Ian is joined this week by Mike Larson, and the duo kick off the episode by discussing the elephant in the room – the level of interest rates. Ian discusses the mechanics behind the ungluing of global long-end interest rates, while Mike gives his view on swap spreads. The pair talk about why the level of swap spreads should continue to decline, especially given how much 10yr Canadian rates have underperformed the United States recently. Ian gives his view on the absurdity of trading the ‘higher for longer’ and the ‘soft landing’ narrative at the same time. The show finishes with Ian and Mike outlining their favorite trades and which positions are the most crowded.
Mike Larson: I think it's Canada that has it right, right now. And I think to your point, what people maybe aren't talking about is what if the data accelerates and they need to actually go further than the 500 quarter terminal?
Ian Pollick: But you can't discount that. You can't say that's not going to happen, right?
Mike Larson: Yeah.
Ian Pollick: Good morning, everyone. So as we head into the long weekend, we have a huge amount to unpack from a very busy week. I am joined today by my good friend, actually one of my closest friends in the business, Mike Larson. Cash investors, you'll remember him from his stint on the Government of Canada desk. Right now he's on the interest rate derivatives desk. Mike, thanks for joining.
Mike Larson: Yeah, thanks for the invite. A long time listener and first time guest. So happy to be here.
Ian Pollick: I can't believe this is your first time on the show.
Mike Larson: It's taken a few episodes, but we made it eventually.
Ian Pollick: I'm very sorry. Let's just talk about some of the big issues out there. And you know, I know we discussed a little bit what we want to talk about, but we got to talk about the elephant in the room, which is the level of yields. You know, we've been in a situation where the back end has effectively become unglued. What do you think is happening?
Mike Larson: Yeah, I mean, I think the pressure on the long end really has been a bunch of factors, probably some poor positioning, you know, maybe early set up for month end general supply and treasuries building, you know, albeit we had belly supply this week. Oil is up a lot of chatter on higher for longer and the repricing of 24 dots domestically we had a bit of a challenging Ten-Year Supply Day in Canada yesterday. You know, I think the Fed and the bank have both done a good job convincing the market we are higher for longer, which certainly helping this steepening the 24 dots moving higher in the US and cuts being priced out until the fall of 24 and really Canada nothing until 25. So the market's telling you, you're nearing a cycle end twos are stabilizing, cuts are being pushed out, neutrals higher. Is a soft landing achievable or are we going to break something along the way?
Ian Pollick: Well, it's weird, right? Because, you know, I find it very hard to reconcile this, and you have on the one hand, okay, higher for longer. And like, I get that, right. It's like a small open economy. The cost of not fighting inflation is a bit higher. You've got to keep rates higher for longer. Fine. And so mechanically that pushes cuts out. It stabilizes the front end to a degree, and maybe you could argue it raises neutral, but I actually think it's the soft landing narrative that is keeping neutral, higher, but also it's transferring all this kind of vol to the back end of the curve. And that's happening at a time where I don't know who the natural buyer is, and I'm not just talking about Canada, you know, it's a structural investor market, LDI heavy. What I'm really talking about is long and Treasuries, who is buying this stuff? And in the absence of that, you get this movement in the back end of the curve. And I just don't know how sustainable it is, because if you believe in higher for longer, then that decays the probability of a soft landing. And so if you have a deterioration in growth fundamentals, I would think that you get lower ten year yields, right? And so I think this is where I'm struggling to see this being as sustainable. But let's bring it back to Canada for a second. Right? You think about your own experiences. You think about what the Bank of Canada's told us when we think about the next potential hike or notch from the bank. Are you in the camp that you think that they could hike again or no?
Mike Larson: You know, if we look at October pricing right now, let's call it, it's 50% probability of a hike. You know, we've really corrected post CPI across the curve. And I think we've we've stretched at least relative to the US. I do think we could get a hike this month and it certainly would come as a surprise to nobody. The Fed's got 12 members calling for a hike pre year end. The bank is priced for let's say one more hike and then holding terminal at five and a quarter through the middle part of next year towards the end of next year. So not to be a bit of a fence sitter, but I think 50/50 is about appropriate right now. We need to see how the data develops over the course of the next month.
