Canadian Curve Comment

Although the Canadian bond bears had some excitement a few years ago, the recent experience has been quite subdued despite a certain amount of macroeconomic fireworks (figure above).

My eyeballing of the Canadian curve suggests that it is pricing a plausible macroeconomic scenario: the economy faces weakness due to a certain someone south of the border hammering out tariff rate posts, but the weakness is somewhat manageable, and possibly only mild cuts are needed. Supply chain disruptions and tariffs might put some upward pressure on prices, but that would be offset by the prospect of weaker growth.

This puts the 10-year Government of Canada at a mediocre valuation level. It incorporates a small term premium against the prospect of mild rate cuts due to weakness, but it does not have a great cushion against a cyclical upswing. Although there is not a lot of evidence of such an upswing, it is entirely possible that a certain someone again chickens out and does not change tariff rates that matter for Canadian growth by that much. At which point, price pressures may start to matter again.

My initial scan of data pointed towards the “mediocre growth at best” story, but I hope to expand upon that impression in a follow up post. Since I have been fairly quiet recently, I wanted to just get this initial comment out first, rather than wait to see what happens with my data filtering. (Statistics Canada changed their website and I was missing Canadian data updates for some time, I finally bit the bullet and incorporated the “stat_can” module to my platform so that I can update again.) If one wanted to take macroeconomic positions, I think Canadian rates are not the best instrument — the Canadian dollar (might) be more exciting, although I am not the person to ask about currency guessing. (I got my first forex call correct, and decided to retire undefeated.)

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(c) Brian Romanchuk 2024

U.S. Treasury Curve Comment

Happy Canada Day! I do not have a lot of time to look at new topics, but I saw an article about the Treasury curve that triggered a desire to drop a comment.

The above figure shows the slopes at the front end of the Treasury yield curve. Specifically, the black line shows the 2-year yield less the 3-month bill rate, and the red shows the 2-/10-year slope. The current situation is somewhat unusual in that the 3-month/2-year slope is mildly inverted, while the 2-/10-year slope is mildly positive.

Whither Treasury Yields?

Since I am allegedly writing about the intersection of the bond market and economics, I need to periodically check in with what is happening in the bond market itself. (Since I am not plugging financial forecasts, I do not have the pressing need to point out how brilliant my calls are — or why the markets are wrong — which is a constant source for articles for most other commentators.)

Normalcy Bias In Economic/Financial Research

The announcement and then rapid capitulation by President Trump on his tariffs on Canada and Mexico (but not China!) engendered a certain amount of mockery on Bluesky. At first, street economists were mocked for not predicting the tariff moves. Then the capitulation generated a round of “told you so’s” by people defending the street economists. This article mainly discusses the normalcy bias of street research, and then finishes off with comments by an enraged Canadian on latest events.

Oh Noes, Not The Gilt Death Spiral!

Ray Dalio’s musings on rates markets are once again doing the rounds on social media. As anyone who has followed popular rates commentary could guess, he was predicting doom, with the U.K. gilt market being the intended victim this time. This article is a series of my standard rants that I hopefully have not repeated in some time (as a “gift” to new readers). They will cover why popular rates commentary is dysfunctional, and why the idea of a “gilt death spiral” shows the serious defects of conventional thinking about interest rates.

Yield Curve Indicator Still Waiting For A Recession

The U.S. 2-/10-year slope inverted in mid-2022, and we are still waiting for the recession that was allegedly predicted by the yield curve. At this point, the yield curve maximalists have to be hoping for a recession triggered by a trade war in the coming months. At which point, the maximalists will argue that the yield curve predicted the trade war in 2022 the same way it predicted COVID-19.

For those of us who are not yield curve maximalists, we can argue that the yield curve roughly predicted what it is supposed to: an end to the Fed rate hike campaign as well as cuts. The problem for bond bulls is that the cuts were relatively mild, and as Friday’s labour market report showed, the economy remains resilient. My favourite labour market indicator — the employment-to-population ratio — is doing nothing interesting, which is consistent with steady growth.

