Keep It Simple - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by Darren Campbell, BMO's head of FICC investor sales Canada. This week's episode is titled Keep It Simple. I'm Ben Reitzes, and you're listening to Views from the North. Each episode, I'll be joined by members of BMO's FICC sales and trading team to bring you perspectives on the Canadian rates market and the macro economy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated. Mr. Darren Campbell, thank you for joining me again. Time kind of went by very quickly here, and I looked down my list, and then it was your return. And you said, "Oh, it's been that long." It always feels like yesterday. You have so much fun, it always feels like yesterday. So thank you. Thanks for coming back on.

Darren Campbell:

Thanks for having me back.

Ben Reitzes:

Very eventful couple of weeks, to say the least. We had the bank cutting for a second consecutive meeting last week. Very dovish. They've effectively changed the way they're functioning now and the onus is now on the data to keep them from cutting rather than prompt them to cut. So effectively, they're cutting unless you get very strong data, which arguably we've got a little bit of that today, but we'll get to that in a bit. What are your thoughts on the bank here? Do you believe in the extreme dovish narratives that are flying around? Others were chattering about a potential 50 basis point rate cut from the bank. What are your thoughts there?

Darren Campbell:

I don't think we're going to be dealing with 50s, but I do think that... If I can just steal all your work from yesterday, I think you published a really good piece yesterday that goes into detail around the output gap in Canada and how that's going to be probably a key determinant in how they're thinking about things. So I think you're right. I mean, to have any kind of chance of closing and narrowing the output gap, you're going to need to be doing something to spur growth, and there's just not a lot else other than to be cutting rates and to be probably pulling forward the pace a little bit. So in line with the narrative that you just outlined, I think it was Sam Buckley on our trading desk that really made that statement yesterday that it's going to take a change in the data to change the course for the Bank of Canada. I think it's spot-on.

It's different for the Fed at the moment, and so Canada, US in the front end has had a good run, and if anything, it makes maybe some sense to take some chips off the table. But I think if anything, it'd still be leaning towards owning Canada in the front end if we cheapen back up a little bit. Even in a scenario where you're just pulling forward the pace a little bit for the Bank of Canada, I think you can still get some more performance in that type of trade in the front end. But 50s, no, I don't really see that as a likely scenario. But are we in an easing mode right now? Absolutely in Canada, whereas it's still a little bit wait and see for the Fed. I think SEP is probably likely, obviously, but it was balanced today. It's not a slam dunk. So there's different narratives at the moment.

Ben Reitzes:

I don't think the Fed was going to give it up today. If they're willing to commit to next meeting, then they might as well go to this meeting. So, I mean, the door is open for September from the Fed. We'll get to that in a minute, though. The only mistake you made in your little narrative there was that you wholeheartedly agreed with me and you shouldn't feed my ego that way. It's not good for anybody. It's not good for me either, geez. But no, I mean, as I wrote this week and clients can have access, BMO clients, the crux of it is, effectively, how can Canada get above potential growth? Where is that going to come from? And if you look at the backdrop of the economy, you look at the indebtedness of households, you look at where government spending is, you look at tax policy and how that's impacted business investment and the attractiveness of doing business in Canada. Where are we going to get growth from? What is going to be the driver?

And it's just... Right? I don't really see anything, and it really pains me to say it because Canada as a country was just so much potential that we're just not really using at all at the moment. And other than rates coming down, maybe substantially, and by that, I mean well below neutral. And so I think that's where there's a little bit of gray area but well below neutral and you get housing picking up, and that really takes a lot of the pressure off the consumer. So you get housing picking up, you get consumption picking up and then the dynamics do change pretty substantially. Then you can get some above potential growth, not necessarily that's healthy growth because at some point that's going to cause problems, like all this debt does have a cost. At some point, we're paying it now, if we cut rates enough, we're just going to end up paying it down the road again. But it's just something to think about for the listeners out there.

