NextGen Treasury: Managing Liquidity in a Rising Rate Environment
December 06, 2022
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Manage Cash Flow,
Markets Plus
- Keywords:
- financial stability
- next gen treasury
December 06, 2022
|
Manage Cash Flow,
Markets Plus
Nearly every major economy hit the brakes in 2022. Over the past five decades, monetary policy has never tilted so overwhelmingly toward rate increases as it has this year. The Federal Reserve and the Bank of Canada have raised interest rates six times this year, citing persistent inflation. We expect this trend to continue into early 2023.
How you manage your liquidity during this time is vital. For many businesses, rising interest rates and interest market volatility are making it more difficult to maximize liquidity, minimize operational risk, achieve optimal returns and secure palatable borrowing costs.
To help put things into perspective, Johanna Skoog, Managing Director, Head of U.S. Treasury and Payments Solutions, BMO Capital Markets recently moderated a discussion with two experts who provided their insights on the economy and liquidity management:
- Jennifer Lee, BMO Capital Markets Senior Economist, is known for her analysis on the U.S. economy, as well as on financial markets and economic activity in Europe and Japan.
- Benjamin Lambert, Managing Director and Head of Liquidity Solutions, BMO Capital Markets, has deep expertise in partnering with clients to deliver liquidity solutions across their working capital reserves and strategic cash.
Following is a summary of their conversation.
North American economy: good news, bad news
Lee began with a bit of good news. After four consecutive rate hikes of 75 basis points, central banks are no longer using the term “front loading”—that is, implementing a series of large rate hikes over a fairly short period. In this case, 3 percentage points in just over six months. She quickly noted, however, that we’re not done with rates hikes and that rates will remain elevated for some time.
"In the U.S. we're probably going to be living with a fed funds rate in the range of 4.75% to 5% for about a year or so,” Lee said. “The reason behind that is because the U.S. economy, even after 375 basis points of rate hikes, remains very, very resilient.”
Along with stronger-than-expected third-quarter U.S. GDP results and gains in consumer spending, the continued tight labor market has made this a mild recession so far. According to the October Job Openings and Labor Turnover Survey
, there are nearly two job openings for almost every unemployed worker. Canada, meanwhile, reached a record of nearly 1 million job vacancies in the second quarter of 2022. "Until that lets up, we will probably continue to see pressure on wages,” Lee said. “And that, in turn, would need upward pressure on inflation.”
Lee said that BMO expects U.S. real GDP to grow at an annual rate of 1.9% in 2022. She added that BMO has raised its forecast for Canada’s GDP growth rate to 3.5% from 3.3%. BMO expects both countries to experience a downturn in the first half of 2023 followed by a modest recovery in the second half, resulting in net zero growth. Both the U.S. and Canada should rebound to about 1.5% growth in 2024, Lee said.
What does all this mean for North American central banks? BMO expects the Fed to raise rates an additional 100 bps over the next three meetings—50 bps in December and another 25 bps in both February and March—which will result in a fed funds rate in the 4.75% to 5% range. As for the Bank of Canada, Lee said BMO expects two more rate hikes by January totaling 75 bps.
“Remember that a slower pace of rate hikes does not mean cutting,” Lee said. “This means 50 bps instead of 75, or 25 instead of 50. But if you get weaker economic growth, if you get weaker job growth and less spending, that will help with the decision to slow [rate hikes] down a bit. That's what makes this whole situation so unique: bad news is good, good news is bad, and unfortunately that's the way of the world these days.”
Return to liquidity management fundamentals
Businesses are trying to make sense of the topsy-turvy conditions that Lee described. It’s led to a lot of caution and uncertainty, as well as what Lambert described as “rate hike fatigue.”
"On the one hand, we have clients analyzing all the economic data, the Fed talking points and juggling between the dovish and hawkish comments that come in day after day,” Lambert said. “On the other hand, we have clients that are still trying to make sense of all this and still don't know what to do with their cash.”
Lambert said this is the time to return to the fundamentals of reviewing liquidity management strategies. “We need to go back to the old practice of analyzing cash flows, where cash flow is coming from and where they need to go.”
That means separating cash into three buckets:
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Operating cash. Your day-to-day working capital cash with immediate access for payments, payroll, etc.
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Reserve cash. Funds used for regularly occurring future payments in a one- to six-month timeframe, such as for property taxes, dividend payments, debt repayments and bonuses.
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Strategic cash. Long term cash (beyond six months) that is seldom used. These are the funds set aside for major events such as acquisitions or large capital expenditures.
During the previous low interest rate environment, companies didn’t need to apply this discipline as much. “Why put cash to work when the rates are close to zero?” Lambert said. “Now that the environment has shifted and there's value to capture, we need to go back to this practice and reallocate cash across the different buckets to identify which class could be put to work, and which cash needs to stay overnight to keep the daily liquidity funding.”
Lambert also pointed out the importance of being flexible enough to adjust your investment policy when necessary. “The message is to stay nimble, to go after value, and to fit that value against your liquidity needs, your yield appetite and your risk appetite,” he said.
You can listen to the full conversation here:
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Johanna Skoog: Clients and colleagues, welcome to the latest edition of NextGen Treasury. My name is Johanna Skoog, I'm the head of I&CB US TPS and I'm your host today. With this series, we aim to deliver great content and ideas on topics that are timely and most relevant to you. In previous sessions, we discussed the latest tips on how to minimize your exposure to fraud with expert Larry Zelvin, and last year, expert Jim Santoro spoke about balancing the liquidity scales.
Speaking of liquidity, today we're bringing back the liquidity conversation. Over the course of this year, nearly every major economy has jammed on the breaks. In the past five decades, policy has never tilted so overwhelmingly towards rate increases. In North America, the Federal Reserve and the Bank of Canada have raised interest rates six times this year, citing persistent inflation. We are expecting this trend to continue into F23. What does this mean for you? How you manage your liquidity during this time is very important.
