Just Be Long - Views from the North

Ben Reitzes:

Welcome to Views from the North: A Canadian Rates and Macro Podcast. This week I'm joined by Adam Whitlam, a member of BMO's institutional rate sales team. This week's episode is titled Just Be Long. I'm Ben Reitzes and you're listening to Views from the North. Each episode I'll be joined by members of BMO's FIC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. 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. Welcome, Adam. It's been like forever. I say this every week to everybody, but it always feels like I'm using everyone too much and then I look back and I'm like, "Oh, I haven't spoken to them in four months."

Adam Whitlam:

Honestly, it's been a pretty wild few months. It really flew by. It feels like it was just yesterday.

Ben Reitzes:

I think maybe that's it, maybe the market just keeps me and everyone else so busy that time is just flying by, grinding us down. So, this is a pretty active week. It's been a wild ride the past few weeks. We had some regional banking fears, then a hawkish Fed, then a massive payroll. Then, we got a huge CPI out of the US and we're just kind of... Volatility reigns supreme, all the while Canada is just tearing it up here the past few days. What are your clients thinking? Adam has some very important clients on the Canadian landscape, and so his views are well renowned and I'm always interested to hear them.

Adam Whitlam:

Well, if I could give you an accurate forecast of what was going to happen to rates time and time again, I probably wouldn't be working here anymore, but-

Ben Reitzes:

I don't need a forecast, just your views and what are your clients thinking? What are they looking at?

Adam Whitlam:

So, what you kind of alluded to in the Canada performance there's been a lot of buying. A lot of it's been centered around the broader sell off that we've had in rates and a lot of that just comes from attractiveness all in rates positions versus where they were say to end 2023. So, the broader yield backup that we've had over the last couple of months have just brought in a lot of buyers. The Canadian market in particular has been absolutely on fire. I think a part of that is even though it looks expensive, there's a reluctance to be short going on right now. We saw a pretty big squeeze in some of the curve positioning into the end of 2023 last year, things like 10s bonds, 10s bonds box, Canada-US cross market.

Ben Reitzes:

Anything related to the long end?

Adam Whitlam:

Anything related to longs where if you were a dealer and decided to draw your line in the sand. When Canada-US longs went from -70 to -90 and you thought, well, we're not going to break -90, well, when it got to -125 and you got stopped out four times over, there was some real pain in some of those trades and we saw that pain from hedge funds, we saw that pain from the dealer side and I think there is a lot of reluctance on the street now to get caught wrong-footed. Some of those flows were well broadcast, some of them were not, and I think there is this underlying suspicion that perhaps there's a program afoot, this curve keeps flattening. We don't want to get caught wrong-footed, we don't want to get caught short. There hasn't been enough supply I would say in the long end as well. We've had a couple of blackouts. A notable one would be Quebec who's been out of the market for quite some time for a couple of different reasons.

And then on the corporate side too, we haven't seen nearly as much long issuance on the corporate side. So, there's been a couple of reasons there. You've seen LDI players continuing to add to long positioning as yields back up, despite the fact that Canada might be up from the US as yields back up in general, they continue to add to longs and it's not like we need to see someone coming in to buy a billion longs to see that rally. All it takes is a couple of different players in buying 25 to 50 million clips at a time over a period of time and that combined with street covering brings in a pretty big bid for Canada relative to the US. So, right now it's a bit of a don't be short hot potato and that seems to be squeezing the market higher.

Ben Reitzes:

So, we just need to see more bonds for starters, supply would help. It also feels like after the fall, after that squeeze, we probably just still need to recover as much as anything else, as in so many bonds were taken down and they're not coming back that we just need to see a few supply episodes, and again, the provinces really not being overly aggressive, at least especially not in the long end is kind of keeping things from normalizing some extent. But as the weeks and months go by, should this normalize, will we see Canada cheapen up? Will the curve steepen at least on a relative basis compared to the US? Is that a reasonable expectation?

