Ian is joined by Jeremy Saunders this week, and the co-hosts begin the show discussing the manic week that was. There was not a lot of visibility to the moves in bond and equity markets over the prior few sessions, and Jeremy discusses his view on what was real and what was myth. Ian spends some time talking about the lack of evidence to support a few of the theories that markets are thinking about. The duo spend time talking about the level of interest rates going forward, disagreeing on the most likely direction of longer-term interest rates over the coming weeks. Ian provides his view on what the Bank of Canada is likely to do at their meeting next week, while Jeremy gives an update on his Fed views. The show completes with Ian and Jeremy discussing their favourite expressions of macro themes in the bond market.
Intro: So you believe that inflation is more important to growth. Again, I think on the if you just took the blind output to the macroeconomic model, you would be right. But the macroeconomic model does not consider the existential risk of Which is what we just talking about.
Ian Pollick: Happy Friday everybody and I do mean happy Friday because it's been one heck of a week. I am joined today by Jeremy Saunders, Managing Director on our XVA desk. That is the first time I've used the MD in the introduction. That is fantastic. It rolls off the tongue.
Jeremy Saunders: This is like a LinkedIn advertisement.
Ian Pollick: That's good. Hit him up for coffee. Listen, it has been a very wild week. It has aged me terribly and I actually haven't been aging all that well to begin with, but let's start off.with a fun fact, right? Let's just bring a little levity to what's been a crazy
Jeremy Saunders: At least it's not trivia.
Ian Pollick: I have two fun facts, left hand, right hand, you choose. Left hand. Okay, left hand. Here's the fun fact. Since 1990, the top 10 and bottom 10, i.e. the best and worst S&P 500 return days, 85% of those days have occurred in the middle of the global financial crisis and the pandemic. Yesterday, we got a new entrant. So I'm just saying, this is not a healthy market. You tend to see these massive moves in equities when you are already in a recession. And I'm gonna leave that there, but let's just start off talking about the elephant in the room, okay? The elephant in the room is let's either find a solution or debunk the myth. What do you actually think happened this week? With swap spreads, with the meltdown in duration, what do you think actually happened?
Jeremy Saunders: Okay, so to start with swap spreads, I think you need the context here, which is that in the last... month and a half before this meltdown, the swap spread community, let's call it fast money community, had gotten very excited about long US dollar swap spreads. And there's a couple reasons for that, mostly emanating from US Treasury, Scott Besson talking about deregulation, SLR reform. Various members of the Fed, including Chair Powell talking about SLR reform. There are also a significant prong of the US government's agenda seemed to be deficit reduction, which would be good for spread. So you've got all these factors that had gotten a lot of analysts and a lot of research pieces and a lot of fast money very excited about spreads. And there was a rip, let's call it 10 year spreads, 45 to 37. So you've got a... And I don't want to say fast money is weak hands, but they are mark to market. They don't have a mandate to be long spreads. There were surely some swap spread tourists with less than rock solid access to continue to repo and involved in the trade. So so the starting point is weak hands are long. And I think, you know, the idea that foreign central banks were dumping bonds to harm the United States or to gain leverage in a negotiation. I don't have any insight to that. But what I can say is when the market starts going from there's a 0 % chance of that happening to there's a 10 % chance of that happening.
Ian Pollick: Even a 5 %
Jeremy Saunders: sure 5 % chance that it is worth more than what does that do to the fair value of spreads? Right. And so I think you know, me and you have tried to work through questions like who could hold spreads up and why and would they and the answers are not very clear.
Ian Pollick: Yeah.
Jeremy Saunders: So, so really all of which is to say is an obvious catalyst, which is a U S government seemingly enacting a policy platform that includes a vague and not so vague threats on to the security of a US Treasury coupon and even the suggestion of that is going to make spreads go down and when you pile onto that a lot of positioning that is very very quickly offside from a community that's not necessarily mandated to be in the product to begin with I think you've got the makings of a waterfall.
Ian Pollick: Let ask you this, I'm going go through a list of all the things I've heard this week. I want you to say yes or no in terms of whether or not you believe. I like this game. Okay, so number one is China is selling treasuries.
Jeremy Saunders: No idea. Probably not.
Ian Pollick: Number two, foreign investors are not showing up in the auctions.
Jeremy Saunders: I think that's likely true.
Ian Pollick: Corporations were drawing down their credit lines in anticipation of funding frictions or just opportunistically that removed cash from the repo market. And that was one of the contributors to hurting any levered long, whether it's basis or spreads.