Ian Pollick: Yeah, and I think it's the labour market report. Right. And what's weird about this whole thing though, it's like if the Fed doesn't go, they're seen as behind the curve and therefore you have inflation and inflation vol that moves to the back end, you get the steepener. But if the Fed does go again, it's seen as maybe a bit too much, then that means you don't have enough cuts for 2024 and all of a sudden there's no soft landing. And so the market is pricing in this sitting on the fence, but it's put itself into a box. And so ultimately, I think that's unsustainable. I do agree with you, though, that when I look at the pricing on at least ROIS curve, I think it's very fair to have these residual hikes living in 2023. I find it very weird that Peak terminal is in March 2024 and that your first cut isn't until your first full cut from today's level is not until the end of next year, right? Or March 25th like that is almost priced for zero risk. And so when you are talking to investors, is there a theme that people are giving you that? Do they really believe Canada doesn't have to cut rates next year?
Mike Larson: No, I think that most would believe that the bank needs to be cutting rates next year. The way I'm thinking about it and the way I'm looking at it is it's tough to classify Canada as maybe being totally wrong right here. Like I do think we need cuts next year, but I actually think it's the US that looks rich at the moment. If I look at it on a relative basis,
Ian Pollick: Like the policy forwards.
Mike Larson: Policy forwards, you know, the Fed just came out and said year end, 24 dots are going to be 5% and 8% based on the data they have now further out. Those forwards aren't there yet. So I do think Canada looks a bit cheap. I do think if the US is going to have cuts priced, we probably do need something price. But they've really communicated the higher for longer, and at least on the Canadian side, the market is listening to that.
Ian Pollick: Well, it's funny, right? Because, you know, this is very similar to 2022. Oh, Canada looks so wrong. How could Canada normalize? Look at the US and then everyone reprice to Canada. You think this is one of those situations where Canada is not wrong?
Mike Larson: I think it's Canada that has it right right now. And I think to your point, what people maybe aren't talking about is what if the data accelerates and they need to actually go further than the 504 terminal? That's not my base case, and I wouldn't suggest that to anybody.
Ian Pollick: We can't discount that. You can't say that's not going to happen. Right. So let me ask you this. You know, when you think about the move that we've had in duration and so you've had this very weird bear steepening of the curve. You're a swap trader. And so how is this manifested itself into the swap curve, whether it's spreads or whether it's some of the one year or two year forwards, what's the most prevalent theme that you're seeing?
Mike Larson: We've been pretty sympathetic to your views. You know, we thought spreads had been a bit high. Generally good carry profile to be short. The front end, if you look at twos, let's say a basis point, a month, a bit better receiving going through there really for what feels like the better part of summer. So the short front end spread view has been a trade we've liked. It doesn't feel like that trade is over just yet given we've got the highs and yields thing kind of further back up, you probably see a bit more receiving given the entrenched narrative that terminal is five and a quarter for the moment. You know, a bit further up the curve. The big impact has been, at least in the last week or so, the cheapening of Canada versus the US, and the pressure this has put on belly spreads along with some domestic and maple supply that's hit the market-
Ian Pollick: And so what you mean by that is as we cheapen, people come in to receive CAD and spreads fall.
Mike Larson: Exactly as we cheapen people are coming in to receive CAD spreads fall both on an outright basis with the backup and yields like you know we got through 4% in CAD tens, which I thought would be a bit more of a holding level, at least duration wise. We kind of broke through that pretty easily, but it's better receiving and buying into the downtick that is keeping spreads in the back foot.
Ian Pollick: And so when you think about, let's say, the next three months of spreads and let's marry it to your rate view where, yeah, maybe you get some more hikes, maybe the level of yields is a bit high, but overall spread view Are you agnostic on direction and spreads or do you think it's going to become more directional?
