Ian is joined this week by Mike Cloherty, and the duo begin the show by discussing what to expect from the bond market when Middle East tension dissipates. The mechanics of the repricing are well understood, though Mike sees more downside risk to the very front-end given the current starting point of Fed expectations. Ian discusses why the CAD rates market has gotten so expensive, and why the repricing in the short-end has limits. The pair talk about CIBC’s new interest rate forecast and the risks around it, in addition to an updated view on the performance of swap spreads going forward. Mike discusses recent SOFR trends, and the show finishes off with a pop-quiz.
Intro
You've talked a lot about dollar swap spreads. You you nailed this move, call it four or five weeks ago. I guess number one is, do you still feel this way? I think the two-year spread move is pretty much done here. Out the curve a little more to go, but most of it is behind us.
Ian Pollick
Good morning everybody and welcome back to another episode of Curve Your Enthusiasm. I'm super excited to be joined by one of my longest friends in the market, a mentor of mine, ⁓ Mike Cloherty, who recently joined CIBC as Head of US Rates Strategy. Mike, how you doing, man?
Mike Cloherty
I'm all good. How you doing?
Ian Pollick
I'm good, I'm glad you're here. Let's get to business. You know, there's obviously a lot going on right now and the elephant in the room is just the huge interplay between what's happening in the Middle East, how it's impacting central bank pricing, how it's impacting energy markets, and how that's all feeding back into the bond market. And so we're getting this optimism, memorandum of understanding, maybe it's there, maybe it's not, around this eventual cessation of hostilities. How are you thinking about the mechanics of the repricing on the day after? Because there will be a day after tomorrow. And so like how should we be expecting the dollar rates market to react on that day?
Mike Cloherty
Sure, so what we've been seeing up till now is that, when we get bad news, we see oil prices go up. That makes shorter term inflation expectations rise, cheapens sort of front end rates. But if you look at forward inflation rates, we've actually been seeing them go down every time that, you know, short inflation expectations go up. Basically, what's happening there is there's expectations that there'll be economic slowdown as a result of these higher oil prices. Your standard Fed models your standard economic models all say that an oil supply shock is a Growth risk much more than you know permanent inflation risk. It's really a price level story And so like that's just leading to see these sort of offsets. What that does is it's dampening longer-term volatility and all of the cheapening happening at the front end. What that means is that, you know, if we get some significant oil price relief on some better headlines around this, you know, what we'll see is the front end should get most of the benefit. We sort of wring out any near-term tightening expectations, even start to, you know, price in some more ease possibility.
But much much less of a reaction out the curve. So it's really a steepening sort of thing where fives really underperform on the curve. So sort of, you know, big twos fives steepening a little bit of a fives tens flattening because that sort of bad economic effect gets priced out.
Ian Pollick
Talk to me about levels. Like, are we talking about a significant rally? Are we talking about a sell-off?
Mike Cloherty
Rally. You know, it's really just that you're sort of taking out some of those Fed rate hike type things. And so, you know, the knee jerk on this would be that we shift from pricing in some probability of a hike to, you know, a partial probability of an ease, not a radical move in rates, but you know, front end clearly outperforms, belly clearly underperforms.
Ian Pollick
Well, let's talk about the composition, because I think it's pretty important, right? You're in this world where you're going to mechanically reprice. And so, like you said, you reduce some of the urgency for central banks to hike rates. At the same time, you're removing some inflation premium. But both of those things, I guess I could argue, are pretty positive for growth. And so does that keep real yields biased higher?
Mike Cloherty
Yes, I think we get again in that. That's why the belly of the curve sort of underperforms because you don't get any relief out there where, you currently we've got some expectations, some scenarios priced in where, you know, we do see a big growth hit from this, which sort of leads us to you know, sort of a forward easing or sort of a low stretch, a low growth stretch, which keeping some of those, you know, belly rates down, that all starts to go away. So, you know, big benefit for the front end, you get some benefit for the belly, but again, it performs the worst on the curve.