Adam Whitlam:

You've talked about on this podcast before and we've talked about on the desk ad nauseam, the bonds are coming. There are lots of bonds. Deficits are going up, not down. Bond borrowing requirements are going up, not down likely. We'll see what happens in the budget, but I find it hard to imagine when you have a government that's implementing a $30 billion bond purchasing program for CMBs. They have to finance that somehow and it's not going to come in the form of fewer bond issues. So, I think similar to what we're seeing in the US, all signs point to a bigger bond crop. My colleague Joel was alluding to it where we start to see problems in the US Treasury market with off-the-run benchmark bonds now where you're starting to get these dislocations where double old twos relative to twos say in the US traded a pretty hefty discount or double old fives traded a pretty hefty discount versus CT-5s.

And so, to me that is a canary in the coal mine of there are too many bonds. If it's a benchmark bond, that's one thing. You have the swap buyers that need to use the benchmark bonds, but you have these off-the-run bonds that indicate, hey, there's kind of a lot of bonds outstanding currently and I think you're going to see a similar issue in Canada. Now, one problem that's been structural here for a long time when we're talking about the long end is typically in Canada there hasn't been enough long bond supply to satiate the investor demand side, but I think that that's going to come more into equilibrium. So, does owning a tenure bond in Canada at 360 make sense at this point? I don't know. If we think our star is going to be higher and there's going to be a higher bond crop or more bond supply, there is a good argument to me that fast-forward five years, that's going to look expensive.

Ben Reitzes:

That's fair risk premium also I think is probably something that is lacking in the market I would guess just because just based on the risks you mentioned and if inflation's a little bit higher or [inaudible 00:07:09] is a little bit higher or whatever that is that the risks of that are not zero, and so that needs to be at least to some extent taken into account and we probably don't really do that just because of supply and demand fundamentals at the moment, but that can change. Speaking of supply and demand fundamentals, pretty wild day today. It's Wednesday, the CMBs 10-year CMB deal came today and we've had a rip-roaring market again, Canada massively outperforming. The CMB deal performing okay. Those spreads have come in over the past, I don't know, six weeks or so. The government took down 50% of the deal. You mentioned they're issuing bonds to buy CMBs. You can go back to our CMB episode to listen to our opinion on that. It's not particularly positive, it hasn't changed. What's your opinion on CMBs here? What's your opinion on CMB spreads and where do we go from here?

Adam Whitlam:

In the short term, I think you probably see CMBs winding back out again. We've seen this time and time again. This street has a tendency to richen up CMBs in the... If you say CMBs come mid-month is when the issuance gets done. A mortgage originator hedging has to be done by the end of the month prior or the start of the month. So you have a situation where, or an ebb and flow where, typically CMBs could be under pressure leading up into the start of the month for the two weeks from the first of the month until the middle of the month when they do an issue. Typically, you'll see a bit of a grinding bid come in, which is exactly what we've seen happen again this time and we're going to see it again for the five-year, we're going to see it again for the 10-year.

And then post-deal, typically we see a little bit of pressure, there are accounts involved in the market that look to take profit if they get any tightening in spreads. If you get a rebound in swap spreads, sometimes we'll see swap spread pressure into a deal. You get a rebound in swap spreads, you'll look for some of those asset swaps to get taken off. So, I would think in the near-term, CMBs probably widen out a little bit. In the medium-term, long-term, whatever you want to call it, I'm very constructive on CMB spreads.

Ben Reitzes:

Don't you have to be?

Adam Whitlam:

You have to be, there's just not enough. There isn't and with the government purchase program there's going to be even fewer. And now if you are an international investor and you need something with an explicit guarantee that trades back of a Canada and now we have our own Canadian government is becoming a large holder of these things, you have more comfort to buy them and there's just fewer around. So, CMBs are just going to disappear. So, I'm very constructive on CMB spreads over the next medium time horizon, next few years. So if you do get a backup, how far is that going to go? Maybe 10s go to 40, I guess it depends on the risk, but maybe 10s go to 42 or 43. I think you have to buy them there because fast-forward a year and they're at 30 and you're thrilled that you own them.

Ben Reitzes:

Yep, that's fair. I agree, tighter range, fewer bonds and the whole trading range will be tighter both for fives and for 10s probably just with the government taking down oh so many bonds. For better or worse, I guess it's better for CMB investors, so get them while they're hot.

Adam Whitlam:

Get them while you can because they will be hard to come by and we have these buying programs where they're focused on one line or one name and that's what they want to buy and they'll buy it. So, these things will disappear and they'll just continue to ratchet.