With rising interest rates and interest market volatility, it will become more difficult to maximize liquidity, minimize operational risk, and achieve optimal returns and palatable borrowing costs. If you've been keeping an eye out on the rising rates, you're not alone. Managing liquidity in this volatile time has been one of our most asked-about topics. To help put things into perspective and to answer some of your questions, I'm joined today by two expert speakers. They will provide their thoughts and unique perspectives on liquidity management and we'll follow that up by a panel discussion where they'll answer your questions. A quick introduction of our experts today, and we'll dive right into it.
First, we have Jennifer Lee, BMO senior economist. She is known for her analysis on the US economy, as well as her commentary, analyzing financial market and economic activity in Europe and Japan. Welcome, Jennifer. We're joined by Ben Lambert, managing director and head of Liquidity Solutions at BMO Capital Markets. Ben has deep expertise in partnering with clients to deliver liquidity solutions across their working capital, reserve, and strategic cash. Welcome, Ben. Now let's get into it. Jennifer, over to you for your views on the economy.
Jennifer Lee: Thank you very much. I thought I'd start off with some positive news, which I feel like I haven't done in ages. Are you ready for this? Here we go. I haven't heard any of the major central bankers use the word "front load" in a few months. There we go. There's your good news. I'm going to do my mic drop now. Of course, maybe after like what, 475 basis point hikes in a row, it's hardly frontloading anymore. If it's considered frontloading, I think we would've been have a bigger problem, I guess, on our hands.
Now, of course, it doesn't mean that rates are headed the other way, there's going to be higher for longer and rates are probably going to be staying elevated for some time, meaning that in the US, we're probably going to be living with a Fed funds rate in the range of 4.75% to 5% for a while, like about a year or so. The reason behind that is because the US economy, even after like 375 basis points of rate hikes remains very, very resilient. I have to say, I've been pretty surprised by the data, just the fact that they've just been managing to hold up after all that tightening.
Now, not every single data release obviously has been doing so, but it's still pretty broad-based. Now, most recently we just got the latest real GDP reading for the third quarter and it was revised higher to 2.9% annualized, and that was higher than the first estimate. We saw broad base gains in consumer spending and business investment and exports but of course, there's some offset from housing and from imports as well. Since then, the handoff to the fourth quarter, we're still seeing a pretty decent passover. Consumer spending is still rising, albeit at a slower pace, but still on the rise.
We've got evidence of that from the October retail sales report. Business investment in machinery equipment, it's still growing and trade looks like it was up until October, it was still adding to GDP growth, but we saw a pretty big deficit in October. It looks like we can start seeing trade subtracting from growth. In Canada earlier this week, we got the third quarter GDP numbers finally, headline was very solid up 2.9% annualized, but the details were not solid, consumer spending was down, but that was okay because that allowed consumers to soak away some of that hard-earned money for a rainy day, and so that boosted up the savings rate a little bit.
We all know that having some savings put away is never a bad thing. Housing was still there and there's probably more of that to where that came from. Net exports and business investments also boosted the headline as did inventories. Now, for all of 2022, we did lift Canada's GDP growth rate to about 3.5%. Originally, we had about 3.3%. For the US, we're looking at a number just under 2%, maybe about 1.9%.
We still continue to expect a downturn in the first half of 2023, which I guess is just right around the corner. Then a modest recovery in the second half, which basically works out to zero growth, netting out to zero growth, so it's almost going to be a write-off for 2023, then we're going to get some rebound in 2024, in the neighborhood of about maybe 1.5% or so for both countries. Now, here, I feel like I should also mention our global growth forecast because we are all still getting that question. Do you all see a global recession coming in the next year or so? Right now, the answer is no, not quite, but it's pretty close.
Right now, I should say, we started off the year looking at 4.5% growth for 2022 and 4% for 2023, which feels like the good old days at this point, and of course, we had the Russian-Ukraine war break out, the lockdowns and restrictions in China, and of course, the uber-hawkish talk from the Fed. Now we are looking at 3.1% growth for 2022, 2.3% for 2023. For 2023, aside from the pandemic and the great financial crisis, that is the slowest pace in about three decades. Now, there's no hard and fast rule about what specific number it would be that would constitute a global recession. By definition, it would be just an extended period of economic decline around the world.
Here at BMO economics, we look at a numbers sort of in the 2%-ish range, we're going to give a low 2s. Given our call for 2.3% next year, we're pretty close. I don't think it's going to take too much to tip us over into that recession category or recession camp. By the way, a number of those big thing takes, the global thing takes have also been weighing in on this whole concept. The IMF in October said that the, "worst is yet to come," and they marked down their forecasts as well, but they didn't call for an outright recession around the world, but they did say that some countries will feel more of a recession than other countries.
They also mentioned, not in October, but a little while before that, they talked about inflation and how it's been stubborn and more broad-based than anyone would have thought it would be. They encouraged central banks to be equally as stubborn in fighting it. We all know what that means. It's basically means that you would require more interest rate hikes. The World Bank, by the way, had a different angle. They agreed with the view on inflation, but then they warned the devastating consequences to the global economy if central bankers raised rates too quickly and is too aggressively.
Anyways, regardless, there's going to be pain everywhere. Some countries and some regions will suffer more than others, and they have their own challenges. I'm thinking China with its COVID lockdown and these restrictions and now it's protests, which look like they might be hiding some of their desired effects. Of course, with Europe, I don't know where to begin with that, you've got energy crisis in Russia and all that. Probably recessions there for sure.
Getting back to North America, the reason why we are only looking for a mild recession, goes back to the whole labor market, just the fact that it remains very, very tight, not as much as it once was, but I will still say this that, if you're a job hunter, it is still the best time to be looking for a job, and for those who are trying to hire, this is still the worst time to be looking for workers. You don't have to look any further than the job vacancies or the job openings data. Very few people, I remember back in the day that used to look at the US JOLTS report, which is the job openings and labor turnover survey, and now we are really scrutinizing it, even as much as the monthly nonfarm payroll report.