Ian Pollick
Okay, no, this makes intuitive sense to me for sure. And I think, you know, we just released our new rates forecast. And I think that's almost the exact tone that we're trying to take in it. Like for those of you haven't seen it, you know, our expectation for duration is not actually all that different from end of year levels relative to today. But the path that you get there, it's U shaped. It's just we've been kind of mucking around with what that trough looks like. And so going back and forth, you know, obviously, you have this idea that you have some better growth support in the dollar market. It'll take or alleviate some of the pressure for central banks to act in the peripheral markets, Canada included. But it's also this idea, I think that, you know, you are going to return to these pre-war themes of fiscal sustainability. And that's going to ensure that long rates just don't fall all that much. At the same time, you know, one of the things that Mike and I've been talking a lot about is when you have inflation so far above target, bonds are just not a great hedge. And so you're in this very strange correlation environment where risk off is higher yields. And over time, I think that changes. But really, like we have pushed the Fed call out to 2027. It's really hard to see easing this year. It's kind of hard to see easing in the next year, really, to be honest with you, but we're keeping it in there. So we have somewhat of a flatter dollar curve this year, a bit of a steeper curve next year.
In Canada, it's a very similar story. No Bank of Canada action this year. So the curve is biased a bit flatter just because the next move is likely to be a hike. But Mike, if you think about the rates forecast that we just put out, and I know we've been doing it with a bit more frequency than usual, just given some of the facts on the ground are changing. Where do you think the risks are?
Mike Cloherty:
So I do think that the risks are a little bit towards front end rallying more than we expect purely because the break-even payroll growth related has fallen so much as immigration has cut the number of available workers. Even some of the sort of like echoes of the baby boom, we have a little bit of a slowdown of workers entering the market there.
So, with this, you know, break-even rate down, call it somewhere between 30 and 75 is kind of where you see most of the estimates around that. You know, it doesn't take that big a shock to get, you know, to start to print negative payroll growth. Now with a 50K break-even, if we start to get some slightly negative payroll growth, it's fundamentally not a big deal. The problem is in the US, we're just used to seeing 250.
Ian Pollick
Yeah.
Mike Coherty
Kind of numbers, the sentiment shock is material from that. So it makes the Fed go from tight side of neutral to easy side of neutral. And so that sort of is the, I think the near term risk. You know, and then otherwise, not expecting radical moves in here for quite some time.
Ian Pollick
So is that another way to say that you think that obviously, you know, from our discussions, it sounds like when Warsh comes in, there's going to be some inertia in terms of some of the big things that he can do right away. And maybe there's just going to be tiny things that he could do right away. But if you start to get into an environment in the second half of this year where it looks like private paid employment is starting to decelerate a bit faster, such that you take your household survey and it's just weakening quite a bit. You think he gets that kind of coalescing around the idea for cuts?
Mike Cloherty
Yes, think if we, know, again, it's really just more the sentiment would swing a lot and the background roar gets difficult for them to stay away. I don't think that this is the most likely outcome in here, but the odds of that happening and us getting a few cuts, I think material higher than odds of us getting any hikes in here. So we should be pricing in, that skew should make us price in a little bit of easing once we get on the other side of this whole lull in the conflict, should I say.
Ian Pollick
Okay, well let's just switch gears here just a little bit, okay buddy? I wanna talk about some of other stuff that has been echoed around Warsh's arrival at the Fed. And it's all related to the balance sheet, it's related to how that balance sheet interacts with funding markets. And so we've just gone through this pretty big geopolitical event for the past three months. What's super interesting is that dollar funding markets have actually been super well behaved. And that's not typical when you think back to I guess the past three or four years, you know, have elevated volatility. That's kind of not what's going on this time. So my question to you is like if I think about SOFR like what is different this time and how are you thinking about it going forward?
Mike Cloherty
So for balance sheet specifics, long-term, smaller balance sheet creates some more volatility in that. But short-term, so first of all, he's got a lot of other stuff on his table. I don't think we even get to the balance sheet discussion for quite some time. It will also take a significant period to change the regulations that are needed before they can take any steps on the balance sheet. And then they have to let treasuries mature often, and that takes a lot of time.
