Category: Market Action

Jobs, jobs, jobs!

he Canadian labour market rebounded in April by adding a substantial number of new positions, setting up a hotly debated decision from the Bank of Canada on whether to start lowering interest rates in June.

The economy added about 90,000 jobs in April after a slight decline in March, Statistics Canada said Friday in a report. It was the strongest month of job creation since January, 2023, and handily beat analyst expectations of 20,000 positions added last month.

Despite those gains, the unemployment rate held steady at 6.1 per cent, because the country’s population is growing at a feverish pace. The jobless rate has risen by more than a percentage point since the summer of 2022.
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In April, employers mostly added part-time positions, which rose by about 50,000. The private sector accounted for most of the employment growth, although there were strong gains in the public sector as well.

The total number of hours worked jumped by 0.8 per cent in April, suggesting an upturn in economic growth to start the second quarter.
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Average hourly wages grew at an annual pace of 4.7 per cent in April, down from 5.1 per cent in March.

This had an immediate effect on bonds:

Implied probabilities in swaps markets now suggest less than a 50 per cent chance the Bank of Canada will cut its key lending rate at its next policy meeting June 5. Immediately prior to the data, those odds were pegged at about 58 per cent, and in recent days had risen to above 70 per cent, with traders bolstering their bets in particular after a surprisingly weak employment report last Friday in the U.S.

Swaps markets are now implying 70 per cent odds for a cut at the bank’s July meeting. And they are fully pricing in two rate cuts by the end of this year.
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The Canadian dollar immediately spiked on the data, rising to 73.30 cents US, up from 73.10 cents, reflecting the lower probability of near-term cut rates. There was a sharp reaction in bond markets as well, with the Canadian government 2-year bond yield rising a further 5 basis points after the data. It’s up about 10 basis points in total for the day now, at 4.309 per cent, narrowing its spread to the U.S. equivalent bond.

Pre-Announcement

Post-Announcement

The BoC’s Financial Stability Report had some interesting things to say:

Hedge funds and pension funds have significantly increased their use of repo leverage

Leverage obtained by asset managers through borrowing in the repo market increased by around 30% in the past 12 months.25 This increase was driven largely by hedge funds and pension funds increasing their repo leverage by approximately 75% and 14%, respectively.26 Pension funds are the largest non-bank participants in Canadian repo markets, with over $90 billion in total borrowing outstanding. These pension funds face relatively less refinancing risk than hedge funds. About half of pension fund repo leverage has a maturity greater than one month, while about 70% of hedge fund repo exposure is under one week because hedge funds tend to rely more heavily on overnight and short-term repos. Some individual repo positions held by hedge funds are also very large and highly concentrated—for example, in a single Government of Canada bond.

The largest pension funds and insurance companies are typically sophisticated users of leverage that manage their liquidity risk and use liquidity coverage ratios to monitor planned and potential outflows.27 Nonetheless, even sophisticated users can run into difficulties during periods of market stress, as seen in the October 2022 UK pension fund experience and during the March 2020 “dash for cash.”28

Discussions with market participants and analysis of trading data indicate that one of the drivers behind the increase in hedge fund leverage is relative-value strategies. An example is the increasingly popular cash-futures basis trade in the Government of Canada bond market (see Box 3). These trades can provide market liquidity in both futures and bond markets. However, the large degree of leverage employed can leave hedge funds vulnerable to changes in the price difference between the underlying securities as well as to sudden changes in the availability and cost of repo financing.
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Box 3: Cash-futures basis trade

The basis trade, a relative-value strategy that has been a feature of the US Treasury market in recent years, is becoming more popular in Canada. This type of trading strategy uses a mix of long and short positions to capitalize on price differences between bonds and bond futures.

Market participants typically use a high degree of leverage—or borrowed funds—to increase profits for these trades. For example, when bond futures contracts are relatively more expensive than the underlying bond, an entity could profit from a cash-futures basis trade by selling bond futures, buying the underlying bond, and borrowing cash in repurchase agreement (repo) markets using the bond as collateral to finance the position.

Basis trades can improve market efficiency by reducing the cost of buying bond futures and supplying futures market liquidity to those who prefer holding long futures instead of bonds.31 These trades can also pose risk in times of stress—both to those making the trades and to financial markets more generally—due to many factors.

• The pricing discrepancies tend to be quite small, so to increase the profitability of the trades, financial firms (usually large, foreign-domiciled hedge funds) often use a large degree of leverage, which they typically obtain in the repo market. Indeed, the increase in the basis trade has been cited as one of the contributing factors for the surge in demand for repo funding seen earlier this year in Canada.32 High repo leverage, particularly when it is obtained through overnight or short-term repo maturities, can amplify sudden price movements in the underlying bond market.
• Maintaining these trades could become costly if repo rates were to spike suddenly, or if higher bond market volatility were to result in larger margin calls. The unwinding of these trades as a result of these shocks could lead to abrupt sales of fixed-income assets and, possibly, to strains on market liquidity. The more leveraged a hedge fund is, the more vulnerable it is to such shocks, and the greater the risk it poses to the overall system. This was evident in the US Treasury bond market in March 2020, when pandemic-related market stress caused many hedge funds to unwind their sizable cash-futures basis trade positions. This unwinding resulted in a large volume of US Treasury bonds being sold and contributed to the severe hampering of what is normally considered the most liquid bond market in the world. The one-way selling negatively affected market participants around the world that rely on the liquidity and stability of US Treasuries.33 As the International Monetary Fund recently noted, the aggressive use of repo leverage can also leave these trades vulnerable to other shocks, including upside inflationary surprises that could lower the value of bonds.34

The cash-futures basis trade is estimated to have grown steadily in Canada (Chart 3‑A), with exchange-for-physical transactions reaching $51 billion by the end of April 2024.35 This represents about 8% of the total trading volume of Government of Canada bonds (Chart 3‑B).36, 37 Of the total volume, 45% is in 2-year futures contracts, and the remainder is split somewhat evenly between the 5- and 10-year futures contracts.