Now our last check, we just got the October report. It still shows that for 16 months in a row, there have been over 10 million job openings out there which outnumber unemployment by a factor of almost two. In other words, there are nearly two job openings for every unemployed American. In Canada, there are nearly a million job vacancies out there, which is a near record, and that is almost equal to the number of unemployed Canadians. Until that less up, we will probably continue to see upward pressure on wages, and that in turn would mean upward pressure on inflation.
Now there has been some encouraging news on the inflation front. We have the October US CPI report which caused a lot of hoopla for lack of a better word and I'm so of being too technical there, but it did come in well below expected. The core reading in particular was up only 0.3% month to month which is the smallest increase in over a year. The year-over-year trend slowed from 6.6% in September, which was a 40-year high to 6.3%. Then a week later, we got the Canadian CPI numbers for October and it didn't deteriorate. It was steady at 6.9% and they kept putting some distance between itself and that 40-year high of 8.1% back in June.
The average of the cores though, were still quite steady at 5.4% which isn't great, but at least it didn't get worse. Because central bankers they've been burned before, I think it's totally understandable that they don't want to be too trigger-happy. Pretty sure, the Fed Chair Powell back in August was saying that the cost of doing too little is greater than the cost of doing too much. He's been saying that up until recently and other members of the FOMC are also echoing his words such as the Cleveland Feds, Loretta Mester.
What does this mean for the Fed and the Bank of Canada? Here are our calls. The Fed after 375 basis points of rate hikes, we continue to look for another 100 basis points to come in the next three meetings or so. We're looking for 50 basis points in December and judging by Fed Chair Powell's comments on Wednesday that's supporting that view. For another 25 beeps in February and 25 beeps again in March, which will land us at 4.875% or in the 4.75 to 5% range.
For the Bank of Canada, we are looking for two more rate hikes, about 75 basis points. This follows 350 bps of hikes. Maybe another 50 bps in December to 4.25% and another 25 basis points to 4.5% in January.
Once they reach terminal, they'll hold and assess the landscape because we all know there's a lag response to the policy actions, but there is a risk that rates will be higher than what we have penciled in. What is next? I'm going to shamelessly borrow from ECB President Lagarde comments. I'm going to semi-quote her, but when she says, "Everything is data dependent and decisions will be made on a meeting by meeting basis," so that's a great quote to use but for sure, we got to keep an eye on the data on oil prices, for example.
Because if oil, if it continues to decline and it's got to stay there for a few days, by the way, it's got to stay there for more than a few days, then that can actually ease pressure on other costs like on transportation. That'll help the overall inflation story. Of course, it all comes back down to core and just making sure core CPI heads back south towards that 2% mark. Remember that a slower pace of rate hikes does not mean cutting. It just means 50 instead of 75 or 25 instead of 50. If you get weaker economic growth, if you get weaker job growth, and less spending, that will help the decision to slow things down a bit.
Slow growth not how to do it. That's what makes this whole situation so unique is that bad news is good, good news is bad and unfortunately, that's the way of the world these days. I think that covers my comments. Back to you.
Johanna: Thank you, Jennifer, for your comments. It was very insightful. Now, we'll turn over to Ben for his commentary on liquidity with clients.
Ben Lambert: Good afternoon everyone, and thank you very much, Johanna, for hosting this session and, Jennifer, for sharing the good news, bad news story. Obviously still a lot of caution, still a lot of uncertainty as we perfectly describe Jennifer. As we're facing a rising rate environment which is at the end of it much more aggressive that anyone's initial forecast, as we look back earlier this year. Obviously, we talked to clients on a daily basis and we actually have to admit we see a lot of stress and almost I would say rate hike fatigue at this point.
On the one hand, we have clients analyzing all the economic data and the talking points and I would say juggling between the dovish and hawkish comments that comes day after day, whether it's the GDP data one day or Chair Powell comments yesterday. On the other end, we have clients that are still trying to make sense of all this and still don't know really what to do with our cash as they approach us. Whether you sit on one end of the spectrum, on the other side, or in the middle, it's perfectly fine. It's perfectly normal. I would say do not worry, there are solutions to accommodate everyone and help navigate this rate environment.
One thing I'll add is let's remember that we probably have not seen this pace of rising rate environment in quite a while. On my hand, I've been almost 20 years in banking, tenancy and liquidity since some prime sovereign financial crisis. I have to say the rate environment that we deal with at the moment is probably one of the most challenging I've had and the most difficult to navigate I've seen.
I would say speaking under Jennifer's control, I'm not sure ever been in such a situation. I think that, Jennifer, correct me if I'm wrong, but really last time, we came out of a zero rate environment, that we've done over the past 12 months. The Fed was not fighting real inflation, but reproducing accommodation. Really a new territory that we've been progressing through, so far, a difficult environment to deal with.
I would say, over the next part of this session, we'll try to make a bit of sense of what's going on, and look how to best navigate at these times when it come to liquidity management.
There's three main things on that purpose I would like to talk about today. The first one is the impact of this rising rate environment on our corporate liquidity market. What we've witnessed after 12-month now, is that this space of rate hike, this rising rate environment, has fully shifted the market from what we call diversification to value. We've witnessed that dynamic both across the client and bank perspective. I would say, let's look at, challenge you first. You're probably sitting and listening to the sessions, like, "Oh yes, that sounds familiar." Let's take a step back.
During the pandemic, we saw big influx of cash deposits. On the corporate treasury side, clients were uncertain about the cash reserve they would need to maintain given the uncertainty linked to the health, the geopolitical environment, as we exited the pandemic, and plan, grow on their facility and committed to cash, and keep those as reserves along that side. Now, as we entered into '21 and early '22, we saw a bit of normalization that happened on the fund behavior side. Clients started to deploy cash for CapEx, debt repayments.
