Flattering Flattening

Welcome to Views from the North, a Canadian Rates and Macro podcast. This week I'm joined by Andrew Wallace, one of our government of Canada bond traders. This week's episode is titled "Flattering Flattening." I'm Ben Ritesis, and you're listening to Views from the North. Each episode I will be joined by members of BMO's FIC sales and trading team to bring you perspectives on the Canadian Rates market and 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 [email protected]. That's [email protected]. Your input is valued and greatly appreciated. Andrew, welcome back to the show. Thanks for coming out again. Thanks for having me on. It's a tough spot, I guess, following. I think your last podcast was Joel's final episode, so this is a tough act to follow, I guess, like bringing on someone after Led Zeppelin plays in it, maybe. We'll give it a good shot. We'll be alright. I see a drop-off in your listeners, I guess, this episode was last one. That's my problem to figure it out in a minute. Don't worry. So, eventful past week plus, and still coming couple of days, it is Wednesday, November 4th in the afternoon, after 4 o'clock, and we had the bank account of last week, they raised rates as, I think, most expected. I'd say in the aftermath, I've gotten more questions than I thought, or more people than I thought. Questioning why they did it, and just really asking if it was a mistake, and what their rationale was, what drove it, just lots of questions around the whole thing. What was your view on the bank last week, were you, were you as surprised, I guess, what was your take? Yeah, so very consistent when you said you've had people last a little bit coming to you since the meeting, asking if it was a mistake, and I'd say very consistent with what the discussions we've had with our clients as well. That sentiment's obviously been shared. I'd say, like, almost borderline angry from someone, which I, so I personally don't understand that. For my view, they were very clear, we thought, at that September meeting, that something changed, the way they were looking at things, they were worried about the inflation outlook, they had set this, from our view, anyway, that meeting set October to be live. And at that point, probably data dependent. Now, the argument, I'd say, that the individuals that think it may have been a mistake, was the data, the last few data points have been on the softer side. So why did they feel the need to go here? You know, pretty clearly they're concerned about inflation, and the fact that they're looking at headline inflation now versus core is a pivotal change. You're looking at something above 3% versus core around two, where it's been consistent. So I think the shift to that, you know, justifies why they would want policy rate to be a bit higher. Again, we're not moving, they weren't moving from 375 in overnight rate. It was from 225, 25 base point higher, you know, where it goes from here, but they were below neutral rate in their mind. Whatever they're looking at, which they've communicated at, you know, in some of their dialogue, was suggested that inflation is a bit of concern. So they thought, you know, we'll move policy rate 25 beeps higher. I think, you know, from that standpoint, and, you know, I think on the desk, we kind of shared the same view, that it was pretty logical. So not surprised at all. What I was surprised by was after the September meeting, you know, they had a couple speeches and events where they kind of walked back, it seemed what they talked about at the September meeting. And that's what caught us off guard a bit was, okay, you've kind of set the table to make October live, and then, you know, speak a little bit more devastally at those odies. And that had as a bit more confused, you know, but in the end, I guess it kind of was the original thought after September that, you know, there was a good chance they were going in October. So I guess, yeah, a long way of saying not too surprised. Yeah, fair enough. Probably the question I got asked most is like, why are they no longer looking at core, like that? Why is that shifted to headline inflation? And that's, I mean, that's, that is the question, I guess part of that seems to be model driven, the new premium model is give them a better breakdown on CPI rather than just looking at core. I can only even said that they used core because it was to some extent a shortcut to viewing what underlying pressures are because they couldn't really break down where the pressures were coming from before and they couldn't forecast it that way. Now, seemingly they can, I'm skeptical by nature of modeling and its effectiveness, especially in Canada, given that the, the death of data we have to input into these models. But it certainly looks like the bank is much more focused on headline inflation and the 12 month horizon on headline inflation appears to be kind of what's driving things now rather than looking at where core was last month or next month or whatever. It's, it's, oh, we have headline inflation well above 3% for well, pretty much over a year. And what does that mean? Like what's our job? Our job is 2% inflation. So if our job is 2% inflation and as you mentioned, policy rates are below neutral. With that backdrop, should you have policy rates below neutral? And the answer is, the answer is no, like that's nice that there's an output gap, even if it's still there and it is shrinking, but it's there, but that's not enough to contain these inflation pressures. And so the risk for them is more inflation, not less. And if it's more and not less, then you probably need to push resire. So the question now