W.T.F.

As we learned this week, WTF may not stand for what you think it stands for. The leader of the official opposition gave us an alternative meaning to WTF. Where’s. The. Funds. I am sure this will become part of some vernacular throughout Canada for a while, but it leaves me to wonder if there are other acronyms for WTF?

Today, lets ask if WTF could mean Wheres The Futures? As discussed many times, the futures markets can be a source of great influence on things like stocks, bonds, commodities and currency prices. Futures markets are where traders, and by default large financial institutions and governments place their bets, hedge their exposure, and try to, for lack of a better term, guess what the future might hold ,and how they might profit from it. Of course, a lot of the time their wagers turn up bust, and that is quite okay, as the point of a bet in the futures market may not just be to make money, but rather to avoid losing money.

Futures markets are a big space, and generally speaking, only the most experienced people should play in the market. Futures markets are often used to ” hedge out” risk. For example, if I was a big bank, and noticed that a lot of my current business was all fixed rate business, I may go into the futures markets and buy some exposure to a variable rate product. It doesn’t mean that I think rates may go up or down necessarily, but it means that if rates move suddenly in one direction or the other, I have mitigated my loss to a fixed rate product. For example, last year we saw a lot of borrowers take fixed rate mortgages due to rising Prime, and a lot of talk about rates moving higher. For banks to lock in mortgages in the 5% to 6% range was great. While every realtor, mortgage broker and hairdresser seems to know that rate cuts are imminent, what if rates went the other way? What if fixed mortgage rates went to 8%? Not probable, but certainly possible. So, the big bank might go into the futures market, and place a portion of their book into variable rate securities that would continue to go up in value as rates went up. Of course if rates fell, then the position would be at a loss, but that is okay, as the banks wagered an amount they felt comfortable losing in the first place. They were simply taking a portion of their profits on the fixed rate business they were booking, and used a little bit to hedge out some extreme movements in interest rates – should that happen. They enter into the contract knowing full well the value of that position could be worth $0.00 on the maturity date, but they do it to ensure they don’t get offside if rates ( or anything really for that matter ) make an extreme move. A better example would be a farmer. If I am a farmer that grows corn, and I see that corn is really really high, I may go and purchase a futures contract on lower corn prices. This way, if the price of corn on the open market drops ( and my corn crop is now worth less because of the lower price ) I make up some of that loss on the contract I purchased that bet on lower prices. It won’t make me whole, but it cuts down on some of my losses. If corn stays high, I lose the entire value of my futures contract, but I am okay with that, because the price I will get for my corn crop will more than compensate me for the small loss on my contract.

I have just made a really oversimplified version of the futures market, but I think you get the idea. The reason it is important to understand all of this, is because the data coming out right now is parsed through more than ever. Every single data point is looked at and over analyzed more than a high school boy that just got his first kiss from a girl. While we tend to see things that may lead us to believe one thing, it may not mean it is fact, and could lead us to make false assumptions.

Keeping things in our arena, interest rate movements will tend to be looked at more closely by us than by most. Do you take a fixed, or a VRM? 3 year or 5 year? There is a lot of choices to make. Quite often people will complain that the spread on a 3 year seems to be higher than a 5 year. They figure it is because the banks are ” screwing” the client. Maybe, but it could also mean that the bank has already got enough 3 year paper on its books, and to diversify its risk, or reduce its exposure to a certain time frame, they may be willing to reduce their spread or profit on a 5 year to try and get more people into that product. Often times we see the spread on a variable product move, and can’t seem to figure out the reasoning. The reasoning could just be the banks need to get certain exposures, or reduce exposures to variable rate products, so they make it more or less attractive to borrowers to go in the direction that the banks needs to balance and mitigate the risks out. Banks need to always ensure they are diversified in terms of fixed vs. variable, but also over timeframes. A bank would never want all of its book renewing at the same time. So, Mr. bank would ensure they have renewals coming due over multiple years to hedge out the risk from rates changing drastically when everything came due.

Certainly bond yields play into this, and banks have armies of people that will try to flesh out the next move in yields, the economy, rates etc. and will make their wagers to try and come up on the winning side. However, banks also have armies of people in their risk mitigation departments that will try to reduce risk, or spread it around should something not go as planned. Think of it as the Ying and Yang of banking. For every trader try to make a billion dollar bet, there is a lawyer in the risk department trying to make sure the bank doesn’t get wiped out on a single trade.

The reason this is all very important right now, is that coming into 2024, we all just seemed to know that inflation would fall, and alongside it so would rates. Well, we are about 7 weeks in, and rate cut bets have been pushed out further and further, and we are also seeing bets on less cuts than we thought in December of 2023. As inflation has remained stubbornly high, and US data has blown the doors off to the upside, rate cuts bets keep getting pushed back. We have pushed back the first rate cut by 60 days already, and the market has cut 2 full rate cuts ( 50 bps ) out of the 2024 calendar. If we see another good employment report out of the US, or inflation numbers come in a touch higher than anticipated, we could easily pushed back rate cuts another 60 days, and drop another 1 or 2 cuts off of the 2024 calendar. While it sucks for a lot of people, it also means that large banks, corporations, and governments have to start to re hedge their positions. This means that we may see some data that may be a little….well….murky at best, as everyone tries to re align, and re position for what they now think might be coming. It is akin to an airport that cancels planes landing during a storm, and then all of a sudden the weather clears, and air traffic control has to scramble to get everyone back in line, back in sequence, and figure out a plan going forward. With rate cut expectations changing, a lot of market players are scrambling to get their risks and their exposures back in line, which could lead to some volatility, but also some false positives.

Be super careful what data you read and listen to in the coming months, really make sure you look at all angles, and keep in mind that most everyone has a vested interest in presenting the data to you in a way that is most profitable for them. Be independent, use your head to think, and ensure that you are looking at a lot of peoples data from different sides before coming to a conclusion. If you don’t, you may very be asking yourself W.T.F….