Mike Larson: I think the two year spreads still have some room to go lower. Keeping with the theme, there were highs and yields. I think if we back up further, there's probably some more money to be put to work receiving the front end. Whereas I do think if any of these accounts that have been paid in are short here and the market turns in rallies, we could see further short carving there. So I like to use spreads lower from here. If I say they're 11.5 middle now, I think the high single digits is a pretty good target. Ten year sector, I'm a bit more agnostic on. We've had a good pullback this week, September has been a heavy supply month.
Ian Pollick: Yeah, we had a nice move right like from 16 basically sub 13 ish.
Mike Larson: Which was your first target and ten year spreads was 13 basis points. So from my perspective, I still don't think there's a ton of support for ten year spreads. Generally, ten years are getting cheap on the curve. If I look at 5s10s30s. If I look at five year, five year where that is level outright, I think there's a lot of work that can still be done to potentially keep some pressure on ten year spreads absent renewed interest in asset swap buying. So I lean small short on the margin here, ten year spreads, but I'm curious what you think, given we moved to your target pretty quickly.
Ian Pollick: We definitely moved to my target and it was not a popular view. And so I'm a bit validated that it happened. But when I look cross market at 5s10s30s, just domestically, that ten year sector is very cheap. The one thing that worries me though, so that could bring in some cross market receiving. What worries me though, is that there's a lot of evidence. When I look at the futures data, remember that we have the only-
Mike Larson: Reverse algo.
Ian Pollick: The reverse algo method, CIBC Ram, it's the only positioning indicator in Canada. And remember, this is based off of nanosecond tick data that we use in the Montreal exchange. And what it shows us is, number one, shorts are slowly starting to cover, which feels a bit weird given the move has been futures led, but you are seeing a bit of short covering. And the reason for that is because you have just so much PNL, right? Like there has to be a monetisation event because you have so much PNL in these short positions. And so I worry that this maybe starts to rich in cash a little bit, particularly to CN. So, you know, at least from an invoice perspective, I can see a potential move in the opposite direction for spreads, but I haven't seen a lot of invoice spread trading recently. Are you seeing invoice as prevalent as it was, let's say, six months ago?
Mike Larson: It's not been as prevalent as it has been six months ago. I'd say that most accounts are generally looking to express their view in ten year spreads or most accounts looking at the forward curve and the dislocations there to express a view. So it's not been as busy as it has been historically.
Ian Pollick: Yeah, and I can see that in the data too. But let me ask you this. We got the quarterly bond schedule last week and we saw there was an additional five year auction that we weren't expecting. And you kind of take a step back and say, well, where is this coming from? Well, we know that at the federal level, expenditure growth is rising a bit faster than we had expected in the budget. But also the and it sounds trivial, but the CEBA loan repayment, even though it's only three months, you know, that could be 10 to 15 yards that the government needed to fund Q4 that they're not getting. So issuance risks are rising. We haven't, traditionally, seen a huge impact of supply increasing in Canada and the move and spreads. Do you think that changes if we really do have a US type of well, there's more supply coming online. Does cash cheapen enough to continue the movement lowering spreads in your view?
Mike Larson: I think it could-
Ian Pollick: Yeah.
Mike Larson: I think especially I mean, you spoke of the CEBA loan payback, you know, federal expenditure growth, the CMB program, you know, again, depending on where that supply-
Ian Pollick: Done not done, let's grow 150%. Okay. Yeah. That one.
Mike Larson: Depending on where all the supply may or may not hit the curve, I think cash could cheapen up and Canada/US on the back of that cheapen up potentially in the long end which would be a spread narrower across the curve.
Ian Pollick: So let's just tie this into, you know the core transition. We've been in a core world for, what, three months now?
Mike Larson: A bit longer than that maybe, but give or take.
Ian Pollick: Core futures seem to be ramping up in terms of open interest and volume. Is there anything notable from this transition that we should talk about?