Obviously, you're paying debt as interest were rising, and this was becoming more expensive. We saw a bit of a shift of priorities for clients, and also a shift in appetites, when it comes to going after a yield, and after value, only focusing for diversification across our bond group, and capital preservation over the previous month. Now let's take the bank perspective for a second, and this is what's on the slide, and which could be able to illustrate the point which I'm making. Clients who are coming to banks with cash in hands, really not focus on the yield during the pandemic.
As I mentioned, we are looking to place, and put cash, to put on their bank's partners' balance sheet. That's the peak that you see on the left side of the chart, during the pandemic period. As we started to exit the pandemic, banks started to put caps and limits on balances they could accommodate, on pricing potentially as well, to make sure they could service all their clients, and keep capacity on their balance sheets, on the go-forward basis.
Now, from the bank perspective, we started to see normalization of balance sheet behavior as well. We saw less risk on balance sheet with a rebalancing of inflows between loans extended and deposit capture, which is that middle inflation point you see on the slide, as we exited the pandemic. If you look closely, you'll see that over the last couple of quarters, we start seeing loan growth, and loan being sent to clients outpacing the deposit collection.
What does that mean from a client point of view? It means that banks, as they try to self-fund this loan growth, and this new loan appetite, this new normal, we will have appetite to capture deposit and extend value to collect those deposits. I would say, good news, banks are still here for clients, they were here during the pandemic, they're still here after the pandemic. Now, even better news, is that there is value associated with deposits, and some banks, to support their loan growth, will go after their value.
On the one hand, clients, open for yield, some banks open to support their loan growth and provide value. Conditions were created to shift from that diversification angle to the value proposition that we look at at the moment. First thing, shifted from diversification to value. The second thing I'd like to mention, is going to help us navigate this environment, is that we have not to go back to the discipline of reviewing liquidity management strategies. What does it mean? It means we will need to go back to the old practice of analyzing cash flows, where cash flows coming from, and where they need to go.
The way I look at it and is the second slide when I look at the moment, and the way we like to look at it, and the way we recommend to look at it is to surrogate the cash into three different buckets. First bucket, operational cash where you place your working capital cash, day-to-day, immediate access, which is the cash you need to deliver for payments, collection, payrolls, financing. A second bucket, which is more the reserve cash which may not be required beyond a month. Generally, for longer foreseeable corporate events, corporate needs, dividend payments, debt repayments, bonus payments, so all that cash within one to six month that you can allocate along to your cash for forecasting.
The last bucket is what we call the strategic cash, which is long-term cash that is really seldom touched that you use for acquisitions or large CapEx decisions, so really like cash that you will not touch six month and beyond. This old practice that I describe as some real users, and when I say old is not related to any recent complacency per se. It's just like that during the past couple years, the discipline was not as much required because of the low-rate environment. Why segregate cash and put some cash to work when the rest are close to a zero or close to zero and the natural solution where to keep fund overnight and fully liquid. That's what we had witnessed until client practice of the past few years.
Now that the environment has shifted and that there's value to capture, we need to go back to this practice and reallocate cash across the different buckets to really identify which class could be put to work and which cash need to stay overnight to keep the daily liquidity funding. On that topic, and to expand a little bit, so I mentioned reviewing liquidity management strategies. Now the third theme I'd like to introduce is to stay nimble and adjust investment policy, so we mentioned the value we can capture. We mentioned the need to be disciplined and really segregate cash accordingly based on needs and based on appetites.
To capture that value that some product to consider and to be able to secure those products and place [unintelligible 00:22:22] solutions, we need really encourage our clients to review and adjust their investment policy. The message really is to stay flexible, to stay nimble, to go after the value I just described, and really fit that value against the need to access the funds, so the liquidity needs, the yield appetite, and obviously, the risk appetites.
Focus on capital preservation is still a key focus at the moment for clients, but some clients may be able to take a bit of principal risk and we look at some of the products that we could consider across the different buckets of cash. We just talked about, so when it comes to operating cash and read that the daily cash we need to get access to. A couple of products that clients and you probably have been leveraging historically or still leveraging today is the current account or if you're in the US, the ECR account, so earning credit value where whereby the deposit you place in your account enables you to offset fees linked to your cash management services and treasury payment services.
With the rate hike environment that ECR, we should have seen a little bump, and you should have got a benefits in offsetting more fees in that environment. If you are sweeping that excess cash, that reserve cash to money market fund, at the moment, you will also see an uptick in your daily yields from the [unintelligible 00:23:59] funds that your funds could be placed with. Now, in this rising world environment that money market funds may have a bit of a lag, and it's mainly linked to the interesting value that those funds carry.
Usually those money market funds, 70% invested overnight and there's some TBIs and some tariffs in there, so by the time they catch up on the rate hike, you see a bit of a lag of yield pickup. More importantly, if you have an interest-bearing account or money market deposit account or a treasury management account in Canada, the rate hike should have translated in the return you get on your bank deposits,
Sometimes for some banks where we are described earlier, have self-funding appetite and are looking to support that long growth, the return you'll get on your account would supersede or may supersede the return you may get on the overnight money market funds or other instruments of that nature. Really for you to better appreciate and understand this dynamic, we encourage you to stay close to your corporate banker or liquidity specialist truly appreciate the value you could capture by looking at bank deposits in a closer manner based on the former banks obviously you deal with.
To echo that, you really need to check investment policy to potential rebalance portfolio, look at bank deposit appetite based on the value that you could extract from the rising rate environment. That was more for the operating cash, the overnight cash that we could access. Now, let's look really quick at the reserve cash and that term deposit, notice deposit product buckets, which is part of this one to six-month bucket of cash that we could leverage.