Ben Reitzes:

So, you're constructive on CMB spreads. What about provinces, provincial spreads, and just risk in general?

Adam Whitlam:

I have been very impressed, I would say, with the performance of provincial spreads in the last little while. Now, I think part of that as a function of risk assets. Risk assets in general have been astoundingly strong.

Ben Reitzes:

That just means he's not long enough in his PA.

Adam Whitlam:

You can never be long enough. If there's one thing we've learned, it's that they only go up.

Ben Reitzes:

Just be long.

Adam Whitlam:

So my view, and the people I talk to would know too, my view is the cycles that we have in credit markets and risk markets at this point similar to business cycles have become much sharper. So, we'll get prolonged rallies and risk assets followed by very deep, but very fast sell-offs. Do I think we're speeding toward that inevitably? Yes, I think that's coming up, but I would've said that last year too and here we are.

Ben Reitzes:

[inaudible 00:11:28].

Adam Whitlam:

Here we are a year later and it's like, "Well, if I was short last year, I'm double short now."

Ben Reitzes:

That carry's going to hurt.

Adam Whitlam:

Right, so I've been really impressed by the performance in risk assets. I think at some point the party will be over. If I had to guess, I'd say it's probably in the next six months. I think the data isn't coming down fast enough to make central banks comfortable with going out and cutting rates. Sticky inflation has been a topic on this podcast for a long time and all over the street and it's performing exactly like we thought it was. It's remaining very sticky. I think the street has a whole bunch of traders out there who are used to low rates and reasons to cut them and it's not filtering through. So, I think the market keeps getting ahead of itself looking for these cuts and not getting satisfaction on the data front, and meanwhile, I think the Fed and the Bank of Canada, the data just isn't trending in a direction to make them comfortable to go ahead and cut rates. So, I think what will happen is you'll see a big risk repricing probably in the next six months.

Ben Reitzes:

Geez, you're bearish. I'm going to take the other side of that. CPI wasn't good for sure, the US numbers, they were hardly constructive, the opposite of constructive. However, the Fed only cares about core PCE or PCE deflator and we'll get that at the end of the month and right now, our forecast is for a 0.3 on the core PCE deflator month over month. Subject to change, but that's the forecast for now. That's what I've seen from others as well. That is hardly disastrous. The base effect, the year ago number for January was 0.5, so the every year is going to come down to 2.7, so that's still in the right direction. So, you're trending the right way and I'm curious to see if January was a bit of a one-off. You get some calendar repricing, the calendar changes and people are like, "All right, well menu price changes, let's boost these prices while we still can."

So, I think we might see something similar in Canada. I think it's a little bit harder here actually, just given that we look at CPI and our metrics are not quite as favorable as that PCE in the US, so things are a bit harder here, but if we get some improvement on the breadth of inflation in Canada, if it's only shelter that's moving things, then maybe the bank will start to look through it a little bit. I don't like saying that too loud, but that's one thing that the governor did mention mentioned in the past couple of weeks is the breadth of inflation and about half of items in the CPI basket are over 3% year-over-year, which again is too high for them, but we'll see where that goes in the next few months. And so, it still looks to me like the Fed has set themselves up for to cut.

We'll see, again, it's inflation dependent, so core PCEs still got to keep coming down. For Canada, it's a little more challenging, but we will see again how the data go and I'm kind of warming to an alternative scenario. So, the base case is four cuts from the bank this year, four cuts from the Fed this year, timing kind of middle of the year-ish, and it's important to be at least a little bit flexible on that because the data do change things and then the base case is kind of more cuts as we move through 2025, but there's an alternative scenario in my mind and I haven't written about it, but I want to, so I'll just put it out here anyways, where we get the cuts this year and as we move into 2025, those cuts actually drive some firmness and activity inflation starts to pick up and, oh no, rates need to go higher again.

So, maybe it looks a little bit more like the late '90s where you got cuts, in the mid '90s you got cuts, and in '98 you got cuts as well, and that was followed by a few more hikes. And so, I think there are decent odds on a scenario like that and that would be a little bit more trouble for risk assets on the second go around, but it wouldn't be an issue this year because you still get at least the first round of those cuts. What do you think about that?

