Ian is joined by Jeremy Saunders this week, and the duo begin the episode discussing the recent bond market selloff. They reach an interesting conclusion early in the episode, highlighting that the ‘way’ in which the market is repricing has not been seen in all of 2023. Ian believes the market is pricing-in more inflation and lower growth in longer-dated yields, which Jeremy suggests is a function of where we are in the cycle. Jeremy discusses his view on the upcoming Bank of Canada meeting, while discussing the ‘big’ global macro themes and what they mean to the bond market and swap spreads. Ian finishes the episode by opining on recent data from the labour market, and highlights his favorite trades for the week ahead.
Ian Pollick: Is this the most hated hike of the cycle?
Jeremy Saunders: (Laughs) I do not think this is going to be the most hated hike of the cycle because the street will, if they hike, this will be very far from the most amount of money lost by street participants on a hike. So I think it's really hard to characterize this one as the most hated. I can think of a couple other candidates.
Ian Pollick: So it's funny, every time you're on the show, I love starting it off with a little bit of trivia. So two pieces of trivia, Mr. Saunders. You choose: sports trivia or music trivia.
Jeremy Saunders: Music trivia.
Ian Pollick: Okay. On this day in 1984, what song went to the top of the Billboard charts? It's very apropos, by the way.
Jeremy Saunders: (Laughs) I don't know.
Ian Pollick: When Doves Cry by Prince.
Jeremy Saunders: All right.
Ian Pollick: Just saying. It's pretty apropos. Can we just finish off with the sports trivia?
Jeremy Saunders: All right.
Ian Pollick: On this day, what tennis player, female athlete, won her first Wimbledon?
Jeremy Saunders: Steffi Graf.
Ian Pollick: Martina Navratilova. Funny Pollick family fact actually. My dad, a really long time ago was at some charity event, and I think he may have had too much wine. And he ended up buying Martina Navratilova's shoe. And this shoe has lived in my house in this glass case for like literally 20 years. I think he likes it more than he likes me. Anyways, okay, so trivia is over. Look, it's been a huge week. Before we talk about the week ahead, the Bank of Canada, I think the natural starting point for me is how peculiar the market's been trading. And what I mean by that is shape of curve, level of yields. And so I think the obvious question that I'll pose to you to start the episode, are yields too high?
Jeremy Saunders: Yeah, that's a good question. So I mean, I look at this and by breaking it down, Canada's a little bit hard to tell because we don't have a particularly liquid break even market anymore.
Ian Pollick: A functioning inflation market?
Jeremy Saunders: A functioning inflation market. And so let's paint broad strokes and start with the US. You've got two and five year real yields in the, call it 2% range, and break evens in the two and a quarter range. So how do you get things to change from here? I think going to be pretty difficult given the macro picture for real yields to go substantially higher from here. And so if you want to get yields to go nominal to go substantially higher from here, you're going to need breakevens to go up.
Ian Pollick: I agree. I mean, we have hit, it's interesting because we hit our end of September forecasts like late last week. And so we kind of saw like 350 CAD tens, you know, 4% US ten years. It just happened so quickly. And so I'm left kind of scratching my head like, what is with the rapidity of the selloff and can it persist? And so from my own perspective, I don't mind duration here and I really haven't liked duration all year long. Like in 2022, you had this kind of strategic short bias where you kind of sell strength. It was kind of the opposite this year and it hadn't really worked out. But I think we're at the point now to your earlier kind of point, the marginal catalyst to take yields materially higher is not that clear to me. Like if you decompose a level of yield, it's something very interesting is happening. And it's funny that you mentioned breaks because your fives tens break even curve in the US is now uninverted for the first time since 2021. And so it's like you get to a point where your terminals are priced to the dots, and so any further weakness and this is where I want to talk about, it hasn't been coming from reds, it's been coming from greens because you're repricing neutral, not terminal.
