Ian is joined this week by Paul Jenkin, and the duo kick-off the episode discussing their take of the FOMC meeting. The largest hike from the Fed since the mid-90s didn’t come entirely as expected, with a hawkish set of forecasts pitted against a dovish press conference. Paul discusses the reasons he expects policy rates to set higher than current market pricing, and what that means for bank portfolio behavior. The pair spend some time discussing asset-swap valuations, and what lower housing may mean for funding markets. Paul finishes the episode by providing his view on provincial spread valuations.
Ian Pollick: I like higher rates. I will buy bonds at higher yields. But when we look at the retail data, there's been net outflows. Now, that's probably a mark to market when people get their returns, but they wait. Why is why is it part of my portfolio down 20% and my stocks are also down 25%. So as promised, we are back within one week. We have a lot of stuff to talk about. I am joined today good friend of mine, Paul Jenkin, MD in global markets. Paul, how are you doing?
Paul Jenkin: I'm doing well. And yourself?
Ian Pollick: I'm okay. It's been a bit of a crazy week. I think we should start off with the Fed. So we got the 75 basis points that we were told to expect and the market reaction was a bit strange. Let's just start off with why you think the market rallied so aggressively after the Fed and then we'll get into the details.
Paul Jenkin: I think the market thinks that was the only time they're going to go 75 and maybe they'll be now he's back to not doing 75s like before when he said, I will do anything to fight inflation, but I won't take 75, so.
Ian Pollick: I'll do everything, but I won't do that.
Paul Jenkin: And thenhe hiked 75.
Ian Pollick: Okay. So I mean, it felt like a very technical move when I looked at the survey of economic projections. You did have a very big migration of expectations that were broadly consistent with this idea that you're taking rates into restrictive territory. Everyone was above 3% for 2022. Where I found the most hawkish was the unemployment rate forecast because they now see the unemployment rate in 2024 at 4.1%. And what that implicitly means is that they're willing to break the labour market in order to bring inflation down.
Paul Jenkin: Yes, that's right. Well, they're going to have to inflation will break it or they will one of the.
Ian Pollick: Two something's going to short circuit. Right. And when I look at the GDP forecast, I actually think they're a bit optimistic. You're basically at 2% by the end of 2024. Maybe that's a bit optimistic in terms of how everything calibrates with itself. But the delta in terms of inflation, where they see it, it's the same similar decline year on year, it's about one and one half percent. What did he say in the press conference in your mind that stands out, if anything?
Paul Jenkin: I didn't get the market reaction to it. The Fed. They delivered a dovish Uber hike. And I don't get it. I think the market will sell off eventually. I think rates go higher from here. But the initial reaction was to buy equities and and buy a fixed income. And maybe that's because by going 75, the Fed is going to fight inflation. And that's what the market wanted to hear.
Ian Pollick: And so it's interesting, right, because stocks went bid. They started to weaken to the close on Wednesday. Thursday was a disaster. And we had the surprise rate hike from the S&P, which actually was pretty crazy, right. The last time they surprised the market was in 2015 when they kind of broke the peg. But then rates had a very big sell off early morning on Thursday and finished the day lower in yield. So is this the type of environment where that hedge is back like? Is bad stocks, good bonds? Is that back or you don't believe that?
Paul Jenkin: I don't believe that at the moment. I think stocks are going to I think this could be bad news for people who are long stocks and long bonds at the moment. I think stocks can keep going down and I think bond yields can keep going higher. So it's not a hedge. Everything is a risky asset.
Ian Pollick: So I know you rarely agree with me, even though we're buddies, which is challenging, but so in our forecast we have the peak and ten year yields at 350. Am I right or am I wrong?
Paul Jenkin: Let's say overnight it's going to finish at three and three quarters. 4%.
Ian Pollick: Oh, my God. Okay, let's talk about this. So let's just take a step back. Our policy focus. Let's just focus on the big Canada. So Bank Canada, we are an outlier, I think, versus the street versus the market where 2 to 3 quarters very similar story that's kind of underwriting this levered economy, a central bank in the south that can do more work and slow us down. We see 75 in July. Do you agree or not agree 75.
Paul Jenkin: But I wouldn't be surprised if they only go 50.
Ian Pollick: Then another 50 in September 25 October and then we see the cycle stopping. But I don't think you see it like that.