Jeremy Saunders: I don't think so. I think, you know, that's an interesting one. I don't think we saw particular stress in funding markets, but there is a lot of muscle memory here from 2020. know, 2020, 30 year spreads went down. People may not remember this because so many other things were blowing up, but 30 years spreads in 2020 went down like 40 beeps.
Ian Pollick: Yeah. Like I, so I looked at DVP repo, triparty repo, FEMA repo. If this was true, there'd be a footprint, there'd be something and there was nothing. Um, okay. We're gonna keep going. The sell off in of itself forced a CTD change in your 30 year future. That meant that people who are already long the future were 10 % longer in duration and that forced them to sell.
Jeremy Saunders: Yeah, definitely game up in the future is complex for sure.
Ian Pollick: Okay, overall reflexivity. I don't know what's happening. Therefore, I think I know what's happening.
Jeremy Saunders: I think there's huge reflexivity. I mean, all these market moves are hugely reflexive. Any chatter about, you know, thus the sanctity of the sovereign gets people looking at their book. you know, I think the fact that there's weak hands newly in that trade and offside created a huge waterfall.
Ian Pollick: But like at minus 90, do you think people were selling spreads?
Jeremy Saunders: I think that part of what makes the, call it multi-manager community, such good investments is very strong risk management. And that risk management would involve people selling positions that had exceeded their P &L budget. And I don't think...
Ian Pollick: What about new risks though? Like someone looking at minus 90 30 year spreads and be like, okay, this is a great sale here. see the market.
Jeremy Saunders: I think, I think you'll, I think from the, from the strong handed community, which is, treasury portfolios and bank desks, you would have gotten a buyer strike. You wouldn't have gotten selling,
Ian Pollick: But just a strike in terms of buying.
Jeremy Saunders: Yeah.
Ian Pollick: I mean, this makes sense. and so I think if we have to like really chalk this down, I do think it was a bunch of little things that maybe are turning into medium things. And they all work together at one period of time. Now we've talked about spreads, what happened with duration?
Jeremy Saunders: Well, I'm going to pass to you on that one.
Ian Pollick: I do think that the view was you have these very large tariffs. Tariffs are inflationary. There's a limited response from the Fed. If foreign participation is even a little bit more limited and if fiscal easing is not forthcoming, someone has to go buy a lot of 30 year bonds. And I think that just got compounded with this idea of everything we're talking about. I'm not sure I even understand necessarily what the fire sale was. You know, this is not an environment where you have a disproportionate of non-resident holders of US treasuries. It's about 35 percent. In contrast, you you look what happened in the UK. Something like 60 percent of all coupons in the UK are held abroad. So it's just not clear to me if this was just a market that dried up in terms of liquidity. When I look at bid offer spreads, they look obviously wider, commensurate with the vol, but they don't look as if there was this air pocket of liquidity that should have caused it. the truth is, I don't know. But on the spirit of I don't know, I guess the question is, what are you supposed to do with duration on a go-forward basis? And I'll tell you, my own fundamental profile is this. It is very clear to me that the degree of fiscal easing in United States is probably going to be less than what we had thought a month ago or two months ago. There's probably going to be a bit more policy normalization than people have thought a month or two months ago. You probably have... a bit more demand destruction as a result of some of the inflation kicking into the economy than you did one month or two months ago. And the tightening that we've seen in financial conditions or the overall volatility in financial conditions makes overall new flows almost untenable. And that's why you're seeing all these inflows into money market funds. And so I take a step back and I say, what are you actually supposed to do with duration here? And especially after the 90 day pause was announced. So I'll tell you my answer after you tell me your answer.
Jeremy Saunders:I think the app, the outright level of duration right now is really hard to handicap. If you just looked at the output of your macroeconomic forecast, I think it would be pretty clear that you should buy duration because ignoring the starting point and ignoring the underlying root cause growth is going to be way down. The inflation shock is going to be, I'm not going to say it, but it's It's not it's not going to be permanent. It's going to go away after some time. And and you're going to be left with a much lower level of growth. The problem is both the starting conditions, are you know, call it the last war being too high inflation, which will make a central bank much more reluctant to act at least preemptively. and also the fact that The underlying cause is a government policy, which means is the contractual issuance of that government the risk-free asset.
Ian Pollick: So here's the thing, right? You did have a very binding, unspoken arrangement where you will run a current account deficit, allow the recycling of reserves to come back into the US economy by way of Treasury supply. If that unspoken arrangement, to your point, moved from 0 % probability of being non-binding to 5%, you have dislocations. This is what gives me pause on duration, but I'll tell you, my gut is that I still want to be long US duration. I still believe that this market was obsessed a week and a half ago with growth over inflation. In the past four days, it's become inflation over growth. And I think we are right back to where we were last Thursday or last Wednesday. And I think that the growth dynamic is obviously going to be much more important. So I like duration. And maybe I'm stupid, but I think you're supposed to own duration here. actually like back end duration. We saw the 10 and 30 year options looked okay. It is the scariest part of the curve to own. That's another question. Like what are you supposed to do on curve? Like I am biased for a flatter curve here. Cause and we'll get to this in a minute. Cause I just don't see a Fed response right away. What's your view on curve?
