Ian is joined by Jeremy Saunders and the duo begin the show discussing recent central bank decisions. With four major central banks abandoning their tightening bias, the data has undermined the market reaction by showing a stronger underlying economy. Jeremy talks about the problem with short-end pricing in Canada versus the United States, while Ian shows why US and Canadian inflation is more comparable than meets the eye. Jeremy provides his view on the latest Treasury refunding announcement and the implications on QT, while Ian discusses why recent BoC measures to bring CORRA back to target won’t work. The duo spend some time opining on the path of swap spreads, and have a friendly disagreement on whether the belly is cheap or rich in Canada.
Jeremy Saunders: A lot of the confusion around this was sort of an exponential effect of, A, a lot of people paying attention to the quarterly-
Ian Pollick: Like way more than usual.
Jeremy Saunders: Yeah, that have never looked at it before. And that perfect storm is coincided with the TBAC changing the format in which they released the information this month for the first time.
Ian Pollick: Good morning, everyone. This is the first episode of Curve Your Enthusiasm in 2024. I'm joined today by Jeremy Saunders. Jeremy, how are you?
Jeremy Saunders: I'm good, how are you?
Ian Pollick: I have a question for you.
Jeremy Saunders: No, no pop quiz.
Ian Pollick: No, it's not a pop quiz, it's not a pop quiz. What is your favorite planet? So what's your favorite planet?
Jeremy Saunders: I was going to say Jupiter.
Ian Pollick: Okay, so you just came down from Jupiter, right? You just landed, it was a great trip. And the only barometer you have on the health of the economy is to look at Z4, SOFR and Z4 CORRA. Week over week, both have repriced 20 basis points. What hawkish innovation would you think was introduced in the past week to make them repriced that way? Because you didn't get any is my point. You did not really get anything. Okay, and so I bring this up because in a week where you had more or less an on as expected outcome from central banks, I want to start the episode talking about central bank confidence and the confidence towards reaching that goal of inflation moderate towards target and what that means for policy. So let's just start with the Fed. What happened last week in your view?
Jeremy Saunders: So I think there's a lot of cross currents in the markets right now. People obviously have some PTSD around regional banks. And I do think that positioning came into the week reasonably short. And so you've got some signals from the market that are a little confused, but I think if we're going to talk about the Fed, they pretty much did what people would have expected them to do, which is broadly confirmed their outlook from the previous set and perhaps pushed back a little bit on the aggressive timing that was in the market. I mean, look, the Fed is an inflation targeting central bank, and measured inflation has come down quite a lot, particularly in the US. You've got this weird-
Ian Pollick: But then they also have the other side of the mandate, which on Friday we saw was, at least on the surface, pretty strong.
Jeremy Saunders: Yes, but the other side of the mandate is maximum employment. It's not full employment. It's the most you can get at your price level target. And so I think the Fed's got this scenario where measured inflation has come down quite a lot and is arguably at or very close to their target. But the growth picture, the surrounding macro data is not confirming the inflation measurements if you believe in an output gap or Phillips curve world.
Ian Pollick: If you are a new Keynesian and you believe that economic slack opens up a reduction in prices, you're not seeing that.
Jeremy Saunders: And so the question is, if you go forward in time and you get inflation at your target and strong growth, what do you do? And my position is they're going to cut.
Ian Pollick: Well, listen, I don't think anything we saw this past week, whether it's US GDP or jobs or what Powell said, means you don't cut. I just think it's more in line with at least the way that we've been thinking about the world, which is four cuts this year and they start kind of June, July. But let's just talk about the divergence we're seeing between that story in Canada, because in Canada, arguably, you have a much more softer macro backdrop. You know, growth has basically been zero since the start of last year. Albeit you did get some recent data that was okay that we'll talk about. But against that, you have high inflation compared to the US. Like on a measured basis, Canada has higher inflation than the US, a worse growth picture and economic slack that is now getting larger, not smaller.