Paul Jenkin: No, I think the Fed's likely going to go every meeting until Christmas and I think the Bank of Canada will fall.
Ian Pollick: Okay, Why?
Paul Jenkin: One of the things that came out yesterday is they're going to see a notable decrease in inflation before they think they've won the war. And I don't think inflation's going to come down as fast as people think. Okay. I don't think the structural challenges of the ports. Of the war in the Ukraine. Oil supply are all going to be solved in the next few months or the next. Six months. So I think you don't see it. There's no reason, I think, for inflation to to moderate. I think the next step of the cycle is going to be wage inflation. I know that goes against the call of our economists who don't think we just can go up, but that's mostly because we can't afford them to go up. So I think I don't think inflation moderates fast enough for them to take their foot off the..
Ian Pollick: Okay, So what you're saying is where our call, where you see the vulnerability and our call being correct is this idea that the timing of when we do really get that moderation in inflation is longer than we expect.
Paul Jenkin: That's right.
Ian Pollick: And if you had to guess, where do rates peak out in Canada?
Paul Jenkin: Oh, I think that'll probably be around the peak. So it's not going to they'll get to say three and three quarters or four and then that'll probably be it unless inflation stays high in the next year and then, oh, that's rough.
Ian Pollick: So let's just talk about what a 4% overnight rate does. So, you know, 4% overnight, that puts prime above 6%. Walk me through what that does to the mortgage market.
Paul Jenkin: Like I say, prime goes to 6% and just floating rate mortgages are roughly prime less 100. That puts the floating rate mortgage at 5%, which is flat or five year mortgages are now roughly. Yeah. So a five year mortgage will be higher. Obviously.
Ian Pollick: Home prices won't be.
Paul Jenkin: Well, The home prices have got two things. One, to borrow something from the economists viewpoint of the world is that COVID and all the stimulus that occurred in COVID brought forward a lot of demand in the housing market. So there's a hangover coming, whether rates are low or high. Anyway.
Ian Pollick: Interesting.
Paul Jenkin: Everyone got sent home. Everyone needed more, space rates were low, people bought houses and moved up and upsized. That's clearly if you survived through COVID with it needed a bigger house. You probably don't need a bigger house right now. I think there was a big bring forward in demand. You saw it in cottage country, you saw it in housing. There's a hangover coming, that's for sure. At some higher rates, the hangover will be worse.
Ian Pollick: Okay. So 6% prime. I want to get back to this. So if that took if that puts a variable rate at, let's say five, where does it put.
Paul Jenkin: Fixed this curve inverted?
Ian Pollick: I think at that point the curve is inverted.
Paul Jenkin: Maybe it's not that much higher.
Ian Pollick: Okay, and let's talk about one of the things I find really interesting about you is you've had a very storeyed career across different parts of lots of different organisations. And one of the parts that you see a lot is from your days in Treasury. Walk us through what you think is happening right now in terms of structurally across the street, how banks are operating with more variable rate mortgages. What does that mean for them? And if you do believe that you get higher rates, probably get lower prepayments, probably get lower originations. How does this all change the reaction function of bank portfolios?
Paul Jenkin: So from a bank portfolio, so they're going to originate less fixed rate mortgages into their into the banks, they're less received. They're still going to be issuing debt, they're still going to have deposits. So I think that means they're going to be forced to receive to offset their short position if they want to stay flat as a first cut of it. The next cut is on your point about prepayments. If interest rates skyrocket and housing comes down, then people may stop paying their mortgages. But people with floaters may so with fixed rate mortgages. If prepayment slow, slow below model, then banks will get longer off the back of that. That'll that also mean they're longer from lower rates. So that wouldn't be great for for Nims but it would mean that their, their how much they have to receive is decreased.
Ian Pollick: And is that mean that the the delta on receiving is that a spread widener.
Paul Jenkin: If they have to receive more, that will be a spread narrower.
Ian Pollick: Well, if they receive more, obviously it's an error. But if so, I thought what you just said was that the rate of change of receiving as things start to slow could make them receive less.
Paul Jenkin: That's right.
Ian Pollick: Okay. And so let's talk about that. Like you live in a world where you care a lot about the absolute valuation of bonds in an asset swap framework. What's going on in that framework right now?
Paul Jenkin: It's all looking a little wider. It's all finally getting to levels people like And if you've got bullets to spend, it's getting better.