What's going to drive more business in Canada? What's going to drive foreign companies to come to Canada? And if we do get all those rate cuts, again, you get that domestic demand but then at the same time, the Canadian dollar is probably going to get absolutely crushed in that environment. And then you get the foreign investors as well coming in. It makes Canada that much more of an attractive place to invest in when you're getting this big discount on the currency. So I mean, I don't rule out that we kind of need a maybe somewhat lengthy period of a much weaker currency and, just arguably, unfortunately, an erosion of our purchasing power and standard of living in Canada to tempt foreign investors and foreign businesses to start investing more in Canada. I don't really like that forecast or I don't like that scenario, but it's tough to see anything different unless until we get very different government policy and a big change there. And we'll see what the next couple of years brings.

So I wouldn't rule that out and I'm hopeful we get some friendlier policies at some point to stay as apolitical as I can, but I think that's very much what's needed. We mentioned the Fed earlier, the bank doesn't seem to care where the Fed is or what the Fed does. Unfortunately, again for the Canadian dollar, the dollar's been hanging in there, but it's hard to believe that's going to be the case. Even so though it looks like the Fed's going to cut, you think they go in September after that? How much further do you think? Are they just kind of every other meeting or something along that line and we'll see how the data play out?

Darren Campbell:

I think it's the latter. I think it's see how the data... That's been made very clear. That was very clear in the press today. That's going to dictate the pace, and so we'll find that out soon enough. But I don't think we're going to know. Does it seem logical for them to get pushed into a move in September because of what they're seeing the data and follow that up with another cut afterwards? Yeah, I do think that's a reasonable scenario. So the interesting debate, I think, is where terminal ultimately lands in both countries and what that differential could look like. And we debate that a lot, and I think that the US market in-house view is maybe you get to a three and a quarter. Canada, can we get down to two and three quarters? Possibly. Right now, given current pricing, like I said, there's not that much in it given what's currently priced into the markets, but I still think it makes sense to be owning Canada on weakness.

Ben Reitzes:

So here's something to think about it. There's a couple of different ways of looking at the terminal question. So on Canada, again, I already mentioned that we might need to have substantially lower rates. So again, what's neutral? The bank's got two and a quarter to three and a quarter. Bank of Canada does. That's their range for a while. I was thinking like three and a half-ish might be something a little more neutral for Canada. Maybe it's a bit lower now, depending on how government spending evolves. That does change things, maybe substantially. But again, if you need to be stimulative, you're looking at probably at least, I mean, two and three quarters would be a minimum, and you're maybe even at a one handle if you're at the lower end of that Bank of Canada range.

The thing is, Canada is highly indebted. So we should be more rate-sensitive. So as rates come down, it should be more beneficial for Canada on a relative basis compared to the US, for example, where they are not nearly as rate-sensitive, they don't have the debt, they have long-term fixed-rate mortgages, and so they are much less rate-sensitive. And that's part of why the rates have been able to rise as much as they have without the economy collapsing. But by the same token, when they start cutting, it means there's also probably less impact on the economy. And so maybe they actually have to end up if things soften more than anticipated in the US, maybe they have to cut even more than we think.

And then that Canada-US differential maybe evaporates entirely. So maybe the terminal in the US might end up being lower than we think because they're that much less rate-sensitive. Even if you see it now as like, well, if they're pretty good at these high rates, what do they need materially lower rates for? Well, maybe because rates just don't matter that much, and if the only tool they have is to push rates up or down, then maybe they just have... The only thing you got is a hammer, that's all you use. Maybe they got to go all the way down to, I don't know, whatever it is, something with a two handle or something like that. I don't know. It's interesting-

Darren Campbell:

Yep. And look, I think a lot of these are going to get answered in November with the election, and with the administration that comes in and policy there. I think it's going to dictate a lot of that.

Ben Reitzes:

You think so? I'll take the other side of that. I will not help at all. I think we're not going to know about terminal until we're probably, I think, well into '25. And then there's other factors like geopolitical stress, Middle Eastern issues, and oil prices up 5% today at last look, and the potential inflationary impact of that and how that impacts policymaking as well. There is that potential for rates to maybe have more of an impact than I think in the US and then you have oil prices going up and that drives another second round of inflation that nobody wants to see. And then the outlook gets a little bit scarier, I think generally for financial markets and rates. But I think the outlook's pretty challenging to be highly confident in what's coming. I mean, other than the fact that rates are coming down. So from that perspective, it's like, "Okay, rate cuts are coming. The Bank of Canada is cutting. The Fed is cutting."