becomes like, how far do they go? What's the end point here? What makes sense? There are a lot of scenarios. I don't think it's straightforward as in like, yeah, they're just going here. That's it. It's going to depend on a bunch of different scenarios, but they're not done yet. Yeah, so I think I think on that too, I think some of the markets read at this point, based on them going despite the kind of softer jobs and inflation data call it before the meeting. And based on I guess on the fact that in Davos, when he made those comments over the weekend, that kind of reprised October, it was very much about the energy market. And it's impact on inflation. So I think a lot of the takeaway from the market at this point for the bank account specifically is trying to make it as close to as simple as like their model, whatever it is, is tied to the energy prices. And those go higher. You're probably going to see some more rate hikes. Those come off like they did today, follow in the US midterms last night. Maybe you take out the possibility of them going near term or as aggressively. And that's exactly what happened today. You know, you look at today, we took out quite a bit of hike pricing. I think it's like two and a half by end of the day we have over the next year. We kept pace in the front end with the rally in the US, which kind of surprised a lot of people. We got a lot of questions today about that. And I think a lot of it was, you know, oil lower machines buying our front end is kind of what it felt like today. We didn't see necessarily the, you know, buying in the cash or receiving in the swap space to justify us tracking the US and the richening. It was more, you know, algo driven in the futures pit. And I think a lot of that might have just been, hey, oil's lower, let's buy Canada. We're going to tie that those two together for the time being. Yeah, maybe it was some of the old performance of some of the overseas market too. You could attribute some of that, but I think a large portion of it might be near term, whatever oil does Canada is going to do. The question there, Brent is one of the oil prices of the banks. So Brent was like 75-ish in the July MPR. They expected to be 100 in the current quarter in the October MPR last week, right now it's at 95 bucks. So you're not well below where they had it in their model at price point. Right. That part's important to keep in mind before getting too excited about the bank, maybe passing on the next move. And even then, like, you're going to have to have prices come down an awful lot. And you could still argue that there's a world in which you probably still want to push rates a little bit higher to get back to neutral. There's still that lingering pasture that you could get. And we'll see how the economy performs, but there are, there are potential upside risk there. There's headlines now coming out that some of the senior senior Democrats are looking at getting rid of tariffs in general. We'll see if that actually happens or not, but that would be a big economic positive for Canada and clearly push the bank to be neutral if not higher. So I'll told us more hikes from the bank, or at least one more hike, I think is probably a reasonable base case. I think after they go the next time, so I do think they go in December. I think after that they probably pause for at least a quarter, depending on the data, but I think it's at least a quarter. And they wait to see how the economy performance, because right now we got the pretty weak GDP data last week. And it was bad, pretty simply. August flat, July was flat, September slightly negative, the September flash was slightly negative, and an EPIC U3 at like 1.3, which is well below the bank Canada's 2% in the empire that came out last week. Just to give you an idea of how hard it is to model these things, they put out their forecast and three days later, they're way off. Maybe a way off, but they're off. And we'll see what the final is. Maybe they end up being right at the end of the day, because trade actually is going to add a bit more than we thought, but still this is not easy to do. And so just to stay on growth, Q4 is also going to be soft and momentum into Q4 is pretty terrible. And the likelihood of getting a serious bounce early in the quarter is pretty low, given the kind of new tariff overhang that we've gotten in September. And so what's going to cause the bank to go again after they get to neutral? I think it's more confidence in the growth outlook, which again, you don't get to see that until you're into 2027. Yeah. And do you think 275 would be deemed neutral? - Yeah, I mean, they're, yes. So he said specifically, like he was pretty clear. They're not gonna say we're moving neutral now. They reevaluate every April. It might be higher. It might not be higher. It seems like they're leaning that way 'cause in general, they pretty much follow the US. And if the US neutral is higher, then it can't have a probability goes higher. You have reasons to say otherwise. Like fundamentally, you could say a population growth is really low. I don't think it stays this low personally, but it's really low. That's a negative on potential growth. Productivity's been weak forever. That's negative for potential growth. Inflation, you're assuming is at 2%, so your neutral is still in that range. - Yep. - I personally lean a little bit higher, but that's me. I've been there for a while. We'll see where they end up at the end of the day here. Things can change between now and then, and they'll reevaluate it when they're there. So back to neutral for now, 275, and then off we go. That backdrop, I guess, could also change, depending