All the above can be looked at as the back-up behind Bank of Canada Deputy Governor Toni Gravelle’s March 21 speech, which I reported 2024-3-22.

PerpetualDiscounts now yield 6.56%, equivalent to 8.53% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.34% on 2024-4-30 and since then the closing price of ZLC has changed from 14.50 to 14.83, an increase of 228bp in price, implying a decrease of yields of 19bp (BMO reports a duration of 12.23, but don’t disclose whether this is Macaulay or Modified; I will assume Modified) to 5.15%. Therefore, the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed slightly (and perhaps spuriously) to 340bp from the 345bp reported May 1.

Oh, it’s wicked! Look at the price of potato chips, according to FRED:

This is of great pith and moment, since as we all know the four basic food groups are:

• potato chips
• chocolate chip cookies
• beer
• some more of them potato chips

What are we to do? Is the world ending?

TXPR closed at 596.87, up 0.92% on the day after setting a new 52-week high. Volume today was 6.95-million, highest by far of the past 21 trading days.

CPD closed at 11.78, up 0.94% on the day after setting a new 52-week high. Volume was 66,820, near the median of the past 21 trading days.

ZPR closed at 10.18, up 0.89% on the day after setting a new 52-week high. Volume was 252,000, fourth-highest of the past 21 trading days.

Five-year Canada yields were down to 3.80%.

TXPR closed at 591.41, up 0.64% on the day after setting a new 52-week high. Volume today was 2.65-million, near the median of the past 21 trading days.

CPD closed at 11.67, up 0.34% on the day after setting a new 52-week high. Volume was 140,940, second-highest of the past 21 trading days.

ZPR closed at 10.09, up 0.20% on the day after setting a new 52-week high. Volume was 145,760, near the median of the past 21 trading days.

Five-year Canada yields were down to 3.84%.

The Fed did its thing today:

Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have remained strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated. In recent months, there has been a lack of further progress toward the Committee’s 2 percent inflation objective.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals have moved toward better balance over the past year. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.

In support of its goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage‑backed securities. Beginning in June, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The Committee will maintain the monthly redemption cap on agency debt and agency mortgage‑backed securities at $35 billion and will reinvest any principal payments in excess of this cap into Treasury securities. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals. The Committee’s assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Thomas I. Barkin; Michael S. Barr; Raphael W. Bostic; Michelle W. Bowman; Lisa D. Cook; Mary C. Daly; Philip N. Jefferson; Adriana D. Kugler; Loretta J. Mester; and Christopher J. Waller.

The significant part of the decision is the slowdown of QT:

But some savvy traders are excited about another key decision. The Fed announced that it will significantly curtail its quantitative tightening (QT) program — that’s the selling off of its assets to decrease money supply and increase interest rates — beginning in June.

US Treasury yields fell on the news. Yields on the 10-year and 2-year both dropped by .05 percentage points.

What’s happening: The Fed bought a ton of government-backed bonds between 2020 and 2022 to help support economic recovery after the pandemic-induced recession. Those purchases ended up pushing down interest rates in certain parts of the economy, like housing and auto sales.

In mid-2022, as inflation soared higher, the Fed reversed that and began unloading those bonds.

The Fed currently lets up to $60 billion in Treasuries mature each month without replacing them, reducing the amount of money circulating in the economy. The idea is that QT can help exert some downward pressure on prices.

But there’s also some downside to the practice — changing the amount of liquidity in the economy and redirecting that money could have some major consequences.

As JPMorgan Chase CEO Jamie Dimon pointed out in his annual letter to shareholders last month, “we have never truly experienced the full effect of quantitative tightening on this scale.” The current pace of QT is draining more than $900 billion in liquidity from the system annually, he said, adding, “I am more worried [about it] than most.”

QT reduces the amount of money in the banking system, leading to higher interest rates and tighter monetary conditions, but last time the Fed implemented such a program in 2019, some banks fell very short of reserves.

That led to a “repo crisis”, where the interest rates for overnight loans between banks spiked unusually high. The Fed had to intervene and provide liquidity to bring down those repo rates.

PerpetualDiscounts now yield 6.75%, equivalent to 8.78% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.30% on 2024-4-19 and since then the closing price of ZLC has changed from 14.61 to 14.59, a decrease of 14bp in price, implying an increase of yields of 1bp (BMO reports a duration of 12.23, but don’t disclose whether this is Macaulay or Modified; I will assume Modified) to 5.31%. Therefore, the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed to 345bp from the 360bp reported April 24.