If the United States did not face erratic policy shifts, one could argue that the small positive slope puts bonds in a decent position. There is a small cushion of carry versus the front end, and although a re-acceleration of growth might prompt some hikes, the possibility of some sort of growth accident would trigger deep cuts by the Fed, making the risk profile asymmetric (although the steady growth scenario would be more likely).

Unfortunately, we do not live in that magical world of limited policy uncertainty. Tax cuts are a priority, and even though there are Republican spending cut targets, they are too small versus the hoped-for tax cuts. Using tariffs to keep the CBO happy is easily going to trigger “Transitory Inflation 2.0.” The only major growth/inflation moderating story would be the effect of countervailing tariffs. Although the Fed might attempt to “look through” the immediate price shock of tariffs, their willingness to do will be limited by the outcome of “looking through” the post-pandemic price spike. (I don’t think monetary policy had that much effect on the inflation miss, but I am certainly not on the FOMC.)

Canadian Yields

The fragile state of the Canadian economy has left the Canadian 10-year yield much lower (at the time of writing, 3.5%). This would be upsetting to the many economists who insist that Canadian bond yields trade as a spread to U.S. yields if they were capable of examining their beliefs based on data. (In case it’s not obvious, this is based on multiple conversations I have had with economists over the years. Many point out that the Bank of Canada’s internal models were based on this assumption, without ever questioning whether this point was in their favour.)

For semi-retired Canadians doing some asset allocation shifts at the beginning of the tax year, it would appear advantageous to shift bond holdings to U.S. dollar ones. Unfortunately, the Canadian dollar has not been cooperative, weakening to historically cheap nominal levels.

• If the U.S. dollar bonds are unhedged, the yield advantage could easily be wiped out by a mean-reversion in the currency. Although it is hard to get too excited about the Canadian dollar when Canada is in Trump’s tariffs crosshairs, the U.S. economy itself is in the crosshairs of the same person.
• Hedging the currency — not a trivial task for a retail account — results in (roughly) flat carry, and leaves you exposed to relative growth strength in the United States. There might be an argument that this relative position would have interesting risk management characteristics, but my gut reaction is that most of the volatility will show up on the U.S. rates leg, so the position would end up directional with U.S. rates.

This situation is interesting from the perspective of pop currency trading theories. Since Canadian yields are lower, the dominant theory is that the Canadian dollar will continue to lose value (making unhedged U.S. Treasury longs/Government of Canada shorts irresistible). Although this time could be different, I would point to past history — the CAD/USD traces out an extremely wide trading range, and trade fundamentals will eventually matter. A tariff war might break those fundamentals — but that scenario requires a belief that doing things like trashing the supply chains of the Big 3 automakers and losing cheap Canadian crude is politically sustainable.

The other “interest rates and currency” theory predicts the exact opposite — the Canadian dollar is mechanically priced to appreciate in currency forward markets. This appreciation is referred to as “expected appreciation” — which refers to the expected value in option pricing markets, and is not necessarily a forecast. Some economists appear to be believe that exchange rates are determined by institutional investors arbitraging hedged treasury bills. (Spoiler: this is not true.) The rates market and the currency market are both large markets with largely indirect linkages. Although I respect rate expectations (with some caveats), currency markets can ignore the trade breakeven point (i.e., the forward) created by rate differentials for a very long time.

Although it may have already happened, the situation appears rife for one of the periodic “Canadian bond apocalypse” stories to pop up on hedge fund radar’s. Although some Post-Keynesians also like the idea of bond and currency vigilantes joining forces, my sense is that domestic bond managers would just view any pop in yields a chance to do some duration-matching. If the Canadian economy actually did start accelerating, the Canadian dollar might start performing again.

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(c) Brian Romanchuk 2024

Primer: Introduction To Credit Spreads

After a hiatus resulting from various disturbances, I am back with another book manuscript section. I just reworked this section, and hopefully did not introduce major issues into it. However, I wanted to get this out before next week. Right now, my main concern in life is getting my kitchen sink back.

This section introduces credit spreads from a bond pricing perspective. Looking at bonds is not completely inappropriate, as banks do hold bonds in their liquidity portfolio. The illiquid loans on bank balance sheets can be analysed in the same way, albeit bankers might use different terminology.

Recent News Comment

I am catching up on things post-vacation (new consulting project dropped). I just wanted to make some comments on topics I have run into recently before getting back to some banking texts that I had finished up earlier.