Mike Larson: Honestly, no, I wouldn't say there's been any issues or recent things to highlight. The market's certainly benefited from transitioning to core post the LIBOR SOFR transition. Open interest, as you noted, is right up there with with banks open interest right now so-
Ian Pollick: Is it actually?
Mike Larson: Yeah, it's very close depending on the day, depending on which contract may or may not be expiring post a slower summer period. So core is picking up. You know, the latest development really in our market is term CORRA technically open for business being published now. So something to keep an eye on with how that market develops.
Ian Pollick: So can you just walk us through very quickly for those of us that are uneducated on it term CORRA. Is it going to be a similar type of move in the US where you have this big one sided basis build up? Like how is this working in Canada?
Mike Larson: That will depend on the nature of hedging in Canada, and the difference being is that the interbank market for Canada is technically open to trade to specific participants. Now it will depend which accounts may or may not hedge their term core exposure. I would suspect that it will be a positive basis similar to the US. There's been a couple of very, very wide markets out there to start, but nothing that's suggesting of any transactional nature as of yet.
Ian Pollick: Okay. And so we can say that we've learned our lessons from the US, the transitions happening. That doesn't seem to be a huge amount of movement in terms of stuff that we didn't expect. Is that fair?
Mike Larson: Correct.
Ian Pollick: Okay. So that's good. Let's just talk about stuff that we can expect to potentially change going forward, and what I mean by that is Canada is a market that arguably provides a bit too much liquidity for its size. And so you tend to have these very large positions that build up and sometimes they go right, sometimes they go wrong. But then the pendulum swings and we all know what happens, what's crowded right now?
Mike Larson: You know, it feels like for the past couple of years, you could have probably classified the front end of Canada as maybe being the sector that would have crowded longs. I don't think it's going to come as a surprise that I think there's better buying and receiving into this backup and rate. But despite that fact, we're near the local chips. Positioning doesn't feel as challenged. You know, anything that's been done is rolling down the curve quite quickly and starting points matter. We're at 5%, two year yields. I think a lot of long Canada risk is actually cross market, which depending on where you're looking, may or may not be on side. So the positioning in the front end doesn't feel as challenged as maybe it has in prior months or prior.
Ian Pollick: Because there's a lot of hyperbole, right? Like the most crowded trading Canada is when you when you're cross market.
Mike Larson: Correct.
Ian Pollick: Do you do you still see that as a risk or is it in a way whether it's not as big or whether the hands that is in is a bit stronger than people are making it out to be?
Mike Larson: I always think of the risk as being the marginal hands that are in that trade and who may or may not be entering or exiting a position. And for me, if I think about where some accounts may have this risk on, I think a lot of that risk is on side. So it doesn't worry me at this juncture.
Ian Pollick: Okay. What about some of the dislocations in the curve? So you tend to have a group of investors that polices the one year forwards, the two year forwards. You have very similar disconnects in kind of the 2-1, 3-1 year, basically up to the belly forwards. Are we seeing that as being a bit of a concentration risk or is that I feel clean to.
Mike Larson: I think a lot of accounts tend to look at very similar structures and very similar risk trying to put on positive carry and roll down trades in the event the shape of the curve is unchanged, they can take that off and re-initiate new risk that they like depending on the movements and shape of the curve. I think a lot of accounts look at the same risk and try and achieve the same risk. But because so many are looking at a lot of similar structures, I'm not sure how much of them are getting on the risk they're actually looking for. So despite the fact there is similar interest, I don't think necessarily positioning build up is as concentrated as it could be.
Ian Pollick: And so give me an example. What are these structures? Is it basically 2s5s10s, that carries positively.
Mike Larson: A lot of them can be 2s5s10s structures, more of them can be one year gap kinks in the curve that and investors are trying to take advantage of, for your point has been cheap in Canada on the forward curve for quite some time that can be popular but it's mostly expressing traits that generate positive carry which at the moment have been for flatteners.