Adam Whitlam:

That kind of plays into what I was talking about in terms of business cycles where you get a situation where say central banks start cutting rates and spending behavior from the general population goes right back into, "Hey wait, money's getting cheap again, let's buy, buy, buy, buy, buy," and they get themselves a situation where they have to hike rates. I think-

Ben Reitzes:

You like it, don't you?

Adam Whitlam:

I do like it. I like it a lot.

Ben Reitzes:

I'm warming to it, and in Canada in particular, given the housing backdrop here and just the pent-up demand and obsession, honestly obsession with housing, and mortgage rates and everyone being a housing expert and consumer in way too many... Just too much housing in Canada, rates matter that much more here. And so as soon as there's a green light or seeming green light to start buying more houses, oh man, watch out, and that's when activity picks back up and that's when inflation picks back up and oops.

Adam Whitlam:

The big question there is what happens to the curve? Because in that case you get a bit of a whipsaw like you alluded to with all that housing demand, population growth that we've had ongoing, you're going to need a lot of infrastructure financing. What happens to the curve in that situation? We're very flat.

Ben Reitzes:

So, we're extremely flat, and so I think that maybe that goes back to term premium and people, I guess, putting a little bit less faith in central bank's ability to hit their inflation target, one, and wanting a little bit more compensation for the potential volatility that's in rates over the coming whatever, 5, 10, 15, 20, 30 years. And if you're going to have periods where we get overnight rates at 5%+ for whatever number of years a year or two years or three years, oh well maybe a 3% tenure isn't quite enough yield for me or a 3.5% 30-year not quite going to cut it. I want more than that because, guess what? There's going to be long periods of time where it's going to be way higher than that and we're going to have a problem.

So, maybe you get a little bit of some bear steepening, the dreaded bear steepener. Maybe not immediately on the back of that, but I think that would create a pretty challenging backdrop. The other side of that is there could be cracks in the system that we don't see and some kind of crisis blows us up, and regional banking, you name whatever it is, commercial real estate, whatever else you want, I don't know, Canadian households, I doubted on that one and that just runs everything over and then we do go back down.

Adam Whitlam:

And they get a bull steepener.

Ben Reitzes:

And then you get the bull steepener.

Adam Whitlam:

Okay, so in both cases we're looking for the steepener.

Ben Reitzes:

Are we really going to get flatter? Is that a reasonable outcome? It's just hard for me to believe that outcome, given what you mentioned about off-the-run treasuries becoming problematic and supply globally is continuing to go higher. There's just no restraint on the fiscal side yet and I'm not sure why that changes until markets are like, "No, I refuse to give you more money," which would be back to our friend Mr. Joel Prussky, his favorite thesis.

Adam Whitlam:

And this is where when we talk about why the market is where it is and why Canada's been outperforming, nobody likes where 10-year yields are, but you can't be short them because Canada keeps outperforming. So, the rush to cover and not have that position on... Trying to hedge it with the US doesn't work because you have that higher yield, natural bid for duration that will end at some point, but you can be wrong for 50 to 100 basis points before it works in your favor.

Ben Reitzes:

Which is not okay when you're a dealer, that's a good point. I think the inability to use the US as a hedge is probably problematic, I would think, for guests generally. Interesting, so we just covered in Canada a good point, I like that. That's a different one. So we're in the middle of February. It is Valentine's Day. Happy Valentine's Day, Adam.

Adam Whitlam:

Thank you for having me on such an important day.

Ben Reitzes:

I'm so sorry I didn't bring you chocolates or flowers, but maybe next time. You didn't bring me chocolates or flowers though either, so I guess we're even. Looking ahead to the next few weeks, other than my vacation next week, what do we have on the horizon for markets that is notable that people should be looking out for?

Adam Whitlam:

So, I think one of the big driving factors would be bank earnings season. Canadian bank earnings season is going to kick off at the end of the month. So, currently we've got Canadian names in the US and bailing paper trading about 20 to 25 basis points through the CAD equivalence. So, obviously once they report that kind of green lights for supply, I would think that you're going to see a bunch of the Canadian banks look to tap the US market first, so tap that US market until some of that basis goes away.