You want to be long, generally, I think you use any selloffs to get long. I think tactically being short looks attractive when we get to extreme levels, kind of like where we seemingly are today. But I don't think you can play it from the short side because you just don't know when a next bad piece of data comes and we price it even more. It seemed like the bottom for terminal pricing in Canada was 2.25. Well, we got 2.50 today ahead of the Fed, even with the better GDP numbers in Canada. And so I think it's challenging to try and play it from the short side, even if it's just tactical. So for me, it's belong, steepening is the way to go. We're going to trend that way. The carrier is terrible on a lot of those structures, but if you look back a lot of them, you still would've made money on a bunch of them. And I agree with your thought that terminal probably comes sooner if Canada gets down to what's priced in the market 2.50, 2.75, whatever it is, it's not going to be in 2027.

Darren Campbell:

And so I think that agree with you on the curve, and for Canada, probably feel more comfortable with steepening in Canada at the moment based on a few of the things that we've said. But also when you just look at the shape of the relative curves and you go back in time a little bit in Canada and the heavy buying that we saw in the long end in Canada last year, which really distorted the curve, and in many ways we're still recovering from that. And so, is there room for the long end of Canada to continue to give back a little bit of ground? When you look at 10, 30 in Canada versus the US, Canada's steepened out a little bit more.

We're at negative 20 level, it's got room to move. We think back towards flat. A function of just the Bank of Canada is cutting right now. It's more on the front foot, with easing. The US curve probably had a little bit of that Trump Republican sweep priced into it, and that's being unwell a little bit. And so for those reasons, we think that that box is a little bit more room to direct towards zero. So we do like that trade.

Ben Reitzes:

That's fair. I think the political side of this is an added kicker there. I'd just rather be in steepening on either side of the border personally. But if you think the Trump trade unwinds a bit, that definitely helps that box moving less negative territory for sure.

Darren Campbell:

Not to mention that I think it's over the last three months there's been 31 blocks, 27 of them have been sales. So just to throw that out.

Ben Reitzes:

You kept that tidbit in your pocket, didn't you?

Darren Campbell:

Just to throw that in your face.

Ben Reitzes:

Just to toss it in my face. All right, fair enough. What about provincial spreads? So funding in Canada, the provinces are in really good shape, they're way ahead of where they were last year, and yet here we are, spreads are wider. The 10s, 30s credit box is very steep, as steep as I think it's ever been. Five-year credit's pretty well bid, and there's a good reason for that. But 10s are hanging in there, but the long end, not so much. And part of it's probably because the province are so well ahead in supply that the market is somewhat saturated. But by the same token, it also means there's less coming down the road, and maybe long spreads look attractive here around 94, 95-ish.

Darren Campbell:

I think so. It's summer, it's been a flow-driven market. There's been some lightning up in long-dated provincials, both on spread and outright. I think that can get exaggerated a little bit in the summer markets and it doesn't take much. I mean, when that flow reverses, when you get one or two large buyers at C value in the long end, things can correct pretty quickly. And when you look at... As you said, when you look at the funding of the provinces right now, we're a third of the way through the fiscal year for a lot of the provinces right now, pretty much everybody except for, I guess, Hydro-Quebec, right? And you're 60% funded, so maybe a bit of saturation, but at the same time, you've tapped international markets, you've got those outlets. So I think it's more picking the top, and I guess we're at levels now that are very interesting, and so we like the idea of having a little bit of that trade on and to be adding because we think when it does correct, it could be a fairly sharp correction.

Ben Reitzes:

Yeah, I guess you could get to 90 pretty quick and maybe into the high 80s on those 30-year spreads. What's interesting about spreads being as wide as they are is the fact that the risk environment is just so buoyant. Stocks are bulletproof, arguably, I don't know, it feels like they can't be stopped. They were in pretty good shape today until the geopolitics stuff in the afternoon weighed on them a bit but still ended up nicely higher. And when the Fed's easing in a disinflationary environment, stocks do quite well, according to my colleague Robert Kavcic. And so he knows that stuff so I'm happy to quote him on that. And that's where we are.