Jeremy Saunders: One of these times we're going to have where we both agree on the trades, but not today. is not that day.
Ian Pollick: No, today is not that day.
Jeremy Saunders: Uh, I think Outright level of duration is tough. To me, it seems like an obvious steepener. And the reason why is just term premium. You can already see US term premium resetting significantly higher. And the way I like to look at term premium is I look at, I'm derivatives guy, so I look at one year, one year versus five 30 swap, but you can look at it twos versus five 30s cash. And there is a fairly linear relationship to the level of twos or the level of one year one year to five thirties cash and it's just broken. It's broken badly in the US. We've jumped to a new regime and to me that just screams term premium.
Ian Pollick: But here's the thing that bothers me about that. You know, I love term premium and I really do love term premium. You the weirdest thing about the past week is that you saw this massive move in risk assets, whether it's high yield IG or stocks and yet term premium did not move. And so if I decompose the level of yields, the only thing that I saw was like the average expected policy rate, i.e. risk neutral yields are the only thing that this market moved on. Term premiums hadn't moved. And normally, risk off means lower term premium.
Jeremy Saunders: I suppose, but that's a sort of circular reference, right? Because you're looking at a Fed model of term premium. It's the impolite model borrowed from a Fed idea. Right. Okay. So the IP model I disagree with. I mean, I just I'm a simple man. I look at the curve versus the level and the curve is steepening relative to the level. And to me, that makes total sense. The further out the curve you go, the more risk there is.
Ian Pollick: means that you're you're an inflationary star right now because you have to believe that the lack of sensitivity or lack of elasticity of term premium to decline in risk assets to all these negative growth indicators. So you believe that inflation is more important to growth.
Jeremy Saunders: Again, I think on the if you just took the blind output to the macroeconomic model, you would be right. But the macroeconomic model does not consider the existential risk of
Ian Pollick: Which is what we just talking about. So let's just extend that a bit. And so you said something a second ago, that central banks aren't going to act preemptively. Let's talk about the Fed. As your view on the Fed, let's say before this past week, what was your view on the Fed? And let's just overlay that with what your view is right now. I'll tell you my I don't know if I can remember a week ago. It was a long time. My view hasn't changed. I still think you get three Fed cuts this year. So I have no problem really. And where do you put them? Here's the thing. I have no problem with the magnitude. I have a problem with the timing. And so I still see September as the most logical. And so I kind of fade some of the gaps here. But what's your view on the Fed?
Jeremy Saunders: Yeah, I think that's right. think that, I mean, if I had to pick a, If I had to pick a trade to do, it's receive the Valley versus the wings in the US. And I think you're getting the, too much priced upfront. Growth is going to be worse than expected and term premium is going to be higher than expected.
Ian Pollick: So you end up in this world where your belly forwards kind of come in because you stretch things out, but the finance already priced and probably has to reprice. That's right. I don't mind that. Um, let's send that to the bank. Um, we'll have the bank candidate next week. Let's just start off with pause or no pause.
Jeremy Saunders: I mean, I don't think I have a reason to disagree with the market here. My vote's pause.
Ian Pollick: Yeah.
Jeremy Saunders: What do you think?
Ian Pollick: I struggle with this a little bit. My gut tells me they're not cutting interest rates next week. The problem is though, that doesn't obviate.
Jeremy Saunders: Next week's a long time away.
Ian Pollick: mean, next week is a, next Wednesday is a really, really long time away. I don't think they cut rates next week, but I don't think that obviates further cuts. And actually, the profile that I've been building in my head is I think it's zero in April and 50 in June. And I'll tell you why. You you got this kind of new tariff information about the rest of the world, and it seems better, but on a relative basis, Canada's worse. Fine. On an absolute basis, the weighted average tariff rate that Canada ends up having right now is about 15%. Now, if you assume full USMCA compliance on paperwork and proof of origin, and that some of these southern border, northern border, fentanyl emergency tariffs go away, then you are talking about a weighted tariff rate of like 6.5%. And so while that somewhat helps growth, what it means is that any of the inflation impulse that we were really worried about is dramatically lower. And the bank Canada has been fighting this kind of communications battle saying, well, we can't let inflation expectations become unanchored, business health league survey inflation expectations are high. But the reality is that the inflation imprint is actually quite low, the lower these tariffs go. And growth is being skunked by uncertainty. And so like I would expect nothing next week, a cautious message, no change in the deposit rate. But I do think you can get a much larger non-standard size cut in June.