Jeremy Saunders: Yeah, I definitely think that's true. I mean, I think we've now gotten to the point where central banks ostensibly wanted. If you listen to Fed speak over the last year, I mean there's been a consistent pattern of pointing to what is sufficiently restrictive. Sufficiently restrictive is in a real yield concept. And it's in the, if you think neutral real yields are 50 bps, let's say, on a long run then, and that's consistent with the long run dot given where their inflation target is, then, you know, sufficiently restrictive is something like 1 to 2% in real terms higher than that. And that's where we are. And so on the real yield story, the market is now, quote unquote believing the Fed. What comes next is what the market has as an inflation forecast and the market has an inflation forecast that one year, one year US inflation is 2.25%.
Ian Pollick: So it's believing in the story that you maintain policy at a relatively high level. Inflation comes down quickly. But I think there's an implication here, right, because we saw this bear steepening all last week and that's not what you would normally associate with a sell off, at least what we've seen in the past cycle. And so I would almost argue that if you get this continued repricing of kind of greens, you end up in this environment where you're steepeners trade short and your flatteners trade long, at least for a near period of time. And that's not what we've experienced over the past little bit.
Jeremy Saunders: Well, I think about it more in terms of a growth versus inflation trade off. The upside inflation data, which the market has a model in its collective head of upside inflation data equals higher real yields now, which equals more recession later. And that is a flattener. That's a bear flattener. And what we've seen over the last couple of weeks is that the inflation data has been-
Ian Pollick: In line?
Jeremy Saunders: Yeah. In line. Well it's hard to say that 3.5% core inflation run rate is benign, but certainly not beating expectations.
Ian Pollick: Relative to a market like the UK, North American CPI is benign.
The market's no longer, you know, to borrow the phrase behind the curve on inflation or it doesn't think it's behind the curve on inflation. But what has been getting repriced is the market's view of when the recession will come. And that's because the growth data is outperforming. I mean, I think I certainly on this podcast a year ago had said and I think many people, most participants would have said that 5% nominal rates is not a situation that will persist for an extended period of time, even, you know, a period like a year without something seriously going wrong. And they're being a very negative hit to growth. And right now we're seeing the sort of the theta bleed out on those growth assumptions.
Ian Pollick: Well, I mean, I think that's right. And so it's hard to calibrate what the right level is for, let's say, like a ten year yield or a 30 year yield, because like 30s can literally do whatever they want. If you have this framework whereby you are trading off growth for inflation and people think, hey, you know, the Fed's reached its forwards or the forwards reached the Fed dots, therefore they're incrementally more biased to sustain growth and that can mean longer dated yields can sell off infinite amount. Right? And that's why I think that the curve is going through a very interesting regime shift right now. And what's interesting, too, is like flatteners, if you're an unlevered account, flatteners trade prohibitively expensive, like they are the most negative carry. If I am a levered account, sure, I can put on a flattener. I'm going to make some money. And so you're almost incentivized, given that, what's the larger community in a market like Canada? Well, it's obviously real money. You could start to see some of these steepening trades being put on that actually exaggerate this profile. And that's not what people are expecting.
Jeremy Saunders: Yeah, for sure. I think the real money dynamic is what's going to drive the cyclical term in the, call it 3 to 6 month term is what does that account base do, right? I would say the flip side to that is that it's not clear to me that the real money account base does the flattener steepener in terms of actually executing both legs.
Ian Pollick: No, it's just relative to the universe, right?
Jeremy Saunders: Yeah, and so the carry aspect of that is more conceptual, ironically more conceptual for the real money account base than it is for the fast money account base who actually do both legs.
Ian Pollick: It's the running yield relative to your underlying benchmark. Right? So let's just switch gears for a little bit because one of the things that I'm a bit nervous about and obviously when we think about the jobs report from last Friday, let's just start with the US for a second. Right? You know, obviously ADP kind of shot a false flag, whatnot. But when I look at the data, it was interesting is that, you know, all the accommodation and food services really did not change all that much in the non farms payroll. But you had this massive increase in ADP. And so remember in August, they're changing all the sectoral weights. And so I think that you could end up getting this like lagged impact where that cohort of jobs increases and it delays that big negative turn in the seasonals for non firms. I still think you can generate relatively outsized gains.