Actually, we've seen a lot of cash inflows and a lot of cash from clients deploying into that segment over the past month. Clients were able to segregate cash in that bucket, were able to lock in yield, and create a lot of value for the cash portfolio and the excess cash as they lock in the property of rate hikes. Just a reminder, term deposits, we're locking the funds and get access to the funds [unintelligible 00:26:12] with your interest, and the real value of the term deposit is that you lock in the probability that the Fed will hike in such a way.
At the moment there's a lot of value on the curve, both short-term or long-term between 1 month and 12 months. We see clients playing along the curve and locking yields and getting more value for their buck as we call it. The beauty of the product as well is as clients are disciplined or can provide transparency on the core events, it's natural to tie the material investment to their set up or events, whether it's a debt repayment or dividend payment, or tax payment per se.
Now let's look at the last bucket, the strategy cash where plans can place cash long-term, so six months to one year. We could leverage the same product or beyond one year by the way, and we could leverage the same product on the term side. We also saw a lot of appetite for clients on that tenor, which less than the three to six month given the nature of the portfolio that they have. We started seeing now clients being even more sophisticated in anticipating potential rate cuts in '24. We heard Jennifer mentioning that some clients are starting with the R-word, so I'll say it because he said it as a recession.
We start seeing some limited clients starting to hedge against the rate cuts and going really long term, two, three year to locking the yield today and protect against rate cuts. Other products to consider if principal risk could be part of the equation of your daily cash management, that's something we have to say, we have not seen too much, we haven't seen a lot of risk profile transitioning to that service background. Actually, we have seen the opposite. We have seen clients who are investing strictly in treasuries going to more fixed-value product whether it's money market or [unintelligible 00:28:17] funds or bank deposits.
Because the volatility of the online treasury market at once was such that there was a bit of principal risk that could have been created if they were to sell the security before maturity. A lot of dynamics at play across a product set and really need to stay flexible based on where the value sits at the moment across the different cash buckets. Obviously, we're here to help you review those investment policy, review those liquidity management strategies and unlock the value that we see right now in the market.
Three main things to summarize, the liquid market has shifted its value capture. To capture that value, the second thing, we encourage all our clients to review their investment options and separate their cash accordingly. Three is to stay flexible in terms of investment policy, to go after those products and rebalance the need to access funds, the risk appetite, and the yield appetite to really go and unlock that value. I said a lot here. I'll pause because I want to leave enough room for questions and I'll send it back to you, Johanna, so you could address questions from the audience.
Johanna: Thanks, Ben. This is my favorite part of the session is when Ben and Jen are in the hot seat. Let's get started with our first question going to Jennifer, can high rates trigger a recession?
Jennifer: Yes. Next question. I'm kidding. Yes, for sure, high rates can certainly trigger a recession, especially if the central bank holds it up there too long or, and for too high and you've already seen inflation coming down and you're already seeing demand cool offs considerably, and yet rates are still not moving so that can definitely trigger a deeper recession, I will say. We already have rate hikes going up quite a bit a record amount over such a short span of time.
We've already been penciling in a mild recession and it could be there is a risk of course, that it could be deeper, and that is if the Fed or the Bank of Canada keeps rates too high for too long so it's just key to be nimble for the central bankers to stay nimble. Easier said than done of course, but for sure if rates stay too high for too long then a deeper recession can be triggered.
Johanna: Thank you, Jennifer. Our next question is for Ben, and oops maybe me, but mostly Ben, how do you provide reassurance to clients during these turbulent times?
Ben: Thank you for the question, Johanna. I touched a little bit upon that topic when I started, and obviously, we are here for our clients to help them navigate the changes and address all the liquidity and cash management that they may have in this uncertain environment. I touched upon us being there to partner with them and collectively review their investment policy, they look in measurement strategies but what I wanted to share is that clients are not alone to review and design those solutions.
We're here to partner with them, reassure them, inform them on what's going on and we see with Jennifer's guidance, provide them dates on where the value may sit in the coming days, in the coming weeks, what will happen to their cash and where the cash is being placed at the moment so it's really a partnership like to envision and really something to consider that they're not alone when it comes to addressing those changes and those needs.
Another thing I'll say is, obviously, I mentioned how times have changed but another aspect to consider is that treasury teams also may not be the same. They also have been some shifts on that end so when it comes to new stuff or junior staff, we're just starting their career and think that this rising rate environment and this high pace is normal. We'll also here to them and guide them through those times so my guidance, and obviously, I will let you chime in because you also speak with clients on a daily basis, is to really reach out to your corporate banker or liquid specialist, stay close to them, and please feel free to reach out with any question you may have, whether it's on the rate outlook or on the liquid solution linked to this rate outlook.
Johanna: Thanks, Ben. That's really helpful. Our next question is for both Jennifer and Ben, what is the impact of US interest rate hikes on multinational businesses?
Jennifer: Rate hikes on multinationals?
Johanna: Yes.
Jennifer: That sounds like a currency question. I don't know if I can answer that directly. Can I call a friend?
Johanna: Yes, you can phone a friend and we'll go on to the next question.
Jennifer: Okay. Let me just email him. Okay.
Johanna: Let's pick one for Ben while we're waiting. Ben, what are your general strategies or thoughts on transitioning for best results between this incredible rapid rising rate environment and the expected upcoming decrease in environment, whenever that may be. There's the second part to it, whenever we are at the peak of the increases, what is your thought on the go long now to capture the highest rate concept?
Ben: Thank you for the question, Johanna. It's a long question. I'll try to address both points and please keep me honest if I miss either one of them. The question and I'll take the second one first, which is when is a good time to capture the highest rate concept? It's something pretty tricky. Obviously, we want a lock-in yield potentially mentioned the term deposit that [unintelligible 00:34:53] has leveraged extensively over the past few months to on the one end shield against potential temporary high rate, high postponement.