So meanwhile, where you're waiting for enough treasuries to run off to get reserves back down to where demand is given the new regulations, we're back to a period of abundant reserves. That means that SOFR ends up trading just a little bit above the RP rate for that whole stretch. If we look at sort of other things right now, so I think we had a very low stretch of SOFR, it's kind of coming off that. But people are expecting to go back up to where we were in the fourth quarter. And the fourth quarter was a special case. In the fourth quarter, we had some balance sheet tightness around dealers. That's been temporarily relieved with some of these leverage ratio changes that were pushed through. We also had a pretty abrupt drop in reserves with that time, that has flattened out now. You know, a couple of the things that I think that going back to fourth quarter averages is a bad benchmark. I think that we bounce a little bit, but not that much. And then, you know, that whole balance sheet thing creates additional downside risk. Eventually, the changes they made to leverage were insufficient to a world where we're running these ridiculously huge budget deficits forever. And if you think that, you know, banks will maintain their normal percentage share of treasury ownership, the extra space you created with those changes is long gone by 29. And so we're going to be back in this tight balance sheet world before too long. But in the meantime, like looks like it'll be a little dull, we'll see some periodic year end stress. But other than that, pretty well behaved as the expectation.
Ian Pollick
In terms of what you're seeing on like, SERF’s or any other opportunities, do you think that we can capitalize off anything right now? Or do think the market's fairly priced?
Mike Cloherty
I do think that we're sort of priced for a little bit too much of a bounce and so for back towards those fourth quarter levels and that recovery will be slower and that some of these longer term rates a little bit. But I wouldn't say it's a home run right now.
Ian Pollick
Okay.
Mike Cloherty
I'd say if you have exposure, you want to sort of take positions to hedge that, but like not a gigantic thing.
Ian Pollick
Now, we did go through a period where you had kind of discussion of like the TGA reinvesting in repo and then all of a sudden year in turn, premium kind of got evaporated very quickly. How are you thinking on that? Like, have you changed your mind in terms of the A, the implementation and B, the timing?
Mike Cloherty
Yeah, no, I mean, this whole thing, think was a somewhat ridiculous discussion. I do think that one of the only positive effects from that discussion is that the Treasury wastes enormous amount of time basically having to respond to Senator and other Congress people's staffs, explaining why the Fed not paying interest on reserves doesn't cost the taxpayer time and money. And now they can just forward them the T-BAC thing.
So that gets that whole thing, frees up a lot of time for those folks. Otherwise, it's kind of a nonsensical thing that actually doesn't help much at all. Right.
Ian Pollick
Okay, so it's a dud. We don't have to put too much thought into this. Got it, got it, got it.
Mike Cloherty
Yep. All right. You've been peppering me, so now I get to turn the tables here and say, you know, we've had this stretch where, you know, the Canadian rates look very rich to US rates right now. You know, particularly if we focus on tens, what's your sense? Like, persistent, not persistent? Where are we there?
Ian Pollick
I think we're going into some pretty important seasonality in Canada. Unlike other kind of bond markets like the Bloomberg aggregate, for example, in the United States, Canadian indices rebalance daily. And so the maturity dating of bonds matters quite a bit in certain times of the year. And so we have this big seasonality coming up in June. So on June 1st and June 2nd, which is the maturity dates of government Canada bonds and provincial bonds, you end up getting these super big extensions.
So you tend to have this stylized period where Canada tends to outperform, uh, in like the week or two leading up to it. Uh, you do have some relative flattening that goes on, but what we're seeing, you're absolutely right. Like it's extreme levels of richness in 10 years. You, you've broken past that a hundred basis point level and you kind of look back over the past 25 years and really this only happens 2%-3% of the time. And so we should be paying attention to this. And so the question is like, how'd you get here?
I think the easy answer is someone would say, well, you know, the dollar rates markets been under pressure, dollars have been selling off, Canada has been low beta. That's actually not true. What's actually happened is the directionality has been such that almost all of the rich thing that has occurred has happened on days where both markets have rallied, but Canada has just rallied by a larger amount. I think that's being flattered by what's been a very weak data cycle over the past month and a half, and really a string of two or three really bad data cycles. And so, you you've pared back your expectations for the bank. I think people felt a little bit under owned the market. Five's ten’s was looking a bit too steep. And so I think all these things culminated in this world where just Canada started to outperform. And what's really interesting on that directionality is that there's actually been about 20 to 25 % of the days in May have been days where the US has sold off and Canada has rallied.