So from a swap perspective, that's going to put a little bit of downward pressure on CORRA SOFR, so we should see a little bit of that coming through. We should also see some pressure in swap spreads as well, and also we should see a little bit of a bid emerge in the five-year sector. It's actually kind worth looking twos, fives, 10s that flies cheapened up to last little while. I think there's some constructive reasons why fives might outperform a little bit on the curve here. I haven't liked fives for a long time, but given some of the recent moves and some of the bid for that five-year part of the curve that we're going to see in the next couple of weeks, I think they'll improve from here. So, kind of a good reason to maybe own some fives next.

Ben Reitzes:

So interesting you say that because as mortgage season picks up, I guess that's kind of temporary. Maybe you use any strength in fives to actually sell them is the way that I look at it. I'd go the other way, assuming you think mortgage demand picks up, but it's going to depend on how rates look in general, but you're going to see a lot more pressure on the five-year sector if we see more demand for houses and more demand for mortgages and all that kind of stuff. I think that's probably a spring thing, but you could use any strength if it's on the back of bank earnings season and any issuance there to put that two, fives, 10s on whatever, fade fives, whichever way you want. What else do you like? Any other trades, other than selling all your risk assets and loving fives in the near term?

Adam Whitlam:

I think Canada looks reasonably priced for two... Well, it's a little bit more than two cuts we had in massive rally today, but at the end of the day yesterday we were sitting around two cuts for the end of the year. I think that's actually not a bad level to receive relative to where the US was. US time was around 90 beeps of cuts price the end of the year. So I don't mind that, I think that makes sense.

I still like steep interstitial trades. I know it's tricky because you have to time them right, but I think even if you're receiving, say one year OIS in Canada, if you're receiving backdated, like DSCAP for instance in Canada, versus further at the curve, I think those trades make sense. The big steepener, whether it's one-year versus 10-year, I like that stuff too, but unfortunately at this point there's been a relentless bid for duration. So, it's tricky on the timing front. So, for now I think you just wait for opportunity, try to get long some fives into the end of the month, let the decent bid come in for duration, let those fives go, and then like you said, set up for maybe being short that sector going through mortgage season. Credit? What about provy spreads?

Ben Reitzes:

They've tightened, and I'm not going to say that they're particularly attractive here per se, but I don't think you sell them here either. There's no near term catalyst for things to widen out a ton and if you do get some kind of crisis, they will outperform all other credit. So, it's hard to say that you want to lighten up in that sector.

Adam Whitlam:

What are you going to replace them with? Are you going to sell provincial spreads to buy stocks? The equity risk premium is nothing, so that doesn't do anything for you. We've seen some client resistance in long Ontario spreads kind of down around 87 base points. We're seeing more two-way than anything. I would say from 93 down to the 87 level, there was a decent amount of buying going on, but definitely more two-way around 87. So, I guess I'd say around 87 I'm probably neutral, maybe a little bit of a seller. I don't think there's a ton of room to perform there, but if we do get the risk blow up that I think is going to happen in six months, then yeah, you probably want to own them.

Ben Reitzes:

Six months is a long time. In the meantime, you're carrying that 87 basis points? Not that bad.

Adam Whitlam:

No, it been worse.

Ben Reitzes:

It's a lot of basis points.

Adam Whitlam:

It's been worse. We've gotten down to 83 basis points in longs. I think if you get to 83 or even sub-80 in longs, I think you want to let them go with both hands, but that's still four or five basis points away.

Ben Reitzes:

Why don't we leave it there?

Adam Whitlam:

Perfect.

Ben Reitzes:

Thanks for coming on Valentine's Day, Adam.

Adam Whitlam:

Thank you for having me.

Ben Reitzes:

And you know what? I talked to Robert Kavcic last week, or two weeks ago, about housing and I want to have him back and talk about provincial fundamentals and I want to include you as well at the same time to talk about the provincial market in general. Maybe we'll get Sugar as well, our Jordan Sugar, our provincial trader, and make it a bit of a round table if I can. We'll see if I can manage that.

Adam Whitlam:

I love that idea.

Ben Reitzes:

I'm just pretty ambitious, but I'll do my best. So, I hope to have you back in the post-budget season, let's call that.

Adam Whitlam:

In the post-vacation season.

Ben Reitzes:

Well, it'll be post-vacation because this is the last one before vacation, but around April, May. So, that would be great if you would do that.

Adam Whitlam:

Yeah, absolutely.

Ben Reitzes:

All right, thanks for listening everybody. Have a great couple of weeks. 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.