Doesn't sound like it's going to happen from what Jennifer shared with us earlier during the session, or a more cautious rate high schedule, which is a potential scenario. Question is how do we time when we reach the peak target rate? Maybe, Jennifer, you can pose some guidance if you know or if you have confidence if we reach the peak target rate at the moment. Every time, I think we reach the peak target rate, it looks like the Fed wants to be more aggressive so I'll be cautious. If we reach the peak target rate, that's where we want to lock in the long term. We maximize the optimal return on our cash.
If on the other end, let's believe that the Fed will be, or the central bank will be more hawkish, maybe go short term, there's still value on that curve. We see three more rate hikes in the US for instance as Jennifer mentioned. There's still value capture on that side of the curve. If you believe that the Fed will be more aggressive, stay a bit shorter within those one to three-month term, if you think we've reached the peak and we're more facing rate cuts down the road and we are locking that long-term rates that's locking now, but I have to say it's very difficult to predict.
It's very difficult to get it right. I think we saw all those initial forecast people had earlier this year or even mid-year were revised pretty quickly and pretty extensively as the weeks were progressing. The recommendation and the advice is free to diversify and to later tenures, later maturities as much as possible based on the corporate events that you may have, based on the funding needs that you may have, and really diversify to linearized those return rather than put all eggs in one basket and gamble for when that peak rate hike may be.
Johanna: Thanks, Ben. Jennifer, while we're waiting for a response, I have another question for you.
Jennifer: I have a response, but continue.
Johanna: Would you like to answer the other question first?
Jennifer: Sure. It looks like it was more of a current US dollar question so I did email Greg Anderson, who is our global head of FX strategy. I'll just give you the short answer of what he said. He was talking about how this year's rapid rise in the greenback has punished multinationals that borrow US dollars in order to fund operations with revenue streams in Euro, Yen, and emerging markets. He expects firms to be reluctant to get caught in the repeat. North American multinationals are likely to reemphasize using foreign rates to set their hurdle rates as they evaluate projects.
That could or should discourage foreign direct investment in bridging markets while encouraging capacity expansion within the NAFTA zone. Sounds right to me. [laughs]
Johanna: Great.
Jennifer: Thank you, Greg.
Johanna: Another question for you, Jennifer, where do you think the terminal rate stabilizes, and how long before the Fed starts decreasing interest rates?
Jennifer: Like Ben just said, it's almost like a moving target it seems, but right now, seems like we're almost there. Again, we've had 375 basis points of rate hikes, probably another 100 more to go, 50 in December which is in a couple of weeks, 25 in February, and another 25 in March. Right now, we see terminal being 4.875% or in the 4.75% to 5% range. Again, there is a risk that it would be higher, but Fed Chair Powell was on the wires on Wednesday talking and his first line caught everyone.
It was actually very, very intriguing when he said that it makes sense to moderate the pace of rate hikes and the time to moderate the pace of rate hikes may come as soon as the December meeting. That makes us a lot more comfortable with our call from 50. This is the slower pace of rate hikes after 475 bps in a row, getting down to 50 and then 25 and 25, and then we think they're going to stay there for probably over the course of the rest of 2023, and then rate cuts could potentially begin in 2024. To cut a long story short, somewhere around the 5% mark.
Johanna: Thank you, Jennifer. You're super popular. Lots of questions for you today. When do we exchange Canadian dollars?
Jennifer: You tell me. [laughs] You know what, the currency, American has been one of the toughest things to forecast, especially since the pandemic, it's been extremely volatile. For the Canadian dollar, even, let's just say talk about the greenback in general. We see the US dollar peaking probably around the turn of the year, if not now and I remember in the summer it was around, I think it was July and there was talk about US dollar peaking at that point.
It was because it was after one better-than-expected US CPI report and I remember saying, "Whoa, Nelly, hang on, way too early to call for the peak," but I think at this point, it seems a little bit more likely that the US dollar is peaking around this time around now, again around the turn of the year. Then if it's peaking, then you should start seeing the Canadian dollar obviously benefit from that, assuming, of course, that there is no deeper recession here in Canada, but overall, we still look for a stronger Canadian dollar over the course of the next couple years, just on average but obviously, I can't say that on a day-to-day basis.
If we see peak US dollar now, we can probably start seeing the Canadian dollar's strength over the course of the next couple years.
Johanna: Thank you. I have one more question for you and then I promise I'll shift things over to Ben a little bit. The Bank of Canada has been rising policy rates to bring the inflation rate within its target of 1% to 3% to meet its monetary policy objective. It does not seem to be having much of an impact so far. How far do you think the BOC will go in terms of raising policy rates to meet its objective and do you think monetary policy is an effective tool given the change in dynamics?
Jennifer: That's a lot of packed into that question. I would disagree respectfully and say that I think the Bank of Canada's rate hikes have had some sort of an impact. We've seen slower growth already playing out. Obviously, there is a lag effect in whenever any central bank starts raising or cutting rates. It's not going to happen right away, but you're already seeing that play out in the Canadian housing market where sales have come down sharply. It's already in correction mode.
Prices have come down about 10% on average from their peaks and it depends on what city you're talking about, of course, but I think we still see probably another 10% move in prices nationwide for a total peak-to-trough decline of about 20%. I think it is working. Obviously, some of these rate hikes, monetary policy can only do so much. Fed Chair Powell said this before, we can't change the supply chain problems, but we can influence demand. That is where all of these rate hikes.
Again, in Canada, 350 basis points so far, rate hikes has started to influence demand. We're probably going to see that play out more as some of these mortgage rates, for example, start to reset as well, I know these mortgages, so in closing, I would say that it is still an effective tool, but it just can't change every problem out there because we're in such different times right now.
Johanna: Thanks, Jennifer. I have a different question for Ben. Ben, how does sustainability fit into a company's investment policy, especially in a rising rate environment and what should we be thinking about?