Fed!

The Most Important Fed Meeting Ever happened today, and the Fed remained on hold. Since I am focussing on writing books that are supposed to be somewhat timeless, I do not spend much time on central bank watching. With the disclaimer that I had no forecast, I do not think it is inherently surprising that the Fed did not cut.

Asset Allocation And Banking

Note: This article would hopefully be worked into my banking manuscript. I think it overlaps other article(s), but I wanted to see how this line of argument looks. Needless to say, I have no put the articles into a single document…

One of the difficulties with understanding banking is that one needs to use relatively complex macro models to see how the formal banking system interacts with the non-bank financial system. Analysis based on looking at the motivations of a single bank or based on models where only the formal banking system exists will be misleading. Stock-flow consistent (SFC) models are one of the few attempts at such a modelling framework.

A Non-Forecast 2024 Outlook

Since I am not in the forecasting game, I not on top of what the consensus views are. I also no longer pay attention to others’ Year Ahead Forecasts (which tend to be produced in December and long forgotten by February — people seem to produce them solely because it’s traditional). However, I wrapped up my “central banks as banks” article sequence, and I am now going to catch up on some charts to see where we stand. For brevity, I am just looking at a handful of American charts; I could possibly do some comments on other markets later. As a spoiler, I am repeating what I have been saying for at least a year.

Using Fed Projections To Infer The Term Premium?

I was passed along the article “Views from the Floor — Tighter and Tighter” by the Man Institute published last month. It discusses using the FOMC long-term projections to infer the term premium in the 10-year Treasury yield.

The methodology is straightforward (I have a busy week, so I have not gathered the data to replicate it myself). They describe it as follows:

A better approach is to incorporate the FOMC’s projections of the Fed Funds Rate into the expected path of short rates. This will make term premia estimates more consistent with sub-2% growth. Figure 1 shows that model applied, with an expectation that the short rate matches the Fed Funds Rate over the next year, then it linearly converges to the long-run projection over the next three years, and then remains constant.

"So How Did You Lose Money Buying Risk-Free Bonds?"

The title of this article is deliberately silly, but there are times where I just need to be deliberately silly. I am not going to discuss why people (like myself, sigh) decided to not cut their bond allocations to zero ahead of the recent Bond Catastrophe, but rather how to judge or even calculate returns based on the most common bond market data — constant maturity yield series.

(This article is a bit rushed, since I yet again have family visiting from out of town…)

Slopes And Recession Probabilities

Menzie Chinn just published a short note “Inversions, Bear Steepening Dis-Inversions, and Recessions.” He was responding to an article that argued that a bull steepening is a good sign for the economy, as it indicates less need for the Fed to cut in response to a recession. Chinn updated some recession probability indicators based on the yield curve.

Comments On Logan Speech

Lorie Logan of the Dallas Fed gave a recent speech in which the term premium figured. Although I think Logan’s remarks are fairly innocuous, I saw some chatter that extended to a “oh no, fiscal!” story.

At Least It's Not As Bad As 1994

The current Treasury bear market has been impressive, and unfortunately for the bond bulls, there is no valuation reason for it to stop. For example, the 5-year Treasury is still trading well below the overnight rate. If we look back to the 1994 bond bear market, the 5-year traded about 250 basis points above cash — versus about 100 basis points below now.

Decoupling

Although I am not a forecaster, I periodically comment on what I would probably be looking at if I attempted to do so. Right now, the interesting thing is the possibility of a decoupling between Europe and the United States. The latest round of U.S. data has been strong, the Fed has hiked rates again, and Fed analysts apparently have thrown in the towel on recession risks (oh dear). Meanwhile, survey data out of Europe (particularly Germany) has been weak. The chart above shows what I hope is the current (not forward looking, which is less negative) demand for loans by firms in the euro area. (I write “hope” because I had to pick the series out of a somewhat confusing list on DB.nomics, and the ECB Bank Loan Survey only showed recent data to compare to. In case it is not obvious, I am not a European data maven — previously, I worked with commercial data sources where it was easier to pick out the “standard” series.)