Jeremy Saunders: Well I mean interestingly, you mentioned seasonals in the jobs. Actually, if you look at what's happened in the seasonal adjustments over the last 4 or 5 years for non farms, June has been a very negative seasonal adjustment. And that was true this June to a slightly lesser extent than it was last June. I think the seasonals last June took about 550K jobs off of the unadjusted number.
Ian Pollick: From the establishment survey?
Jeremy Saunders: No from the non seasonally adjusted non farms number. And then this June it took off about 495, something like that. So a slightly smaller downward adjustment in terms of seasonals and obviously on a larger absolute number. So in percentage terms a little less. But nevertheless, you're talking about the dispersion between ADP and non-farms, which is an interesting dispersion because while ADP has, you know, people like to joke about random number generator and so forth, for the last ten months with January excepted. ADP has been a pretty good-.
Ian Pollick: It's been tighter.
Jeremy Saunders: Very, very good predictor of non-farms in this month it broke. The ADP seasonals flatter the number relative to previous June's and the June non-farm number similar to previous June's was very unflattering and so part of me questions the reaction to this number is reading the tea leaves a little has been quite a bullish one for the bond market. Now that's obviously in the context of the setup yesterday if I'm quite a bearish reaction to ADP. Net we're still left higher in duration than where we started this sequence and we got 200K in non-farm payroll.
Ian Pollick: Like the absolute number, right?
Jeremy Saunders: (Laughs) It's a pretty strong number.
Ian Pollick: Like this was the first miss, I think 14 non farms, but it was still an absolute number that's massive.
Jeremy Saunders: It was also the first non-farms where the street has put out a consensus that was not a sequential weakening.
Ian Pollick: That's true. Actually. That's a good point. I didn't realize that. Oh, well, let's just move on to the accuracy of the street and just talk about the CAD Canada data for a second. So, you know, another, another swing and a miss. Jobs comes in three times the estimate, you know, did you have any main thoughts on the jobs numbers in Canada?
Jeremy Saunders: I think it's interesting to contrast what happened in Canada to what happened in the US. In Canada, you got a much larger headline number and you got wage numbers that we're moderating. In the US, you got hard to characterize 200K jobs as a weaker number, but a certainly not an eye popping headline number with stronger wages. And that to me is consistent with what's been going on in the underlying economy and particularly with demographics and immigration, which is that Canada, and I know this has been topical lately on the street and in the sort of, let's call it, you know, Twittersphere and what have you, that Canada has brought in a huge number of immigrants over the last three years. And meanwhile the US has been engaged in something like a culture war where the anti-immigration side of that war has been having a lot of success. And so when we look at these numbers, what it says to me is that Canada has been more successful at bringing labour supply to market.
Ian Pollick: Well, that's why the unemployment rate rose, right? Like you're in this dual situation where you're getting the past drip of population growth in 2022, but then you have more people being pulled into the labour force at the same time. And so, you know, that's a very benign reason why the unemployment rate rises.
Jeremy Saunders: Our growth inflation trade off looks much better than what the US's does. And I think that has pretty interesting implications for policy.
Ian Pollick: Well, for sure. And so like the other thing that I saw in the data, there's two things I just want to mention before we kind of talk about the bank. But the first is, you know, I'm a granular guy, and so I look at some of the data sets that most people don't. And when I looked at the amount of hours worked lost due to illnesses, it is now at the highest levels since Omicron in 2022.
Jeremy Saunders: And are you talking Canada or US?
Ian Pollick: I'm talking Canada. Like you have a sicker labour force, which is one of the reasons why you're seeing hours worked and labour market growth starting to diverge. The other thing that I was noticing is I built a Beveridge curve for Canada, so that's just the vacancy rate of the private sector versus the unemployment rate. And you can kind of chart it out post Covid, where you're now done this kind of round trip where you're now back on the trend line pre-COVID. And so what that means is for any given level of the unemployment rate, you'll have lower wages relative to the past two years. And that's just a function to as well, is you have more people coming into the country. And so the labour supply argument is quite large.