on what we get in the federal budget this week. - Yep. - Tomorrow. Usually, we get leaks through the course of the prior kind of one to two weeks, and they give you everything that's gonna be in there. And then the budget comes out, and you're like, "All right, I already knew everything in here." This is not interesting. This time, I mean, that's possible. They already gave us the productivity negative reduction. We already know there's gonna be some small business tax changes, efficiencies, whatever they are, whatever they put in there. A couple other small measures and nothing. Nothing, no big bangs, supposedly. But it's also possible that, if you consider that the Bank of Canada was last week, the Fed was last week, a number of other central banks were also last week, and this week was the midterms. Did the government wanna be upstaged in whatever they wanna kind of put out there on their headlines? Maybe they wanted to be the headline story, and they wouldn't have been last week, and they wouldn't have been this week, right? - Yep. - And so it's possible, I don't think beyond your high, but let's just go possible that there's something big in there, I'm kind of skeptical myself, but you never know, put it out there. Hopefully this will be out before the budget comes out, if not, that's the way it goes. But not expecting anything big in there, which then leaves us with like, okay, well, what's the deal on issuance? And there could be some interesting stuff going on there? - Yeah, there's certainly one thing that we're circled to, I guess, keen on, you know, there's been some chatter, and you know, we've heard from our investor base in that, you know, the desire for real return bonds are getting Canada, obviously, and that ended that program a few years ago now. You know, there seems to be demand for that product, obviously, so I'd say for us, that's the biggest thing we're looking over for, if there's any indication that they are considering or set to bring back that program, and then obviously what it potentially looks like, the full details I wouldn't imagine would be in the budget, if it, you know, is included in the air considering it, probably, you know, the announcement gets made, and then we get further details, you know, over a bit of time before it comes back. But that's, I mean, that's where our focus is, I'd say, if that comes back and then thinking about what the composition of normal issuance looks like, given, you know, the potential that being added to the issuance profile. So that'll be it, I don't really foresee anything to, you know, change how our curve is viewed based on the budget and potential issuance on the back, but it would take probably a pretty major surprise, I think, for that to be the case. But if you do bring, I think the interesting thing is, and we've had these discussions about RRBs, there's kind of a thought like, oh, if you bring those back, you know, it means potentially selling of nominals to buy ribbies from investor base, whatever it might be, I'd actually argue it's probably more less buying of tips, it would just be a replacement asset for some of the accounts that are buying tips right now, they would just buy ribbies instead. So I don't, I don't think it is, ribbies coming back has any impact on nominal GOCs whatsoever, bring it more, exactly. I think it just brings in more buyers and some of those buyers from the US market that are currently buying tips for inflation protection. So there's Canadian investors all about, at the end of 2025, 60 billion in tips. Exactly, so, you know, that's where your demand for ribbies are, it's, and that doesn't, from our view, you know, that suggests there's no real change in, you know, the demand for GOC nominal issuance. Yep, and if anything, so if they, if they do bring parabies back, depending on where they are, what the 10 or the bonds are, if they're, let's say they're 10s and 30s, don't know the size, can't even guess, not gonna try. It could mean slightly smaller, 30 year nominal issuance, slightly smaller, 10 year nominal issuance. Actually, which is totally possible. Yeah, and I think the risk in any cases of lower issuance further out the curve, I actually don't think they change anything this time, but the risk, that's the risk, because generally they want to limit interest costs as best they can. That is a growing issue for every government in the world, including ours. And one of the ways to do that is issue when we're yields are lower, which is the front end. The issue is front, exactly. So everyone else is doing it. I don't think we're going to, but it is, it is possible. And if we're wrong and there is more money needed, it will be in the front end. It could be in T-bills. They could raise the size of two-year auctions, and there'd be no problem. How big could they make two-year auctions without causing any issues? Oh, significantly bigger. Like, like right now, they're issuing five and a half billion in auction in two years, and even five's, five billion today in five years. That's just not a lot of duration at all for our market to absorb. It's so easily digested. So five and a half twos, what could it go to 10 billion? I don't want to say it could go to 10 necessarily, because that's obviously a significant change, but easily goes to eight. Okay. The way the auctions function around twos and fives is drastically different than tens and longs in Canada now, because tens and long is actually like a significant amount of duration for the market to absorb. Twos and fives right now, they're largely non-events, because they're so easily digested. So yeah, twos could easily go to eight, conservatively speaking, I'd