Ben: Absolutely. I know you're passionate about sustainability, I'm passionate about sustainability before I raise the sustainability question, would love to expand a little bit and steal a bit of one of Jennifer's question because on the currency or the MNC question, sometimes clients approach us and say, "Oh, should I swap my CAD to USD or vice versa to benefit from a higher interest rate on my cash?" I just wanted to maybe expand a little bit. If you allow me for a minute or two. I'll take it a yes.
Johanna: I'm only going to give you a minute, one minute, Ben.
Ben: All right. I speak under your control. On that topic and I have the chance to discuss this with some of our clients and at the moment, we don't see a lot of value of swapping from one currency to other and really entering to any type of carry trade from USD to CAD. The main reason behind that is we don't see the yield pickup worth the FX risk. We think the currency movement will wipe out any yield pickup over the coming weeks and month if the currency evolves.
Obviously, I'm not an FX specialist, but if you want to further explore that topic, please reach out and we can put you in touch with our FX strategies or FX specialist to go deeper on that product because while there may not be value on the deposit and instrument yield side, there may be a lot of value on the hedging side. We see something to consider down the road. If I can take another 30 second or another minute, I realize that I partially answered the previous question. The peak of the increase in what you lock in addressed that point but I don't think addressed the rapid rising environment and expected decreasing environment.
I really want to stay honest here and address that side of the question as well. Obviously, I mentioned when to lock in to return an optimal yield at the peak of the target rate. Now, as we look at potential rate cuts in 2024, raise value locking yields right now and hedging over two, three years, if you could put cash work on the tunnel rising and hedge against those rate cuts in '24, that Jennifer mentioned. One thing I'll add is all this concept of going short-term, long-term, and diversifying your time horizon as far as cash investment is also something which is not natural.
On our own, we developed tools to look at different scenarios and look at what we were beneficial to leave funds overnights, put a mix on the reserve strategic bucket, that reserve bucket, and another part of the mix in the strategy bucket longer-term. Again, feel free to reach out. Happy to run some scenarios for clients who may be able to diversify in that aspect. Now going back to the sustainability question, because I really want to address that key topic. We know that sustainability has been at the forefront of BMO's mission when it comes to promoting a thriving economy, a sustainable future, and an inclusive society.
BMO announced a recent acquisition of Radicle, which is the leader in environmental services, whether it's carbon credit or advisory services, very excited about this new solution may be able to extend to clients in the future. When it comes to stability and liquidity and the rising environment. Something I really wanted to share is, at least from my point of view, I think sustainability has shifted from sustaining the business to now fully including ESG or investment policy as part of their board, as part of the business mandate. Obviously, we've seen some demand on the financing side through sustainability-linked loan, whereby clients get a bit of a rebate on their loan for meeting some KPI links to ESG.
We see some appetite on the investment side with green bonds, which has been in the market for quite a bit. We are now seeing more and more appetite on the treasury side and liquidity side. There are solutions that are being developed that we have developed at BMO, sustainability-linked deposits where in the rising rate environment, clients cannot benefit from additional return for meeting their ESG KPI. If as part of your recent policy or as far as your board mandate raise systemic metrics that your business need to hit, just be mindful that there's also value on the cash side on the deposit side for hitting those metrics.
Historically, we've really focused on greenhouse gas emission but the [unintelligible 00:48:15] could be very diverse, could be linked with diversity, inclusion, could be [unintelligible 00:48:20] usage, could be linked to recycling. There's different components that we look at when it comes to ESG and there's value to unlock for hitting those metrics and value you could get translated on your cash investments as well. Really a key solution for us to enable our clients to partner with us in our transition to net zero when it comes to green gas emission or to ESG sustainability in general in the future.
Johanna: Thanks, Ben. That's been a hot topic, and I'm glad that question was asked. Jennifer, back to you. Why isn't the unemployment rate expected to rise further than in the previous recession? I think you started to touch on this topic when you were at the beginning of our conversation today but I think we're looking for a little more depth there.
Jennifer: It all goes back to job vacancies and that's a great question, by the way, we are also asked quite a bit about that. Actually, the New York Fed President was actually talking about this the other day as well. He was saying that the unemployment rate could rise as much as could actually easily hit 5% in the next year. That's actually what we have in our forecast. We've got the unemployment rate going from just over 3.5% now to about 5% by the end of next year. The reason why it's not going up even further, I think is just going back to the whole job vacancy story just like there's so much excess demand for labor and a lot of excess demand.
Before the pandemic, there were about roughly 7 million job openings out there. Now we've got, as I said, 10 million and it's been over 10 million for 16 months in a row, which is almost two job openings for every unemployed American. You expect that when things slow and when businesses start to cut back, that's where they're going to start off is with their openings. Sometimes I use this example, if you're at this company and you've got five people on your payroll and you want to double it up to, or you want to double it up to 10, so you've got five job openings out there to come help us out.
Things start to slow down, orders start to decline a little bit, or just to ease, you start getting some of that backlog of orders out and it's like, "You know what, maybe we don't need 10 people, maybe we just need 7." You take off three openings, or you take three job ads off the roster and you're left with only two openings. You're not cutting back on your existing workforce, but you're just cutting back on people that you think that you want or that you don't really want, but you don't need them right now. That's going to be sort of buffering the demand for labor, the supply of labor as well.
That's probably what we believe is going to keep the job right from rising too quickly. That's still a big 1.5 percentage point increase.
Johanna: Thanks, Jennifer. I think we have time for one more question and I'll direct this question to Ben. What advantages are there to offsetting service charges by leaving higher balances in the operating or checking account versus taking higher earnings in an interest-bearing account, considering tax implications, budgeting, fee structure, et cetera?
Ben: Great question and I realized I went quickly over that concept when I presented the slide earlier on the different products and how we could play between ECR and interest-bearing accounts when it comes to the US side of solutions. One thing I'll say first is I'm not a tax expert, so I will defer the tax implication question to whoever is an expert on that topic. One thing I'll mention is obviously there's a natural inclination to really privilege offsetting fees. What we've seen is clients re-promoting, placing funds in that ECR and earnings credit bucket to waive all their cash management and treasury and payment-rated services fee.