Ian Pollick: So elaborate on that. So what are you looking at? Like what part of the market should we start with? Like you care a lot about CMB's. Where do you wanna start?
Paul Jenkin: Well, CMB'S I haven't carried out in a long time because they ask to swap at a negative spread and I'm always been against receiving things that are negative spread. So but they're finally getting to levels where there's the tens or positive in the fives they're asked to swap at like minus two, I think. So starting to get to levels where maybe CMBs, you could see asset swap into that again by people like myself. I'm sure the bank treasury is still asset swap them. They still carry positive. But in terms of the curve, certainly the seven year sector in Ontario's Ontario's is probably the the nicest spot to receive in terms of roll down. I'm a little more cautious at the moment just because I do think with the state of the world, credit could widen in general. So I think being a little shorter down in the five year sector is maybe a safer spot to be for the CSO. One risk you're taking on for the role down trade off.
Ian Pollick: And what about Canada? Do you care?
Paul Jenkin: Not really.
Ian Pollick: Not really. Okay.
Paul Jenkin: If anything, I would be assured of Canada bond.
Ian Pollick: What about like some of the. Some of the NBS, like some of these nine, seven, five pools? There's anything interesting going on?
Paul Jenkin: Well, Mbes are very interesting. The whole chunk of Mbes have been issued over the last year. All have super low coupons. So versus where we are today in the markets, they'll trade at a price point of 90 or 91. And so if you buy an MBS bond today at 90 and you have prepayments next month that are above forecast, you're getting paid back at par. So it's a pretty good one month return on your right to free pays. And so we've been seeing we have a reasonable number of MBS and we've been we like them because of that coupon and because of the prepayments. And I do think the Canadian market fundamentally undervalues the prepayment metrics in MBS.
Ian Pollick: And why is that?
Paul Jenkin: Government guaranteed bond advertising, it's got a little hair on it. People don't buy it in general.
Ian Pollick: Okay.
Paul Jenkin: Its an Orphan.
Ian Pollick: Okay. It's a little orphan in general. Do you believe in the story that as the balance sheet from the bank shrinks, that as the swap spreads should narrow? Do you believe that story?
Paul Jenkin: And as as the Bank of Canada..
Ian Pollick: Because there's more issues going to the private sector, it's very much a cash story. You know, almost globally, everyone will tell you. And in a market where you have quantitative tightening, swap spreads should be lower. Canada typically has very elevated spreads. That's kind of a function of CEDOR. But what do you believe that story?
Paul Jenkin: Well, I think to be more issuance. So should they be cheaper on asset swap? Probably. I would think it's my view on it.
Ian Pollick: Now, one of the things that I've been talking to clients a lot about is the question of who is the marginal buyer of bonds in Canada. And when we go back ten years ago, it was the pension sector. Funding gaps were still gaps. Insurance, very similar story that seems to have abated. Then we went into the pandemic and Canada was the marginal buyer QE. But because how big of the fiscal programme we had, we had huge deposit inflow into the banking system. If you remove leverage on Canada's and actually the banking system was the biggest marginal buyer of bonds in 2021, it's not so apparent to me today with high inflation, excess savings coming down, know pension funds don't necessarily need higher yields at this level of yields just yet. Who is the marginal buyer of bonds?
Paul Jenkin: I think banks will still remain a buyer of bonds. The Canadian provincials have looked great on the metrics, so when you look at it against risk weighted assets, they can be funded in the market. So I think the Canadian banks will keep buying. It's just it will depend upon their deposit growth versus the roll off of their underlying bond portfolios and what they have to do to receive. I think they'll continue to be the marginal buyer, the one interesting person that's not mentioned at all. Maybe retail. Yeah. For the last ten years there hasn't been a nice yield on any bonds in Canada and now you can get north of 4% on a ten year provincial bond. So it could be possible that the retail actually, after years of saying, why would I own a bond that pays 1%, actually come back into the market and buy?
Ian Pollick: Well, it's interesting, and I think that is how I grew up understanding people's reaction functions. I like higher rates. I will buy bonds at higher yields. But when we look at the retail data, there's been net outflows. Now that's probably a mark to market thing. People get their returns. Wait, why is why is this a part of my portfolio down 20% and my stocks are also down 25%. So it's interesting that there's been outflows, but maybe at some point, whether it's through ETFs or mutual funds, maybe that does get harvested. But is it enough? I mean, what what size is that? Can that be at the margin?