And these twist days historically are pretty rare and it's cannibalized the rich thing that you would normally expect to see on days when like dollar rates are leading a sell off. I think that does normalize over time. But when you look at how this has happened, not just why the how, IE internally what's moving, is it like policy expectations or is it term premia? Historically, whenever you've gotten to this level of richness, it's been led by CAD term premia just outperforming.
This makes sense, right? Like Canada has a lot more fiscal space. You know, QEQT is a relatively new development in Canada compared to the United States. And with term premium, what we know is that when you have a shock and term premium, the half-life is just relatively long compared to other stuff, like if you were to reprice the central bank. But what's happening right now is actually it's policy expectations have done a huge amount of the job for us. And so we've kind of normalized where we think the bank is going to a certain degree. We've to your point earlier, we've taken out a lot of fed cuts and we're looking for potential fed hikes. And that's what's got us here. I think it's really hard to keep us here in the absence of like ongoing bad data. And whenever I see data cycles like the one we've just gone through, which is every single indicator is just much worse than expected. That tends to signal that you're probably at the trough of either forecast or expectations being too high, or there's something really happening in the economy.
So bottom line here is like, like fading it here. I think you're meant to have some of this trade on June 1st is here. And so I think you want to come out of this extension short.
Does that answer your question?
Mike Cloherty
Yep, we're all good. Yeah, thank you.
Ian Pollick
Well, I have a question for you. If we're going to play tic-tac-toe, you know, you've talked a lot about dollar swap spreads. You you nailed this move, call it four or five weeks ago. I guess number one is, do you still feel this way? Like, are you still generally bullish dollar spreads? If so, why? And just in general, how are you thinking about the shape of the spread curve? Are there any like idiosyncratic things that we need to keep an eye out of?
Mike Cloherty
Yeah, so broadly, I think the two-year spread move is pretty much done here. Out the curve a little more to go, but most of it is behind us. So what's been happening here is that most of the real money accounts have found that rather than buying off their own treasuries, they're better off using derivatives, either futures or receiving fixed, in order to get their interest rate duration and bucket risk.
And then using the cash to buy credit. So this sort of, you know, duration overlay credit exposure works the vast majority of the time. And so you have a sort of a one way flow in all the derivatives. Someone's got to the other side. That's the hedge funds. When the hedge funds have lots of other nice RV opportunities or other things, they will do those other trades. Right now RV a little bit, quite limited in this dollar space. And so we've seen a lot of people who never would have added in directional risk to swap spreads pile into these trades. They say, nice carry and roll on these things. I really don't know how to trade some of the headlines around the war. So adding yield is a good thing. And a lot of sort of tourists jumping into this space, driving some of it. You know, there can be as long as sort of funding is stable and there's still a little carry-in role. I think we continue to see interest in this. a little further to go in the back end. Problem with the front end, two problems. One is that some of the apparent carry-in role was because when the Fed was buying a lot of bills to get reserves up before the tax date, that caused the year bills to richen. So you sort of had this parent great roll down there. That's unlikely to actually show up. Number two like there still is some intervention risk. So the initial Yen intervention historically they've funded that by selling treasuries seems like they did that again this time Mark was able to swallow that significant amount of intervention.
Ian Pollick
Very well. Yeah, very well.
Mike Cloherty
…absurdly well but, you know, if we get some more rounds of that, I think at some point starts to weigh on things, particularly given that the entry point isn't as juicy as it had been last time around on spread. I think that move is pretty much behind us. And again, there's a little bit of juice in longer things, but most of it long gone.
Ian Pollick
Okay.
Mike Cloherty
And then let me jump back to you. Last chance to bully you. There's significant downside risks to the Canadian economy relative to some other countries in part, you know, some of that downside risk emanating out of DC. But what we've seen is sort of this global repricing towards heights for central banks around the globe. But, you know, Canada, a little different economic backdrop. How's that interplay the Canadian front end with the of the global move versus the country specific risks?