Jeremy Saunders: Yeah, so two things on that. So the bank has the opposite problem, right? Which is that the model inputs to your Phillips curve or your output gap model suggests that inflation should be lower, but measured inflation, and particularly in the somewhat arbitrary bespoke measures that they've chosen to focus on are frustratingly sticky. And so I think both of these, both central banks are taking on board the lessons of the last three years, which is to say we can't be as model driven as we have been in the past. And to some extent, we have to trade what's in front of our eyes. And in the US, what's in front of their eyes is inflation, and particularly the measures they've decided to focus on, have gone down quite a lot. And in Canada, inflation, and particularly the measures they've decided to focus on, haven't gone down as much. But I do want to caveat that by saying that we're getting, I think a lot of us have gotten distracted by these very narrow measures, trim and median, three month annualized in Canada and the six month annualized core PC in the US. If you take a 30,000 foot view of what's happened to inflation in both countries, actually the US has had more price level appreciation than Canada and the 12 month rates on almost every measure including trim and median, which the Cleveland Fed puts out, have been higher in the US for almost the entire time.
Ian Pollick: Well, that's the thing. If you look at a like for like basis, it is not clear to me that what the short end is pricing in, i.e. that you need more Fed rate cuts relative to Canada makes a ton of sense. And so one of the things that we've been asking ourselves is on this idea of these tailored bespoke measures of inflation, why does Canada look so different? And so remember that at least CPI trim in Canada is at a 20% level. And so you're removing 40% of the basket. There is literally no other country in the world that comes that close from moving so much from the distribution. And the problem is, of course, is that all the disinflation is at the tail. And so if I were to take a different measure and do like Canada trim 10, you know, you're putting back in shelter components, you're putting rent back in, but it is running at three-three six month annualized versus trim at three-eight. And so that puts you basically flat to where the US is. But the point is that, you know, that last mile problem is much harder for Tiff than it is for Jay. And so I think that is something that at least the short end has not accurately priced. And the most interesting thing about the price action last week is that Canada sold off one for one with the US on largely US innovations.
Jeremy Saunders: Yeah, I think that's partly a function of how Canada gets priced, which is equals a fixed number to the US until someone tells the market that it ought not to be, right?
Ian Pollick: But that's the theme, right? The past three years, when Canada looks mispriced, the US reprices to Canada, right? That’s why this is a little bit different right now.
Jeremy Saunders: So let me ask you this. If you came in next Monday morning, and you said, ah, now it makes sense, what does the Canada curve look like in the front end?
Ian Pollick: To me, the Canada curve in the front end has at least 125 priced and has at least a quarter ahead of the Fed. That, to me, I’d be like, you know what, this is much more realistic. Just speaking to the fact that whether you believe in an aggressive Tiff or not, that the data is just worse in Canada, that you have a more levered economy in Canada and therefore keeping policy at restrictive levels for that much longer doesn't make a ton of sense. You have twos fives steeper, twos fives tens cheaper than dollars. To me, that is something that would remediate where I see the problems in the curve. Jeremy Saunders: Yeah, totally. I think what you're trying to say and what I agree with is that the things that Canada is focused on in terms of measured inflation are providing a perhaps false picture of higher inflation and that at some point-
Ian Pollick: Or more persistent inflation.
Jeremy Saunders: Yeah, and that at some point, the data is going to catch down, the arbitrary slice of data we're looking at is going to catch down to reality and present the true picture.
Ian Pollick: Well, I think there's a risk that the Bank of Canada kind of abandons CPI trim and goes back to CPI X8 world.