Is it possible that Germany and/or the euro area have a recession without the United States having one? I am not forecasting that outcome, rather I want to discuss why the possibility is interesting from a bond market behavioural perspective. (Although if the U.S. continues to avoid recession — “ha ha” to all the yield curve fundamentalists.)

Advantages To Procedural Changes In Bond Market?

From my recent Torrens Zoom call, I ran into questions about procedures in the government bond markets. The main question was whether I saw potential changes to the markets to improve things. The second was more of a concern about the complexity and opacity of the bond market.

Yield Curve Control Blues

The Bank of Japan surprised people with a change to its yield curve control (YCC) policy. This has caused a mild sell-off in Japanese bonds, with the 10-year Japanese Government Bond (JGB) yield up 15 basis points on the month when I last checked.

Although I think some of the usual suspects have tried to get excited about this — a harbinger of doom to Japan and/or the global fixed income complex! — this is still in nothingburger territory. (Note: people who discuss bond yield changes as a percentage of previous yields — e.g., “bond yields rose by 100%!” when the yields go to 0.2% from 0.1% — are innumerate clowns and are safe to ignore.) Nevertheless, if the yield cap was raised by a lot more, there would be a lot of wailing and gnashing of teeth.

One standard dodge of a forecaster is to say that this might be important for global bonds. This makes one sound like a very serious forecaster with an eye on those darned black swans. However, any number of things can cause global bond yields to rise. If you want to be a yield forecaster (I don’t!), at some point you have to put your money where your mouth is and either recommend long/short positions and/or option strategies (if you want to position for tail risks). Although I am not a forecaster, I see no reason why I would change any non-Japanese market views as a result of these recent events.

Achilles Heel Of YCC

Yield curve control is a popular discussion point, particularly for Modern Monetary Theory types. My view is straightforward: yes, the government can make yield curve control stick. The problem with the policy is when the yield target is revised.

With short rate targeting, the central bank is not directly causing capital gains and losses for bond holders. Sure, they cause carnage, but they have plausible deniability: bond yields are set in the market, we are just setting the overnight rate! Sure, it’s stupid, but plausible deniability is still plausible deniability. On the other hand, with yield curve control, the central bank is directly handing out mark-to-market losses to widows, orphans, and pension fund bond managers. That’s a pretty potent political coalition burning you in effigy on the steps of the central bank’s main office.

It is also a financially unstable policy. A short-rate pegging regime works because forwards represent a market-clearing level in the private sector. Only an academic or central banker would be delusional enough to believe that central bankers can plant “expectations” where they want by announcing shifts to their views. In reality, the forwards represent the average guess as to how wrong the central bank’s forecast it. Once the central bank starts planting forwards by decree, market participants only have it a “take it or leave it” decision. If the forwards are too low, they dump bonds en masse — also known as an attack on the yield peg.

Needs Institutional Support

Anyone who has been paying attention to central banks has noticed several allegedly “permanent” self-imposed policy regimes by central banks over the past few decades (being a more detailed regime than the looser statutory inflation-targeting regime), each being abandoned whenever it became inconvenient. The lesson is that the only credible monetary policy regime is one that is backed by statute.

That is, the only way yield curve control is going to be a stable long-term policy is that it has to be set by law — and the rest of economic policy needs to be coherent with the policy. My view is that we are nowhere near a situation where policy is coherent with YCC, which is why I am not enthusiastic about the policy.

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(c) Brian Romanchuk 2022

Initial Comments On Sissoko Paper: Money Markets

I ran across Carolyn Sissoko’s working paper “Financial dominance: why the ‘market maker of last resort’ is a bad idea and what to do about it” (link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4240857). Although I agree that non-bank finance (“market-based finance”) is going to be the source of financial instability under current institutional arrangements in the developed countries, I am not too sympathetic with her framing of the issues. Private sector balance sheets have been tilted towards non-bank finance as a result of institutional and demographic trends, and the traditional banking system has been de-risked courtesy of banks relying on tools provided by non-bank finance.

Slope Inversion: What's Next?

Although it is safe to expect that the yield curve tends towards flattening during a rate hike cycle, the current movement in the 2-/10-year slope is relatively dramatic (figure above). This article discusses some of the mechanics of how slopes are traded.