's be honest, the last budget and the last fiscal update and the election platform are pretty aggressive in terms of spending and have really taken a few steps back in terms of the fiscal metrics and things like that.

Ben Reitzes:

That might just have been election-driven though. And so I don't know, we'll see on. They've tended to be more fiscally disciplined than people giving me credit for, for a long time. I agree, give it a year, see where they sit a year from now and until then, I think they're still definitely on the list and I still like them as well. I think they're still in pretty good shape.

Robert Kavcic:

I think so. If you're going to give them the benefit of the doubt of having just come through an election, stack them a notch ahead of Ontario.

Ben Reitzes:

Yeah, that's fair. I agree. Jordan, what are your favorite trade ideas? What are you thinking there?

Jordan Sugar:

Just go back to what Robert was saying, we're seeing that translate in client demand and spread. Everyone tends to agree that Alberta is cheap, but they're willing to wait, like I said, to see this fiscal picture play out a little bit more, I think before they take a stab at it. Saskatchewan, they also agree good fundamentals and maybe a little too cheap as well, but if you can buy Alberta at flat to Ontario, where's the upside to buy Saskatchewan at two or three back? They'd rather just buy Alberta. That seems to be a wait and see still. And then there's still very good demand for Quebec trading, almost a full two basis points through Ontario.

Where we are seeing and getting to favorite trade ideas, where we are seeing good demand in Alberta is that 2033 part of the curve where there seems to be... There's not clear consensus on how one should draw their Ontario curve. And I think a lot of the street and maybe clients alike are incorrectly, including the cheap Ontario March 33s that should be just an author on bond that will naturally trade cheap to the Ontario curve. But more importantly, a lot of the Alberta, BC, New Brunswick and Manitoba bonds are all trading off of that cheap Ontario.

And now we're starting to see international clients come in and buy the Alberta December 33... Sorry, international and domestic clients both buying the Alberta December 33, the June 33, the Manitoba tenure, the New Brunswick, anything priced in that part of the curve, which is probably about six to 10 basis points depending on the name, too cheap to Ontario. A lot of that product's getting scooped up and I think a lot of the street has incorrectly sold it too cheap. And we're starting to see a lot of demand for all of that stuff. Outright, you want to own it. If you want to sell 5s or 10s against it, sure, I wouldn't be selling longs against it. Maybe just extension type trades seems to make sense. And there are a number of clients currently doing that.

Ben Reitzes:

Ontario came earlier this week with a new issue, June 32s. Brought the issue size up to six and a half billion the same as Ds 31s. And so that's probably the end of that issue. They're not going to issue any more bonds probably in that term. Maybe we could get one more reopening. But if they come, do you think the next one would be a December 32 or they'll just skip right into June because funding needs are not what they have been for the past few years and so maybe it's back to an annual cycle for 10s instead of twice.

Jordan Sugar:

I'm inclined, for the reason that you just mentioned, to think that they do go to an annual cycle. We've tried to get a little bit more clarity and we're still trying to get that. I do think it goes to June 33, but the jury's still out on that. And I do think that... Let's just assume it's a June 33, that it is going to be... It's going to just make all of that stuff priced off of the Ontario March 33s, still again, way too cheap.

Ben Reitzes:

What's the context there? Where are March 33s? And where do you think at June 33 is? No, we will not hold you to this when they do eventually-

Jordan Sugar:

For example, the June 31, June 32 Ontario role is around an all-in pick of five basis points. You have the Ontario June 32, March 33, an all-in pick of about 12 basis points right now. And I think that when you consider where a June 33 should come relative to the Ontario June 32, it's in the context of five basis points. And everything, all of the peripheral provinces, for lack of a better term, are all trading back of the Ontario March 33s right now.

Ben Reitzes:

Given that the 10s-30s Canada curve's flat. Makes good sense. All right, thanks guys. Thanks for coming in today to come on the show. Appreciate having you both and I will most definitely do this again because always good to mix the trading side with the fundamental side. Thanks again for coming in.

Jordan Sugar:

Always a pleasure to be here.

Robert Kavcic:

Always, Ben. Thank you.

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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