Ian Pollick: I agree with that because the forwards by themselves are very steep. Right? So realising those forwards relative to spot never made a ton of sense. And actually the better trades were the forward flatteners. You know, there is a school of thought and I want to run this thesis by you where people and let's not talk about core futures, let's talk about the one year gaps. And people say, you know what, there's not a lot price in Canada. Maybe that's because the Bank of Canada has a single mandate. They target inflation. That means if there's any jurisdiction where higher for longer is going to be more meaningful and realistic, it's Canada. The other school of thought is like, well, wait a second, You know, you now have mortgage originations that are skewing shorter. You still have hedging needs from these originations. They're not all offset by GIC flow. And so maybe some of the stickiness in the level of front end CAD yields is a function of end user behaviour. And therefore maybe there is more priced in theory, but it's being washed out by a larger account base which is the treasuries. What school thought do you subscribe to? Do you believe that maybe there would be more cuts, but there's just a structural pain flow because mortgages have skewed shorter.
Mike Larson: If I look at where my concern, you know, Canada specifically would be, I would look towards the housing refinancing and the mortgage refinancing that needs to happen two years from now on. The bulk of all these mortgages and low rates coming out and that part of the curve. You know, if I look at two year, one year, it's around 4.2. So it would be a punitive level certainly, but it doesn't feel like it has the potential to really derail things right now. There I do agree with the anecdote that it seems mortgages are skewing shorter, so there might be a bit more renewal to come in. But for the moment, I think the curve is kind of priced okay in this moment forwards.
Ian Pollick: Okay. So look, we're getting a bit long in the tooth here, so I want to talk about favourite risk, you know, what is your favourite risk right now?
Mike Larson: I think I've kind of alluded to it earlier. BoC wise, the pricing is really corrected in the front end post that CPI report we had. I think getting long Canada/US to you know, is a good opportunity in this backup. We moved 12 to 15 basis points. For me, I slightly prefer that trade in rate given I still think two year spreads are a little bit elevated. It's going to trade short, so maybe a bit of an overall long against that trade, especially as the market seems to be for the moment agreeing with an ideal of five and a quarter terminal pricing in Canada at the very least. So I think it takes advantage of a candidate cheapening in the US market not pricing in what the Fed has been telling us, that 50 basis higher in 24 dots at this point. I think you alluded to it earlier, I think 5s10s bonds has really cheapened up or the cheapest levels of last year getting very interesting versus the US as well. I like this trade. I think it's a less directional way to fade the speed of that. Steepening we've seen 2s through 10s and also takes advantage of 10s30s Canada being quite flat,
Ian Pollick: Very flat.
Mike Larson: Through -32, -33 basis points around there. I like that trade and rate. I still think ten year spreads could feel a bit of pressure, whereas 30 year spreads, 10s30s spreads, which is a bit flat. So you've got a bit of protection against a further flattening of 10s30s spreads widen. So being long 10s in the curve in Canada and front end Canada/US I like-
Ian Pollick: I agree same trades from my perspective. The only thing I would add is, you know, you're priced to perfection, right? And I will say this time and time again, things are never different, right? Rates go high. People are levered, people get hurt, economy slows. And so I think that we've really swung the pendulum from putting too many cuts into 2024 to not enough. And so when I look at some of these OIS switches like March, April at Positive, that doesn't make a ton of sense to me, particularly around the end of Q1 and NPR, Non-NPR. So I like those micro trades. They make sense. I also think that just reiterating the year theme, I do think that CTD ten year roll can start to steepen from current levels just because I think a lot of momentum will have to start covering soon just to monetize some-
Mike Larson: Covering futures.
Ian Pollick: Covering futures.
Mike Larson: Yeah.
Ian Pollick: Yeah, and so that's going to hit the CTD. Look, I was super stoked to have you on. This is a great conversation. Any final words?
Mike Larson: Just thanks for finally having me. Hopefully it's not as long until next time.
Ian Pollick: Yeah, we won't have you on episode 130. Everyone, we hope you have a great, long weekend. And remember, at least in the past week, there were a lot of bonds harmed in the making of this podcast.
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