Jeremy Saunders: And do think there's any chance that, you know, not to play devil's advocate that that's big braining it a bit and that they might find it easier to communicate 25-25?
Ian Pollick: Oh, for sure. I mean, like I think I'm being really cute on this. I think that a risk management approach tells you what you should do is probably cut rates next week because it's the fact of the easiest and then maybe deliver another one in June. But I do think there is a sensitivity to market pricing. You know, we've swung from 18 basis points priced, seven basis points priced. And I do think there is more sensitivity around that, particularly now. And I do think it's hard to make the message. Like there's not going to be any forecasts in this NPR. Let's just be very clear about that. There's not going to be a forecast. That is wild. And so it's hard for them to calibrate a policy response when they don't have a forecast yet, which is the only reason why I think that what they will do is not cut interest rates.
Jeremy Saunders: And what do you think about terminal in Canada now?
Ian Pollick: I still think terminal two and a quarter probably makes sense. You know, I've been doing kind of a running costed of the platforms that we're hearing from the two major political parties in Canada in the lead up to the election. You know, you're both just north of 20 billion. The multipliers are a bit different on each one. One is going to write checks, one's going to write taxes or reduce taxes. They both hit differently in different times, but they both matter. And so I do think that there is this kind of waiting to see what the outcome of the election is. And, you know, that may be unspoken and it definitely is unspoken, but I think that actually legitimately matters for the bank. And so it's hard for me to see a world, unless the global economy is tailspinning and you're a small open economy, that you probably are very close to being done. I what do you think about that?
Jeremy Saunders: Yeah, I think the window for fiscal stimulus in Canada has never been more wide open. think you can see the last week has been competing announcements of lower tax cuts. I'll do this incentive. I'll be spending money on this. And the narrative in Canada around fiscal spending, all the political narratives in Canada have been completely flipped on their head. I think it's wide open and the debates are going to be about where does the spending go, not the level of spending.
Ian Pollick: For sure. think this is the first, know, Craig Bell said this best, and he was saying on a conference call he had the other day, is the first Canadian election where the real issue is Canada and not just what are my taxes going to be? What's happening to my PA? And so like, I do think there's this like very latent animal spirit that I the country is ready to accept. Now that's obviously not happening right away, but I think it matters. Okay, favorite trades.
All right. I choose the opposite trade of you. I think I like five stories box. I like the US steeper. I like Canada flatter. I would do the Canada and swap and the US. and the US in cash because I am still worried about swap spread flatteners and so I think you're getting both continued increase in US term premium, Canada reaching somewhere close to its terminal and that being communicated and causing some paying in the belly of the curve from both corporates and retail. So I think there's kind
Ian Pollick: Well, we could not, we literally could not be more pro-op.
Jeremy Saunders: All right, one of us is going to be right.
Ian Pollick: So I had two 30s flattening in the US. It has moved, you know, above that 90 level. I think it's very, very juicy. I think it carries very well. I definitely like Canada US tenures here still, Canada cheapening. I can't escape this idea that all the supply before any additional spending is announced just means term premium Canada need to go wider. so regardless of market direction, I think you're now in this environment. outside of this past week, which has been super weird. Canada US actually held them pretty well. Canada needs to cheapen out. So still like Canada US 10s. I like 230s flat in the US. And I'll put a little variant that's not necessarily pure duration, but I like a flatter 510s Ontario credit box or some type of core provincial 510s box. My view here on ProBees very quickly, yes, there's a lot of supply, but net supply is actually lower than the year before of the net supply, something like 50 % of it is originally issued five years from the crisis. That means you have probably a lot of maturities in HQLA books that probably get to me need to be replaced, which means I think you get a lot of issuance in the belly of the curve at let's just say, historically tight levels of belly spreads, probie spreads that I think should be taken advantage of.
Jeremy Saunders: But not on asset swap.
Ian Pollick: Not on asset swap.
Jeremy Saunders: Not on asset swap.
Ian Pollick: Okay. I wrote it down anyways, do you want to know what the other fun fact was? Here's the other fun fact before we end the show. Since 1990, there has been 11 times where the S &P 500, US 30 years and DXY have all had a one and a half standard deviation sell off on the exact same day. And 90 % of those observations occurred in the Asian financial crisis. So again, super healthy market. I hope everyone has a great weekend. Stay calm, stay relaxed. And remember, there were probably a few bonds harmed in the making of this podcast.
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