Jeremy Saunders: They really kind of, it's going to be a tough communications exercise to-
Ian Pollick: Well, you know, this whole we redid these and they'll say, look, we trained our models pre pandemic. They've already dropped common because of the problems with it. The way that trim is, like I said, it's ignoring all of the disinflation. And so are you really in this type of environment going to ignore that? At least 10 percent of that tail, which is really pushing inflation down. I don't know. But let's just talk about the data for a second, right? We're fresh off very strong jobs report. And I said earlier superficially because I think the reality here is that you had that polar vortex. It was cold. Hours worked was low. That means the wage pie is being divied amongst a smaller amount of hours. And so wages look much stronger than they did. And in fact, if you were to look at full year growth in the United States, almost 85% of jobs were part time jobs. That, to me, does not scream a very tight labour market.
Jeremy Saunders: I think that some of the surrounding data like average hourly earnings and the workweek that have got a lot of people a buzz on various social media and research notes is, we can take those with a grain of salt, but it's really hard to argue that the data wasn't strong. There was very strong revisions.
Ian Pollick: Unequivocally, you had a large number of jobs being produced. And I think, you know, the question, and I think Goolsbee talked about this. It's like, well, wait a second, even in a world where average hourly wages weren't that strong, you're generating all these jobs. You have to start out questioning productivity because productivity is the buffer that eats inflation. That's something that's a Canada problem. We don't have productivity, which is why wages are so important. Where in the US you have massive productivity, yet why are you absorbing so many jobs? And so in the absence of that productivity, then you have a real issue.
Jeremy Saunders: There is a seasonality issue around January. Clearly the last couple of January's have been strong. I mean, the traditional seasonal pattern of you hire a bunch of seasonal workers in September, October, for the Christmas shopping season and you let them go in January is clearly going away. Now that's not to say the number wasn't strong. The unadjusted number was still 100,000 above what it had been for the last couple of years. What is a seasonal adjustment meant to do? It's meant to try and let you compare.
Ian Pollick: Apples to apples.
Jeremy Saunders: Yeah, but so like a January to a February to a March when there's these things. You almost have to look at the unadjusted number compared to previous January's at this point, because I think the seasonals are having quite a lot of trouble. Well, quite a lot of trouble is not the right word, but-
Ian Pollick: The interpretation of the seasonals is hard. And even in a market like Canada, like remember Canada opened up later than everyone else after the pandemic. And so we had this weird pattern where we went into lockdowns at the start of the year and we opened them up in the spring and summer. And so the January seasonals were just decimated. And you saw that in 2021 and 2022, but then 2023, you know, you had this massive jobs report. And so the seasonals seemed to go the opposite way. And I think that leaves me very concerned about jobs this Friday being another, like, just disgustingly blowout number.
Jeremy Saunders: I tend to agree. I think the seasonal is going to be a big problem in Canada as well. So, so Ian, make CAD GDP make sense.
Ian Pollick: So listen, it was very strong. And it seemed to be that more growth is still occurring on the supply side of the economy. And so just for context, remember the Bank of Canada had 0% growth in Q4. If I look at the numbers that came out, you know, last week, you're tracking one-two for the quarter. The bank's pretty good at its near-term forecasting. And so I'd be very surprised if they were that off base, but the data is telling us what's telling us and you're tracking one-two annualized for the fourth quarter of last year, the handoff is 1% for Q1. What I think though, doesn't change even with that level of growth is that it's all coming from supply side. There's not a lot of demand coming from this growth numbers. And so I'd be more concerned if I could see the demand-ey stuff contributing more to growth, but that's not what we're seeing. And so if anything, within the context of, you have slow growth in Canada, you have inflation that's not telling the full range of the story because you're not measuring it accurately. And the strong growth is a function of really supply side growth that will bring down future prices. It even exaggerates this idea how wrong the cross market curve is.
Jeremy Saunders: But we are going to need some. confirming data to fix that.
Ian Pollick: And Friday's potentially massive jobs report is not going to be the one to do it. And so let's just take a step back because the bond market prior to the Fed last week did have a very large test and it passed that test and that was the quarterly refunding. And so in the event, we found out that there's this weird surplus that was unexpected, that's large tax receipts. And so the big story here is that coupon supply is doing nothing wrong in terms of expectations, relatively tepid growth. But the real story is that bill supply is not quite negative. And so walk me through what you think this means.