Jeremy Saunders: And I mean, I think there's probably a compositional effect. I think once we get higher quality data, there's going to be a compositional effect here too, which is that because Canada has had an easier time filling the hard to fill jobs which are mostly lower paying service facing jobs, that is pulling down the-.
Ian Pollick: Wage pie.
Jeremy Saunders: Yeah, the unweighted, average hourly wage. But to take away from that that, you know, Canada is in a worse spot growth wise I think is the wrong read and the market's not reacting like that.
Ian Pollick: Well, I mean, look, you've had stuff like one year, one year cross market that's moved 50 basis points in the past month. And so, you know, this whole narrative that Canada is a very indebted economy and rate hikes move very quickly is proven to be somewhat unfounded. And as you look to the next cycle of this, which is, you know, where does your neutral rate have to live? You know, Beaudry talked about it. He said, in a world where you have immigration that could exceed targets, you were talking about faster trend labour productivity and more labour growth, and therefore you have higher rates over time. So I don't necessarily think market pricing is wrong. And so like I'm out of the trade, I don't think there's much to do there now. But let me ask you this, because we're obviously tiptoeing into the bank in two days. CIBC Economics has courageously changed the call for a hike this week. They think it's the last hike of the cycle. Is this the most hated hike of the cycle?
Jeremy Saunders: (Laughs) I do not think this is going to be the most hated hike of the cycle because the street will, if they hike, this will be very far from the most amount of money lost by street participants on a hike. So I think it's really hard to characterize this one as the most hated. I can think of a couple of other candidates.
Ian Pollick: Off 2021, I kind of meant like, is this the unnecessary hike that you know, the bank is being forced into? Like do you think the data has supported during the intermediate period? And let's put some context here. Yes, Central bankers don't stop out of a trade to do one more hike. That aside, I have not seen a huge amount in the data that tells me they have to go.
Jeremy Saunders: Yeah, but you've hit the nail on the head, right, which is a reasonably consensus view heading into the last meeting was that they would set up last meeting for a hike this meeting. And so I think if they had done that, it would have been much more consistent with a bank does not really think that rates are insufficiently restrictive but is trying to create like what I would call time under tension, which is to allow the transmission of the rate hikes to permeate throughout the curve by continuing with the threat of rate hikes, which prevents inversion but not actually delivering incremental spot tightening. But the fact that they chose to go one meeting early, while it seems fairly minor, if you listen to their reasoning around it, it was very clearly around rates or insufficiently restricted. And for a Central bank to quote unquote, stop out of their pause-
Ian Pollick: And to believe that rates are not sufficiently restrictive.
Jeremy Saunders: That wasn't 25 bps. That was they've got another level that is meaningful. And I think they will probably get there this meeting. And for what it's worth, I mean, they did get quite a lot of bang for their buck. They got, you know, the first two contracts, which were 15 bp inverted, moved to 15 bps uninverted, ten bps uninverted. And that was in addition to the, you know, 15 or 20 deep sell off in the front contract. So if their goal was to propagate their tightening out the curve-.
Ian Pollick: At least to fives, like at least to mortgage rates, right? Like it has filtered.
Jeremy Saunders: I think if I were them and that was my logic, then I probably wouldn't risk it going back.