Paul Jenkin: Going to be in the margin? Well, if people become dissatisfied with the equity returns and if equities go sideways for a while and who knows what an inflationary world does for equities, it could be that people say, finally, maybe it is time to have some fixed income exposure as opposed to the past.
Ian Pollick: So let's say let's say we're wrong and you're right and we get to three and three fourths, 4% overnight rate. What is that mean for the marginal buyer? Is that pension funds coming back in?
Paul Jenkin: Pension funds, I think, have moved. They do have their bond portfolios, but they've also moved. And then when insurance companies have moved to using derivatives to get their long dated duration exposure. So when they go back to bonds, I doubt it.
Ian Pollick: Or duration like swaps to.
Paul Jenkin: Their duration needs will, will be there. But they, I think they're looking more or have been the trend with them has been to look for inflation. Hedges Right there. Most of their purchases have been kind of private equity or acquisitions where they're looking to buy protection against inflation, which is finally come home to roost.
Ian Pollick: So let me ask you this. I want to switch gears for a second. And when I think about the forward curve and we think about Canada's forward curve and we look at where the kink is, it's obviously kind of in the two year forwards. What opportunities do you see now against your forecast of 1,000,000% overnight rate?
Paul Jenkin: Well, the forward curves inverted. So definitely think inflation is going to last longer. Or if you don't think the banks could hike as much, then we're seeing something like a one year, one year versus pain. One year, that kind of curve trade does make sense that it's I've been in that trade and it's been it's been wrong. So it's it may it may work out right in the future.
Ian Pollick: I mean, I think you're in levels I think that when you're when you're all the time and the question is is. I have two sticky notes on my desk. One is don't buy boxes. The second one is keep looking at one year, one year. And I think for a market like Canada, we know that things can stay wrong or distorted is a nicer word for a very long period of time. So when you went to Oz was basically 4% two days ago. Now we're closer to three kind of 75, 380. Is this the turn? Is this the turn in rates?
Paul Jenkin: Well, as an old boss of mine who you would know you would use to say that at the start of a hiking cycle, the market is more priced in than actually is actually is realised. So that's when you're supposed to be. If you're a Treasury or CIO is supposed to say, now it's time to go long twos, threes and fours because they'll roll down the curve. You won't realise all the hikes and, and you're going to make money. Now most of the data on that will probably go back to 1980 and say for every hiking cycle that started, that's the right answer. Now, I don't know what the answer would have been if you put that trade on just before Volcker stepped into the room in the seventies when he might have had a bit of pain in the trade. So, sure, I think there's probably, probably going to be a time where you want to receive the front end one year, one year, just north of 4%. I started looking at trades that were earlier in my career, such as when you're one of your pair selections, because they used to decay really nicely with a steep front of the curve as long as the four. If you think the fours won't be realised, those kind of trades decay really fast.
Ian Pollick: Yeah. Now we don't really have that ability to do that in market like Canada, you know, it's kind of upper left only. But do you care about the long term forwards? Because I look at some of these rates like ten year, ten year, 20 or ten year, this stuff, it's all north of 4%. These are very big numbers. Do we care?
Paul Jenkin: With what I trade. I don't tend to trade much past ten years, so I don't really I don't really get that fussed about it. I think that part of the market trade is quite technical with pensions and the insurance companies running it. So it's tough for me to..
Ian Pollick: So that's flow related, right? So that's your non macro. Well, let's let's move over a little bit. So what I do is I want to talk about provincials. You know, you're in an environment where compared to last year, the story was they released the budgets really quickly. They said they had to borrow a lot. In reality, they didn't have to borrow a lot. And a lot of good things happened in macro commodity space issuance is very small this year. On the other hand, budgets still look okay, but it's more bifurcated. West Coast, East Coast and the West Coast names are obviously benefiting from commodity prices, from increased taxation. And I looked back at some of the budgetary assumptions. Alberta assumed $75 oil. Saskatchewan, $70 oil, and every dollar above that was worth like half a yard in terms of budgetary balance. These are very big numbers when you think about your world and what you care about. Is it more name specific or is it just outright assessable valuation?