Jeremy Saunders: Yeah, so I think a lot of the confusion around this was sort of an exponential effect of, A, a lot of people paying attention to the quarterly-
Ian Pollick: Like way more than usual.
Jeremy Saunders: Yeah, that have never looked at it before. And that perfect storm is coincided with the TBAC changing the format in which they released the information this month for the first time. If you go back, Q2 is always negative bill supply. I mean, it's a seasonal factor, right? The treasury gets in a bunch of tax receipts in March and April and it's flush with cash and it absorbs that by net negative issuance of bills and then throughout the rest of the year it issues bills. And so I don't think that this was particularly unusual in the context of other Q2s. And what it suggests is that at the margin, the US Treasury received higher tax receipts than what they were forecasting previously. But people are looking at a number that went from 700 to minus 200 and they're going, oh my God. And yeah, I mean-
Ian Pollick: I don't think it's that sensational.
Jeremy Saunders: No. What this says is, it looks like they'll be able to keep coupons constant for the next couple of quarters. They're not forecasting much beyond that. Ultimately, at some point, coupons will need to go up, but this is not really going to be a term premium. The supply story in the US is not going to be the deciding factor on term premium for the next quarter or two.
Ian Pollick: For sure, like it is not a Q3’23 where the supply was so much larger than expectations that it exaggerated every build and term premium, right? Like that is not what you're seeing right now. And if anything, I would say that term premium relative to like five to five to break evens, term premiums probably look a little bit too high, particularly in the market like Canada. But like, do you have any thoughts on how this net negative bill supply interacts with RRP and your timing on QT?
Jeremy Saunders: Yeah, so it's going to it's going to extend the duration of QT, right? There's an interesting dynamic between the amount of money in the RRP is kind of like a reserve asset for absorption of supply. And as long as there's cash in there, then it extends the ability of QT to continue. And so the fact that there's net negative bill supply means there's $200 billion now that is looking for a home. And that will probably go back into the RRP and that will be reserved money to come back out in Q3 when they ramp up bills again. And so all this means that the urgency around QT is delayed.
Ian Pollick: I agree with that.
Jeremy Saunders: So speaking of front end plumbing mechanics, let's talk about CORRA for a second.
Ian Pollick: I love this subject. So listen, I think it's a pretty easy subject.
Jeremy Saunders: This is going to be interesting to at least a dozen people.
Ian Pollick: I'd say 11 people on this podcast are going to be like, this is spot on. Look, the issue of CORRA is we know what's happening, right? You have this persistent deviation of short-term interest rates from target. And that's a function of a couple things. You know, on the surface, it's this idea that the Fed has talked about. It's like maybe we are below the ample level of reserves in Canada, which is crazy to me because there's 100 billion of reserves. And pre-pandemic, we had a system that had zero reserves. And so why now are you seeing this persistent deviation? I think there's a couple of reasons. I think the first reason, which is relatively simple to understand, is that when I look at the composition of who owns these reserves, irrespective of the fact that it's 100 billion, it's owned by too few people. And because it's owned by too few people, there are other members of the system that need cash. And with these reserves earning overnight money, there's not a huge amount of incentive to trade that flat. Okay, and so you have this upward push. Number two is that when you think about anchoring QT, and you think about that liquidity distribution that the bank should be indifferent around, is five base points that big of a number to interrupt the transmission of policy? I don't think it is, but it's enough that it's got the bank's attention. And so the bank has been in doing these overnight repo operations and recently, like the end of last week, they reintroduced the receiver general balances. The receiver general balances, the interesting thing is if you look back at Bank of Canada research, it literally says these things will do absolutely nothing for GCU or anything for CORRA and there's zero correlation between that and deviations from the target rate. And so what is clear to me is the bank is trying to buy time and that time is they're trying to wait, at least in my opinion, till you get to that period, March to April, where BA runoff gets quite large, like 35, 40 billion. And maybe that's a period of time where you get that reinvestment back into repo. And all of a sudden you're in a world where you're now 502, 503, and that's the new 5%. And so I think similar to what you just suggested on the timing of the U S announcing a QT cessation, there is zero urgency, even at 505, persistently in my mind that the Bank of Canada has to stop QT because it's not even clear to me that when you stop QT, CORRA doesn't have to go back to target. Like there's no mechanical reason why this has to go back. And so you need something bigger and you need to learn how your participants are trading in this new world.