Ian Pollick
Yeah, you know, it's a good question, right? Like, you you and I were in Europe a month and a half ago and the story we were telling people was that it's a very narrow path to actually get a rate hike in Canada this year. you know, the worse and worse the data gets, I think that just validates our view that it's really unlikely that the bank feels a huge amount of urgency here. It's not zero. And so you should have some premium living in the curve.
I think a lot of it was, you know, you had like other markets like the UK, people were just very received the short end. And so, you know, in the absence of a more urgent channel getting the bank to hike, you ended up having this like big flush out. And so part of what is left in the market, I would argue scar tissue, i.e., it lives there, it may not be harvestable, because capacity from levered money just isn't the same as it was three months ago. But I think that's improving.
But what's really interesting about the short end in Canada is that the shape of the meeting gap curve has begun to normalize very, very well. What I mean by that is you had this environment really up until the early part of this month where the market was saying, look, the bank can is going to introduce a new forecast in July. That forecast is going to signal their intention that they probably need to hike rates.
If they're going to hike rates once, they might as well hike rates twice. So your like July-Sep, Sep-Oct, those roles were very high relative to the rest of the curve. And it was very clear that's where the market was putting in its premium. And then you had like, you know, let's call it 15 basis points for each of those roles. And then the market went from like Oct-Dec, which was like eight and like Dec-Jan, which was like low single digits. And so it didn't like really make a ton of sense in terms of the timing. I didn't mind the shape of it. But the timing made no sense to me because number one, you only have one CPI report before the July MPR. That's definitely not enough time for the bank to feel comfortable changing their assessment. And what we're seeing right now is that both of those premium points of Sep-Oct have come down quite a bit. And so the curve has looks almost like just a linear step function of itself. It's lower left to upward right. There's not a lot of kinks. And what's interesting is that reds, greens in Canada continues to out steepen basically almost every other market except for New Zealand, which by the way, what is going on there? Globally, it's like you seven, you eight, it's out steep in dollars, it's out steep in sterling, it's out steep in euros. And the question is like, what's the limitation to all this? You know, historically, it looks like if you go back over the past kind of 20 years, and I think this is very similar to the Fed, the Bank Canada over index itself, over indexes itself to be more accommodative, the more restrictive. And so if the top end of neutral is three and a quarter and the bank tends to ride the wave a little bit looser than tighter, you know, 3% is probably a decent number. And so I think given where U7, U8 trading, you're getting pretty close to being as steep as it needs to be. And you can kind of see that in the way that the one year forwards have traded like, you know, a month ago, 0111 was 60 basis points when you're when you're two year one year was five.
Now that profile is like 45 15 or 45 10, whatever it is. But that's more normal to me. And I think, you know, as we move forward in time, the big risk is the USMCA. And so we're going to get some news on that I think this week. And then we can reassess. But look, we are long in the tooth. People don't want to listen to two old dudes talk about the bond market forever.
But this is the first time you're on the show and our listeners know that whenever there's a someone on the show for the first time, you got to do a pop quiz. You ready?
Mike Cloherty
Oh, I did know this. All right.
Ian Pollick
Yeah, correct. So here's the pop quiz. And this is very much tailored to you, True or false? There is a professional athlete in the United States with the last name Cloherty.
Mike Cloherty
False.
Ian Pollick
It is true, Colin Cloherty played for the NFL.
Mike Cloherty
Oh, that's right...
Ian Pollick
So now you, I know you knew that. There's no way you didn't know that.
Mike Cloherty
I did know it. Yeah, I did.
Ian Pollick
Okay, so now that I've refreshed your memory, here's, we'll go for a bonus round. How many NFL teams did you play for?
Mike Cloherty
Oh…how about four?
Ian Pollick
You actually got it. He actually played for five, but it was on the Colts twice, but you got it. So you get, you get half points. Okay, listen, Mike and I are around. If you want to talk about any things that we talked about in the episode today. And if not, remember there are no bonds harmed in the making of this podcast.
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