say on that, and five's obviously bumped up too. So yes, I guess the point being, the market could easily absorb quite a bit more front-end issuance. And then I guess you tie that all together the way we're looking at the possibly like ribbies and the issuance outlook. It kind of suggests it's kind of bullish the longer end of the curve potentially. Like that's, I guess the risk is skewed that way going into the budget. I think so anyways. And I don't know if you want to get into that now and broader theme trades, seasonally, et cetera, but that couples with what we think is kind of a bullish period for the longer end of our curve that we're in right now. Where we are and what we have ahead, and then you add this kicker of the possibility that this is a bullish outcome for tens and 30s, 30s in particular as well. - Yep, I've been on the flattening train for, I think a year. I'm pretty sure in last year's annual preview or whatever look ahead, I was flattening as biased to flatten. - Yep. - That has not changed if anything. Conviction is far higher now. Everything's the same way. Bank of Canada is hiking. - Yeah. - We have these one coming up, curve flattens. The potential changes in issuance would be curve flatteners. I'm probably missing something here, but all kind of one way, which is nice to see and there's Canada relative to, you can argue almost every other developed economy does not have the same fiscal risk. I mean, we'll find out tomorrow. Fairness. Anything's possible. The budget could blow things up a little bit. I highly doubt it. I think there's no appetite for that in Canada, but I could be wrong. And no fiscal risk means you just have way less risk in the long end of something becoming unanchored. I'm like in the US, I'm like in the UK, maybe that's a little better now. There's France, Europe in general. All have potential issues. So, flattening. - And it's kind of like made us question a bit the past week because call it all else equal for simplicity sake after last Wednesday's bank at Canada meeting, curve flattens. It was kind of like, okay, you know, the direction is very clear. For Canada in particular coming out of that, it was like, you know, it just feels like our curve was too steep anyway. There's been a pivot from the bank. This curve is going to flatten. Obviously, a lot's happened in the week. As we said at the start of the podcast before we came on, like, wow, it feels like a month ago, not a week ago. But generally speaking, like flattening trades have been questioned globally, especially coming over last night in the US today, 1030's made a pretty aggressive stiffening move. So, it's made as question like the flattening trade in Canada for sure, you know, over the last number of sessions. But you kind of put it all together. You take a step back and when I say all else equal, we're not in the business of projecting necessarily where oil's going to go or the continuation of what's going to come of the US midterm results and what, you know, the Democratic House and Senate means and potential president. Like, we're not experts in that field, but what we're talking about, you know, the budget and what issuance could look like and how could that could impact our curve and all that. That's what we're focused on. And to your point, just a few minutes ago, those all point to a flatter curve. So, if you take just that, it makes us want to be in flattening trades, especially like, especially over the next, you know, couple weeks. And I guess the final point on that would be the flows we see. Obviously, we take our queue very much from that on the desk. And the last couple days in particular, we've seen a noticeable pickup in interest from the real money base to buy our long end. So, outright buying a longs and flattening of 10, 30s, 5, 30s type trades. As we know, when the real money base gets involved in Canada, that's when it can be the most influential on where our curve goes. And our flows are suggestive of a flatter curve in the air term from what we've seen. Now, the counter to that and why we have a flattened further. Obviously, what's happened with global curves, but the hedge fund community is still pretty interested in steepeting. And I think, again, that just goes back to the original point when we were talking about where people just don't buy that the bank of Canada is going to keep biking rates. They look at the recent data, they view the pike. A lot of these accounts is a bit of a mistake. They don't really understand it. And they think that, okay. here's an opportunity to get into steepness of curve. So, you know, which one's right? Who knows? But we tend to believe that in this case, you know, when you get the real money base involved in buying the long end, you know, it's typically suggestive of a flatter curve. Yep. And when long bonds go bid, they tend to go in a hurry. We talked about it, I guess, on the desk a little while back and there's, you know, two very scary things, the two scariest things, I guess, in trading candidates, you know, being along the front end when there's no bid and being short the long end when there's no offer. And yeah, when the long end goes bid, it's very, very tough in Canada to get long ones back, especially if, you know, you're going to scale back some of the issuance we talked about before. It's just, yeah, it's a scary proposition when that does happen. All right. You focus on the two's through five's mostly. Yeah. What specific opportunities do you see there? What do you think about the front end here? I wouldn't want to be long the front end here, especially after today's move. Okay. So, I think one of the things to discuss and that