Meet Four Guys Betting Canada Is Due for Quantitative Easingby
Start-up hedge fund places long-short bet on Wednesday meeting
Say QE is best tool to keep long-term rates down for business
From their shared office on the shores of Lake Ontario, literally on the other side of the tracks from Toronto’s financial district, a quartet of refugees from bank bond desks is betting Canada is about to become the latest country to roll out central banking’s big gun: quantitative easing.
With oil’s relentless collapse showing no signs of abating and weakness elsewhere in the economy, more than half the market has put its money on the Bank of Canada cutting its benchmark interest rate back to a record low of 0.25 percent on Wednesday.
The four guys who make up Algonquin Capital have gone one step further. Former debt traders at big banks, they say Canada is ripe for a program of large-scale bond purchases increasingly common to central banks that have run out of conventional weapons. Approaching their fund’s first anniversary, they’ve taken a combination of bets against short-term rates in favor of longer-term bonds that add up to a call that Bank of Canada Governor Stephen Poloz will soon open the door to extraordinary stimulus known as quantitative easing.
“The odds something could happen are greater than what is priced in,” said Brian D’Costa, Algonquin’s president, his three partners nodding to his left and right as they sway in identical swivel chairs. “If the QE call is made we could win really big."
It’s exactly the kind of bold bet they left their trading-floor jobs to make. D’Costa ran the fixed-income trading operations at Canadian Imperial Bank of Commerce, the nation’s fifth-largest bank. Chief Investment Officer Greg Jeffs traded corporate bonds at CIBC. Raj Tandon and Markus Otema cut their teeth trading debt in Europe for Toronto-Dominion Bank and U.S. investment bank Jefferies Group LLC.
Bank bond desks tend to make their money on volume; reaping a small spread matching buyers and sellers as many times as they can as fast as they can. At Jefferies, Otema said being away from his flashing screens for five minutes was an eternity. All four agree the advantage of their start-up hedge fund is it gives them time to think, and the freedom to take positions offering higher risks and bigger rewards.
The idea that Canada could be closer to QE than the market seems to expect is a product of one of their Friday afternoon brainstorming sessions. It’s genesis was in a speech Governor Poloz gave last month laying out the arsenal of extraordinary measures he could use if the ordinary ones, rate cuts, weren’t enough to pull the economy out its tailspin.
Where QE was seen as a last resort when the bank reviewed its unconventional tools in 2009, it now believes quantitative easing and negative rates could be used in any order depending on the need, Poloz told the audience at a Toronto hotel Dec. 8.
Since then, oil prices have continued their fall and traders in short-term interest rate instruments have piled on bets the central bank will cut its benchmark rate from the current 0.5 percent. The odds of a cut stand at more than 50 percent, according to Bloomberg calculations based on that trading.
A rate cut would have the most impact on shorter-term borrowing costs. With so many storm clouds hanging over Canada’s economic prospects, longer-term interest rates haven’t declined nearly as much. The premium the bond market demands to lend money to the government of Canada for 30 years compared with 10 years is now the highest since the early 1990s.
What’s more, the drop in the shortest-term borrowing costs for banks and large corporations hasn’t kept up with the drop in expectations for the policy rate; the spread between those two is the highest since the end of the credit crisis, raising questions about how much another rate cut can be passed through to the broader economy.
“Large-scale asset purchases tend to lower the interest rates on the purchased assets, and on other types of debt of similar duration, which in effect flattens the yield curve," Poloz said in the text of his speech. "This can enhance the impact of lower policy rates by spreading the effect to a wider range of borrowers, thereby boosting economic growth."
Poloz cautioned that the purpose of his speech was to lay out the tools at his disposal, even though he was still a long way from using them.
Nevertheless, with all that’s happened since, quantitative easing might start to look like the most appropriate tool for the job, D’Costa says. The bond purchases in a quantitative easing program would make his bets on longer-term bonds pay off. Negative rates alone would hurt his bet by pushing down yields on short-term bonds.
“It puts a lot of cash into the system, into the banks," he said. "When the banks have a lot of cash they need to deploy it. To lend more."
“Make it rain," chips in Tandon to his right.
Though the market still seems to be discounting the theory, the rapid shift in sentiment against Canada in the last month has it coming up more often in conversation. With government bond yields of all but the longest maturity reaching record lows last week, Mark Chandler, Royal Bank of Canada’s head of Canadian fixed-income strategy, mused that ordinary monetary policy tools would be hard pressed to provide much more stimulus.
“For a significant move the market would have to consider, first of all negative interest rates, and secondarily a higher probability of asset purchases," he said by phone from Toronto.
For Alessio de Longis, who helps manage $6 billion for OppenheimerFunds Inc. and has been betting against Canada’s currency since 2013, extraordinary policy isn’t looking imminent, but it’s getting to the point where it should at least be part of the conversation.
"I still think that QE is a more likely option than negative rates," he said by phone from New York. "QE would probably force risk takers to go up the risk frontier and start buying more credit, start buying more equities, and create more of a wealth effect."
That being said, it’s not like Algonquin is betting the fund. Jeffs declined to say how much Algonquin manages though he did say the majority of the money is from wealthy individuals and an institutional investor.
For the purposes of Wednesday’s rate decision, D’Costa figures QE just entering the conversation will be enough to make their bet pay off.
"It doesn’t take much to fuel the market’s perception that QE is on the table," he said. "If he opens the door we’d probably make the bet bigger, and more aggressive."