Ian Pollick: No, but you maintain a hiking bias going forward. Like that's very clear to me. Yeah. Okay. So the bank's going, that's pretty easy. Let's talk about big thoughts because we're running long in the tooth here. What are your thoughts on spreads here? You know, there's this kind of narrative right now where people look at five year spreads. Yeah? And they're saying, well, rate hikes are now back on the table. The bank's going to maintain a hiking bias. Does that set the market up for a situation like 2022 where mortgage originations fall, deposits stay relatively high and therefore five year spreads have to fall and fives have to richen? I personally don't believe that because I think one of the big offsets to quantitative tightening in Canada last year was that the government of Canada was winding down its cash balances to the tune of 120 billion. And so for the pause that that was destroyed by QT, in other words, created by them winding down and so that maintained an overall elevated level of deposits in the system that ultimately forced this asset demand and balance. But I don't see it this time. I mean, so what do you think about five year spreads? What do you think about that narrative?
Jeremy Saunders: Yeah, I mean, I think big picture, I'm less sure. I think in the immediate term, what we have seen is credit extensions on asset swap. And I don't think the picture is much changed there, which is that, you know, ten year paper looks okay and four and five year paper does not. And so I think that steepening of the fives tens curve can continue. I do think if they deliver another hike here, you know, that should continue to put the pressure on housing market activity and so at the margin that would mean less paying for mortgage origination.
Ian Pollick: But I don't think that turns into net receiving. I think it's a very different backdrop than last year.
Jeremy Saunders: No, I think it's pretty agnostic. And then the other thing is that like, you know, I think expressions of paying twos fives tens have been popular trades. But it's finally worked a little bit. It's not worked that much, but it's worked a little bit.
Ian Pollick: Well, I mean, twos fives, tens in cash. It's moved like 15 basis points in the past, like three weeks. And twos five steepening is like winning lotto max, like it doesn't happen.
Jeremy Saunders: And so my only thought there is in the immediate term, you may see some profit taking in that and that could be a downward pressure on fives.
Ian Pollick: I think so. Like I don't like the twos fives box CAD US because I think that if anything the US, US Greens have more room to do more work than in Canada for all the reasons that we talked about.
Jeremy Saunders: If we want to talk real big picture, I think the big question is, is what steepens the curve?
Ian Pollick: Well, like I said, I think you're in an environment at least for the next month or so, where if you are repricing where easing gets you two in 24 or 25, then duration is being sold off not by terminal but by neutral. And therefore you can get this bear steepening of the curve, which is very rare. And that is not the start of a sustainable steepening cycle.
Jeremy Saunders: But do you think that's like a twos tens bear steepening?
Ian Pollick: Twos tens, like it's not fives bonds. Like I said, longs can kind of do whatever they want, but I'm even less convinced in Canada that that's twos fives. But in your view, what steepens the curve?
Jeremy Saunders: Yeah. I mean I actually think like on a sustained basis it's going to be really hard to steepen the curve because twos tens two years forward is positive. Twos fives two years forward is positive.
Ian Pollick: You have so much steepening in the forwards, the sequential move.
Jeremy Saunders: Right. Exactly. So to get spot steepening there's only two ways to do that. One is you need a really big sell off in the back end and for that you need basically inflation expectations to go substantially higher-
Ian Pollick: Or supply or some catalyst.
Ian Pollick: Yeah, but I think there'll be structural reasons for that to get bought. You know, I mean, I think if you get to a point where you've got like 2.5% reals, 2.25% reals and two and a quarter, 2.5% break even implied in the curve like you're going to see buying there just because there's a portion of the market out there that is matching assets to liabilities. That is a good return. All in their bogey. And like, you know, people-
Jeremy Saunders: And it hurts stocks, right? And so like at the end of the day, you know, you think about how you model 30 year spreads in the US, you look at what you know, Equity Vol is doing and then the higher rates are going to bring spreads lower because you have all this receiving. And I'll say it again, I actually think that I like duration here. I do it. You've heard it here first. I like duration. I don't mind being long. And that's going to turn into a bull flattener rate. Blue Horseshoe loves ten year bonds.
Ian Pollick: Blue Horseshoe loves ten year bonds. Okay, any last thoughts?
Jeremy Saunders: That's it, man.
Ian Pollick: Okay. Good luck in the week ahead. For everyone listening, thank you very much for taking the time to be with us. And remember, there are no bonds harmed in the making of this podcast.
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