I'm interested in seeing is kind of the carry profile globally, but for Canada specifically, I think part of the reason or a large part of the reason our front end is remain bid for a while is because we had the best carry profile of any major currency globally. When policy rate was at 225 and twos were yielding, call it 325, it was the best carry front end. And I think a lot of these global investors, CTAs, whatever you want to call them, some of them thought, okay, you know, let's be long Canada front as best carry profile. And you saw that consistently. What I was interested to see was if we would see kind of a flip of that when we got a 25-base point hike, like we did last week, because the carry profile changes drastically, of course. I don't know that scenario to where it's now in line with the US. There's nothing to suggest that they've started unwinding or those trades, those carry type trades if they did exist in Canada yet, but another 25 base point move in Canada probably means you start to see that. It really changes the landscape. So, it's more because of that. I do agree with you. I think the bank barring, you know, something significant on the data front or energy markets, I think the bank goes again in December. So, that really changes the court carry profile. And that's why I don't think I want to be long the front end, because I'm fearful that if that happens, we did another 25-base point move. It changes that carry trade significantly, and you might say a pretty big unwind of that. The same goes for curve trades under that. It's been very costly with where yields have been versus funding to be in flattening trades. Two's tens, for example, before the rate height, you know, would carry roughly four and a half basis points, and negatively a month. When the curve has been all that volatile, like I understand why it's tough to have that trade on. Again, the 25 base point move changed that a bit, but maybe not enough yet, but you get another move and that the carry of a flattening trade changes drastically. And I think maybe then you get more inclination from people to step into this trade, because it's not as punitive to hold that over a period. So, that's why I don't think I want to be long the front end. You know, I think just, you know, two and a half ish hikes priced. That's probably the lower end of the range of what we're going to see. I would probably fade that. And then you kind of add in what I think could play out in terms of like curve trades and outright trades based on care. If we do get that 25-base point move, that we both expect in December. And it kind of suggests I wouldn't want to be long for an end of Canada. Okay. I have trouble disagreeing with you. We both like flattening, generally, probably further at the curve for now. Yeah. But the curve will be flatter in three months, six months, 12 months time. Yeah. Yeah. I think, you know, more tactically near term, you know, you look at kind of like the two's five's tens fly. I trade that a lot. Like that's probably one of the most, you know, popular trades that I have on a consistent basis, range trades, etc. That's at the rich end of the range. If you look at the US fly, like US flies have traded extremely well. And that kind of started with the risk off trade, coming out of tech earnings. And so if you believe that, you know, this kind of general rally, and if there is this risk off element to it, we're to continue that fly probably could break through the range. It's at the rich end of the recent range right now. I'm not convinced yet, but it's kind of an interesting point in that structure right now for Canada, more so the US, but Canada will track it to a large extent. I could see that fly going either way. At this point, I'd want to be short. The belly of that as a tactical trade, but I, you know, I wouldn't be surprised if you see that range break down. And it'll probably be US lead with Canada following. Yeah. Speaking of US lead, I guess you the other, the other way to look at the flattening trade is against the US. Yeah. Just put the box on that to use some protection. It's kind of that's the other thing too. It'd be harder to love flattening further with the curve in Canada. If we were a lot richer or flatter on a relative basis. Yep. But yeah, we had a, you know, notable move today of one and a half basis points on the can US 10s 30s box, but we're still at a pretty cheap level in terms of that structure. Exactly. So yeah, exactly. If you don't, if you don't love flattening generally, but you do agree with some of the arguments being made of Canada's curve, then yeah, you know, box it up. Like I think like, you know, that's, that's a, that's a good way to play it too. Okay. Any, anything else? You got for the audience any other trades before you wrap things up? No, I think that's it. I think we hit on the main points. Yeah, I do think the December meeting is like, I'm circling that and I find it pivotal. You know, not just for, you know, the weather bang follows through and what it looks like for future pricing, but more for how it really does drastically change the carry profile of outright trades and curve trades. And the impact of that, I don't think that gets discussed enough. And I think it could be very meaningful if we do get that 25 base point move. So something to, you know, keep an eye on and think about as we are going to December with the bank. Okay. Thanks, Andrew. I just come on the show anytime then. Thanks for having me. Thanks for listening to views from the North, a Canadian Rates and macro podcast. I hope you'll join me again for another episode. 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