Jeremy Saunders: And I think there's a question about like, why does this even matter, right? I mean, just for context, we're for the non plumbing oriented. We're talking about a policy rate that is setting at five oh five versus a target rate of five percent. So there's a five basis point difference. Does anyone other than repo market participants really care about this?
Ian Pollick: No, I mean, I think it's interesting because for a lot of people that aren't a fan of short end plumbing, on the surface, you can make a really bad story about this. You could say there's really crappy assets in the Canadian system, collateral is losing value and therefore the price of repo is going down. And it's sensationalist, right? Like it's not true.
Jeremy Saunders: This is a prime zero hedge.
Ian Pollick: Yes, correct. Correct. It is not correct.
Jeremy Saunders: Imminent collapse.
Ian Pollick: Imminent. And so I do think that there's a reason to think about it, but you could also make the case that in a floor system, like how monetary policy operates right now, if 5% is your floor and 525 is your ceiling, the fact that this isn't trading at five and an eighth is probably a win by itself. So is it six beeps through or is it five beeps over? Like, choose your poison how you want to narrate this.
Jeremy Saunders: And in the US, the target range right now is five and a quarter, five and a half. And you've got a constellation of target rates and none of them trade right in the middle.
Ian Pollick: Correct. So anyways, that's why things go on with CORRA. But you know, what's interesting is that in the Bank of Canada meeting, you didn't have a QT announcement, which for some reason, some people expected. Obviously, they weren't reading our research. And then you had this huge volatility in two year swap spreads. So let's just parlay into Canadian swap spread talk. Give me your view.
Jeremy Saunders: So spreads have gone down quite a lot. I think that's the high level description of what's happened. And so the question is, is that a made in Canada story or something else? There's definitely made in Canada elements to it. But I do think it's very interesting, especially in the belly that the net change in Canada since, you know, start of October when spread starting going down, it's actually very similar to the US. And that to me suggests that what's been happening is not particularly homegrown and is the result of a larger move.
Ian Pollick: I think you've had tenor specific homegrown reasons, right? Like twos in Canada versus twos in the US swap spreads, particularly in the back end as well. And so I guess, you know, when you talked about the refunding announcement, but one of the things we didn't talk about is you have the buybacks now and that the margin buybacks operate like QE and should richen some of that deep off the run product. And that also spills over into Canada and you're going into, at least in dollars, very strong swap spread seasonals in February. It's because of all the issuance that you tend to see from the financials early on in the year, the massive purchases, cash richens. And I think that spills into Canada. So I like a steeper spread curve in Canada. I don't know what your view is.
Jeremy Saunders: I like the opposite, Ian.
Ian Pollick: Okay, do you? Yeah, like twos tens?
Jeremy Saunders: Yeah, I do. I mean, I think we've had a big move and it's not been Canada specific. And that big move has basically been that rates rallied a lot and that move got chased by various account types. It got chased by bank treasuries who were worried about missing out on the big rally. It got chased by a model-based account to trade momentum. And it got chased by, let's call it, speculator accounts that are sometimes trading I mean, reversion strategy and sometimes momentum strategy. And we got quite a lot of downward momentum in the level of rates. So I think that explains a lot of the move down in both Canada and the US. And the question is where to from here. My view on the level of rates, especially in the belly, is probably more range bound now because there's quite a lot of uncertainty. We had our repricing of the tails of monetary policy from the sort of right tail to the left tail.