Inflation is slowing, assuming oil prices don't explode higher. No pun intended there. And the Fed looks like they'll be cutting, and so that should be unambiguously positive for stocks, at least it has been historically. So why would this time be any different? If that's the case and risk is still gets relatively bid. I mean, you should see provincial spreads participate in that at some point, and so they were, I guess, on a relative basis, a cheaper risk asset. Do you think that slowing issuance through August will help? Because it's quite anyways, so it's like demand might also slow down enough that...

Darren Campbell:

Maybe at the margin, but like I said, I think it's... All it takes is a couple buyers to just be like, "It's time," and it's likely to be quite flow-driven, I think, in nature, for the next four or five weeks.

Ben Reitzes:

That's just, to me, that we'll need to see a level, and that level's not here. It might be a beep or two away, but...

Darren Campbell:

Apparently, it's not around... It's not here. But our thinking is not too far from here.

Ben Reitzes:

Okay. All right. I mean, that makes pretty decent sense. We're near the upper end of the range that we've seen outside of extremely stressful periods, so that makes good sense to me. I briefly mentioned five-year probably is being very well supported. I mean, that is driven largely by the move in swap spreads and demand that drives for that paper. Do you want to walk us through what's going on there? Maybe we've reached the bottom for spreads. Can they continue to collapse as they have? Almost consistently since April, since the budget came out and it was clear that issuance is going to go up substantially for government of Canada's. Swap spreads have gone one way, down. Do you think we're nearing that bottom and why might we be nearing that point?

Darren Campbell:

It feels like we're basing. I think that when you think about some of the flows we're seeing lately, I mean there's definitely been a pickup in just sort of asset swap buying from a number of the bank treasuries. The fast money flow Canada-US again is either to profit taking or receive Canada positions, or some new risks going on to fade these levels. But again, pay flow in Canada. And again, we're debating this quite a lot with the desk, and it's hard to, I guess, see a big catalyst for dramatic move in either direction, to be honest. I think we're out with this. So does it still represent good levels? Are we going to continue to see picking away from bank treasuries? Yes. Is it a wave of demand? No, but it's just sort of steady picking away that we're seeing.

So the biggest questions are going to be around, do you see a reemergence of the mortgage flows and things like that. And I think that's the more interesting debate as a driver and I think you and I agree that it's going to need a material move lower in rate to see that demand pick up again. And is it 50? Is it 100 basis points? It's probably in that magnitude. It's not 25. Banks are creeping a little bit towards guiding people more towards the five-year point. Like you've seen a slight reduction recently, in the movement five-year rate a little bit more than the front end. As we know, most of the mortgage origination was in the shorter-dated tenors two and three year. It seems like banks are starting to push people in that direction. So if we get a material move lower, then yes, you are going to see a pickup in mortgage demand that is going to lead to pay flow, and that'll ultimately lead to a more meaningful move, wider in spreads. But until then, it's hard to see a big catalyst. But it does feel like we based.

Ben Reitzes:

Okay, I'm not so sure that we based. On the mortgage side first, so I look back at the last time five-year mortgage rates were at 4%, five-year Canada's were 2.50. So 60 basis points from where we are today that's given what's priced in from an easing perspective, that's still a pretty long ways away. So we're still a decent clip away from rallying another 60 basis points in fives. And I mean, it's possible, especially if my sour outlook on Canada actually unfolds. Then, sure, we could see that. But still, it's going to be a bit, at least, and that's me assuming that at 4% for five-year mortgages, people actually get more interested, which is not a guarantee. I just think 4% is not really as punishing as the 4.60 or 5% that we've seen for the past year or so. We're like 4.60, 4.70 now. But that still on the high side.

My first mortgage was like 4.10, and I thought it was perfectly normal at the time. Granted, that was a long time ago. I'm getting old here, but it was at the time, I thought I got a good deal. Little did I know, I should have just waited a little bit longer. Would it come down a ton? So, I mean, we'll see on that front. On soft spreads, as you said, you don't know what the catalyst is for them to reverse. I don't know what the catalyst is for them to stop collapsing, if it is more paper. And the reality is, you look at the government's fiscal numbers year to date, they've just gotten worse. Interest costs are going through the roof, and unless the government tightens its belt, it's just going to be in bigger deficits and more issuance. And that means more bonds. And that means cheaper cash bonds, like swap spreads, just keep going. And you're seeing that, to some extent, in the US, and our swap spreads are still way higher than the US spreads. And we don't need to be as bad as them.