Paul Jenkin: Well, there's definitely name specific. And I think if you if you've been buying Alberta on asset swap instead of Ontario, the path forward looks quite good. I think Alberta is going to be in a good position. Oil stays high. Their revenues are tied to it. So it's going to be it's going to be good to own that credit, whether you own it as a as a selection choice. Ontario On the flip side, More headwinds, the housing markets get a soften. If the economy's get a stagnate a bit, then yeah, it's going to be felt more in Ontario. And if you look at their budget, if I look at what they forecast for where they're going to raise their debt for this year, it's rates are well north of that. So they're going to have to raise more just to pay the interest cost.
Ian Pollick: That's a good point.
Paul Jenkin: And their tax revenues, if you think we're going into a recessionary period, are going to fall. So renew your driver's licence sticker for two years.
Ian Pollick: For two years, just in case. Is that your message? Okay. So let me ask. So you've had the benefit of I'm going to say this in a very polite way. You've had the benefit of seeing various policy cycles and various business cycles that some in the market haven't. Is there something missing from the narrative today that higher rates immediately cause a recession? That is wrong. Are we missing something here or is this just a very different type of cycle?
Paul Jenkin: I don't think we're missing anything. I think I think people are making the media assumption that unemployment rates are going to spike higher, given that a month ago, anyone on this floor would have been saying, you can't hire anyone. Retention of staff is a key theme you hear around. So we're going to go from that being the issue to mass layoffs and an unemployment rate skyrocketing so that we can stop hiking rates because we've done the job against inflation. I'm not sure how I get that, quite that logic. I still I think jobs remain remain an issue for a while.
Ian Pollick: Like tight jobs.
Paul Jenkin: Tyight jobs that we're not. The unemployment rate stays low. It doesn't go higher. So that's not a bad thing.
Ian Pollick: That's not a bad thing. So that's interesting because last week Andrew Grantham had this kind of hypothesis and he said the recession that he expects is one where it's the high productive parts of the economy are the ones that go in recession, but there's not a lot of labour attached to those productive parts of the economy and therefore it doesn't actually do all that much the unemployment rate, i.e. developers, construction, housing. There's not a lot of labour attached to those sectors because they're super highly productive. And so at the end of the day, you could have a situation where growth slows, but the unemployment rate doesn't rise and that's maybe what gets you to your million percent overnight rate.
Paul Jenkin: Well the unemployment rate doesn't go up and inflation doesn't moderate very quickly, I'm not sure how many central banks get a stop.
Ian Pollick: Yeah. So you do not believe in the stop. And so if you think back to periods where you've seen central banks pause. In my career, it is always been a function of risk assets and it's been a drawdown in equities or it's been widening credit spreads, which is another way to say that the Fed put was a bit more responsive. The strike was lower than it was today. Do you really believe that there's an intolerance or an insensitivity to equities falling 3% a day? Credit spreads widening. Is that not part of the reaction function?
Paul Jenkin: Well, I think in the US we've seen a big shift in the political landscape. Right. Biden called the Fed in a chat and then came out and said inflation is his problem. It's his tools to fight and then walked off the stage. So I think you're and you're seeing that I think you're going to see it everywhere, which is politicians are going to say high inflation is bad for my popularity. Inflation is a problem of the central bank. It's their ball to fight with. And if stocks go down, they're going to say, look, our central banker for why he let inflation get out of control and they'll ignore any, any fiscal policy that was responses.
Ian Pollick: Well, that's interesting because you are fiscal policy. If I look at kind of the G7, you go through this very large fiscal drag in almost every economy. On the one hand, I'm like, is there scope in a downturn for fiscal policy to respond? You know, the political appetite isn't necessarily there, but the precedent of just depositing money into people's bank accounts has now been set. So who wins the population or the politicians?
Paul Jenkin: Well, I think think our Canadian government's about to embark on another stimulus package, not as a way to fight inflation.
Ian Pollick: No comment. All right. Listen, we have we've been speaking for 23 minutes. We don't want anyone to go into the weekend listening to this podcast any longer. Thank you very much for listening. Paul, are there any final words that you have for anyone listening on this podcast right now?
Paul Jenkin: All right. I think you need to change your starting comment. I think some bonds have been have been hurt.
Ian Pollick: Yes. Okay. So no bonds were harmed in the making of this podcast. But on the way into the podcast, some bonds may or may not have been hurt. Have a great weekend, everyone.
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