That's part of some of our corporate treasury mandate is really to manage that cost structure that they have. It's really a big inclination to place funds in that product naturally. Obviously, when you look at the interest, you could receive on your accounts, you probably might be able to extend a higher interest income on that end, but it's really a balancing that every corporate server needs to consider based on their personal mandate, personal KPI or at the end of the day, the value they can extract across both products.
Johanna: Great. Thanks, Ben. Thanks, Jennifer. With that, I think we'd like to close out today's session and I would like to thank Jennifer and Ben for their insightful comments and our audience of financial professionals for joining us. From my point of view, I'd like our audience to think about these takeaways, the importance of following the news and staying informed. Stay close to your liquidity advisor, making sure your company liquidity policy is updated and developing scenario planning and preparation for, what if. Soon after this session, you'll receive an email containing a survey seeking feedback from today's session, a link to today's liquidity recording, and a link to submit for CTP credit. Thank you so much for joining us. Chat soon.
[00:53:57] [END OF AUDIO]
Nearly every major economy hit the brakes in 2022. Over the past five decades, monetary policy has never tilted so overwhelmingly toward rate increases as it has this year. The Federal Reserve and the Bank of Canada have raised interest rates six times this year, citing persistent inflation. We expect this trend to continue into early 2023.
How you manage your liquidity during this time is vital. For many businesses, rising interest rates and interest market volatility are making it more difficult to maximize liquidity, minimize operational risk, achieve optimal returns and secure palatable borrowing costs.
To help put things into perspective, Johanna Skoog, Managing Director, Head of U.S. Treasury and Payments Solutions, BMO Capital Markets recently moderated a discussion with two experts who provided their insights on the economy and liquidity management:
- Jennifer Lee, BMO Capital Markets Senior Economist, is known for her analysis on the U.S. economy, as well as on financial markets and economic activity in Europe and Japan.
- Benjamin Lambert, Managing Director and Head of Liquidity Solutions, BMO Capital Markets, has deep expertise in partnering with clients to deliver liquidity solutions across their working capital reserves and strategic cash.
Following is a summary of their conversation.
North American economy: good news, bad news
Lee began with a bit of good news. After four consecutive rate hikes of 75 basis points, central banks are no longer using the term “front loading”—that is, implementing a series of large rate hikes over a fairly short period. In this case, 3 percentage points in just over six months. She quickly noted, however, that we’re not done with rates hikes and that rates will remain elevated for some time.
"In the U.S. we're probably going to be living with a fed funds rate in the range of 4.75% to 5% for about a year or so,” Lee said. “The reason behind that is because the U.S. economy, even after 375 basis points of rate hikes, remains very, very resilient.”
Along with stronger-than-expected third-quarter U.S. GDP results and gains in consumer spending, the continued tight labor market has made this a mild recession so far. According to the October Job Openings and Labor Turnover Survey, there are nearly two job openings for almost every unemployed worker. Canada, meanwhile, reached a record of nearly 1 million job vacancies in the second quarter of 2022. "Until that lets up, we will probably continue to see pressure on wages,” Lee said. “And that, in turn, would need upward pressure on inflation.”
Lee said that BMO expects U.S. real GDP to grow at an annual rate of 1.9% in 2022. She added that BMO has raised its forecast for Canada’s GDP growth rate to 3.5% from 3.3%. BMO expects both countries to experience a downturn in the first half of 2023 followed by a modest recovery in the second half, resulting in net zero growth. Both the U.S. and Canada should rebound to about 1.5% growth in 2024, Lee said.
What does all this mean for North American central banks? BMO expects the Fed to raise rates an additional 100 bps over the next three meetings—50 bps in December and another 25 bps in both February and March—which will result in a fed funds rate in the 4.75% to 5% range. As for the Bank of Canada, Lee said BMO expects two more rate hikes by January totaling 75 bps.
“Remember that a slower pace of rate hikes does not mean cutting,” Lee said. “This means 50 bps instead of 75, or 25 instead of 50. But if you get weaker economic growth, if you get weaker job growth and less spending, that will help with the decision to slow [rate hikes] down a bit. That's what makes this whole situation so unique: bad news is good, good news is bad, and unfortunately that's the way of the world these days.”
Return to liquidity management fundamentals
Businesses are trying to make sense of the topsy-turvy conditions that Lee described. It’s led to a lot of caution and uncertainty, as well as what Lambert described as “rate hike fatigue.”
"On the one hand, we have clients analyzing all the economic data, the Fed talking points and juggling between the dovish and hawkish comments that come in day after day,” Lambert said. “On the other hand, we have clients that are still trying to make sense of all this and still don't know what to do with their cash.”
Lambert said this is the time to return to the fundamentals of reviewing liquidity management strategies. “We need to go back to the old practice of analyzing cash flows, where cash flow is coming from and where they need to go.”
That means separating cash into three buckets:
-
Operating cash. Your day-to-day working capital cash with immediate access for payments, payroll, etc.
-
Reserve cash. Funds used for regularly occurring future payments in a one- to six-month timeframe, such as for property taxes, dividend payments, debt repayments and bonuses.
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Strategic cash. Long term cash (beyond six months) that is seldom used. These are the funds set aside for major events such as acquisitions or large capital expenditures.
During the previous low interest rate environment, companies didn’t need to apply this discipline as much. “Why put cash to work when the rates are close to zero?” Lambert said. “Now that the environment has shifted and there's value to capture, we need to go back to this practice and reallocate cash across the different buckets to identify which class could be put to work, and which cash needs to stay overnight to keep the daily liquidity funding.”
Lambert also pointed out the importance of being flexible enough to adjust your investment policy when necessary. “The message is to stay nimble, to go after value, and to fit that value against your liquidity needs, your yield appetite and your risk appetite,” he said.
You can listen to the full conversation here:
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