But directionally, probably the same way, because until that dynamic changes, I don't know why spreads go higher. Maybe we can base for a time, and I kind of think that's where we are, and we've seen it a couple times. We got to zero, we kind of stopped, and you saw a wave of asset swap buying, and then you got into minus five-ish, you got some more, and then minus 10-ish, you get... It's kind of like every five basis points everyone is willing to step in. It's like, "Oh, this is cheap enough. Why don't I try that? Oops, I'm five basis points outside." I don't know why that changes. I'd like to be wrong because it just means more expensive borrowing for the government, which means me. But I just don't see the catalyst, at least not yet, until something fundamentally changes on the issuance side. And I actually think the current trajectory is worse, which I don't like. Trades, you like the 10s, 30s Canada-US box. What else? Long provies. Anything else that we left out?

Darren Campbell:

I don't think so. I think that covers it. We still see quite a bit of activity in real return bonds, but both sides of the trade. Real yields in the US look interesting around these levels. We're not at the highs, but I think you'd probably rather be long than short real yields in both countries at the moment. Is that a high conviction trade? No, but it's something worth flagging, just given that... Again, I think I probably said in the last podcast, but it's a market that remains open, and there's a decent amount of trade right now. So there's that. But no, I would say there's not a whole lot else.

We talked about owning Canada a little bit on any kind of relative cheapening versus the US in the front end. Again, that's just sort of playing off of the bank needing to be perhaps a little bit more aggressive in the path than it's currently priced. Although a lot of that's already corrected. We were looking at that this morning. You look at the one-year, one-year versus two-year, one-year, and three-year, one-year, you've already seen a big correction. But for all the points you laid out yesterday, the bank is on a path right now.

Ben Reitzes:

Yeah, it is very straightforward. That's why you will always be long and hope you get some really strong data to give you an opportunity to get along at better levels and I think that's kind of what you're waiting for. Today's Canadian GDP number is... An example of that problem is the Fed's the same day and there's other stuff going on, so you not get the move you'd want. But jobs next week, US jobs this week, payrolls, the CPI in a couple weeks, they all might provide opportunities. And at best or at worst, I guess any of those things are just a speed bump or a hiccup for the central banks, as the path is pretty clear, especially in Canada. So you want to use those as opportunities to generally get along. I'm pretty simple on that one at the moment. Not overly complex, but that's kind of how I am. I like to keep it simple. Anything else before we go? Maybe something on the Canadian dollar, because I really didn't talk that much about it and it haunts me a little bit.

Darren Campbell:

I don't know. It looks like it's breaking out. I mean-

Ben Reitzes:

Until today.

Darren Campbell:

Yeah.

Ben Reitzes:

Until today.

Darren Campbell:

It looks like it wants to try to break out of this range, and so time will tell. I think that... I don't know what to say in the dollar, to be honest with you.

Ben Reitzes:

It feels like dollar Canada wants to break out on the high side for sure. And it's really just a matter of time. It keeps kind of creeping higher. It never just explodes. It's just a little bit, a little bit, a little bit, a little bit. And then we've been in that kind of 1.36-ish to 1.38 and a half, maybe it's a little below 1.36 range for over a year, 18 months, or something. And we're just on the cusp of breaking it. Didn't break out yesterday. We got the dovish Fed today. That helped. And the better GDP that helped also, but it doesn't matter. It all feels inevitable. I'm hopeful the Fed comes out super dovish one day and saves us from a much weaker Canadian dollar and much more expensive US dollars for me to buy. But yeah, I don't think it's going to happen.

Darren Campbell:

Currency-wise, it's the trade that seems to be exciting a lot more. People is long yen, and it's a trade that the Montreal office has been talking up for quite some time. And I think they still think that's one of the better trades out there. So from a currency perspective, that seems to be a little bit more interesting at the moment. Yeah, I think we've covered a lot of ground.

Ben Reitzes:

Outside of my wheelhouse. I'll leave the end to somebody else. Darren, thanks for coming on this week. Very, very much appreciated. And maybe I won't wait four months before I bring you back.

Darren Campbell:

Thanks, Ben.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.