Ian Pollick: Now you're going to get back in the middle. Neutral has to be the-
Jeremy Saunders: Yeah, exactly. But meanwhile, now you've got homegrown dynamics in Canada. So two year spreads. Why are two year spread so high? Two year spreads are so high, I think, mostly because mortgage production in Canada is focused in two and three year area. Mortgages are a long duration asset for bank balance sheets and which they hedge and they hedge in derivative. So now the question is, is that going to change anytime soon? I think we've just been discussing how while we think ultimately the bank is going to lower rates. Quite substantially in the near to medium term, let's call it before June, it's unlikely they get enough clarity in the data for that to happen. And so while you've got this scenario persisting of, if you take a variable mortgage right now, you're paying an 8% or 7% coupon. If you take a three year mortgage, you're paying a five and a quarter coupon. If you take a five year mortgage, you're paying a 499 coupon. What is the average Canadian going to choose?
Ian Pollick: They're going to take threes all day long.
Jeremy Saunders: Exactly. And so I don't see much reason for that dynamic to change. And so I think that keeps two year spreads relatively bid on the curve. Against that, I think there's still a dynamic of bank liabilities longer dated. And now they're trying to change that. If you look at what Canadian banks have been doing issuance-wise over the last three months, they've tried to skew it a lot shorter dated. So you've seen a lot of two-year and three-year issuance and much less five-year bond issuance than you had over like, let's say, the course of-
Ian Pollick: But your biggest liabilities are deposits. That has not gone down in this country.
Jeremy Saunders: Exactly. So some of that is unavoidable and I think that continues to keep pressure on the belly of spreads. And I think there's some other interesting dynamics out there with like Canada mortgage bond that are also going to keep pressure downward on belly spreads. And then also I think that my view on Canada versus US duration is ultimately in the belly we should richen because the growth dynamics are much less favourable in Canada than the US. And the last thing I'll say about all this is that part of the cheapening both in Canadian belly duration and also bid to belly spreads in Canada over the last month or month and a half has been a result of seasonal issuance patterns in provincial bonds. And a lot of those issuers now are going to go into blackout over the next month or so as the major issuers have budget updates coming in March and they won't be issuing very much ahead of that. So I do think at least in the near term here, their spreads should be under pressure, particularly in the belly, and the two-year spread trade should continue to confound.
Ian Pollick: Listen, I don't disagree with a lot of that, you know, for what's worth, my favourite trade right now and it continues to be just a cheaping of the belly in cash. You know, twos fives tens to me, I think there's a very big discrepancy between the shape of fives tens versus the shape of twos fives. And fives tens still looks much too steep to me. And so even in a world where you have this repricing of neutral, I think that you are still subject to risking some of the whites and the early data reds repricing faster. That is a twos fives steepener. You know, we're not agreeing in terms of our view on the belly. And so let's just see who's right.
Jeremy Saunders: But one of us is going to be right.
Ian Pollick: One of us for sure is going to be right. And so we'll see, see how that turns out. But twos fives tens, I still think makes the most amount of sense. Because right now, like the level of duration to me is actually getting close to a buy. You know, you have repriced a lot. But PC one relative to let's say PC three, like your butterflies is your highest correlation. So if I'm wrong, I don't mind doing a butterfly space as opposed to being just outright long, outright short. Look, we've talked for a lot. It's a pretty long podcast first one of the year. So I guess it kind of had to be. So thank you for everyone for listening in each week. And by each week, I mean, you know whenever we actually do a podcast. We'll try and do it more frequently, but I hope you enjoy it. I hope you have a great week ahead and remember there are no bonds harmed in the making of this podcast.
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