Welcome to NoMore Risk Better, a Credit Sites Podcast. Across the global strategy team, we aim to make sense of the macro and the micro, highlighting opportunities and the risks facing the fixed income markets. As the macro makes headlines, we leverage our network of experts across fixed solutions to better understand economic trends, rates, gyrations, geopolitical events, and how these factors impact corporates. At Credit Sites, we understand that credit investing comes down to picking winners to generate alpha and avoiding losers.
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I'm your host, Zach Riffis, head of US investment grade and macro strategy at Credit Sites. And I have a very special guest here with me today to discuss his expectations for the path of US interest rates, including other key themes in the US dollar rates market. Today, I will be chatting with Blake Winston. He is an executive director and US dollar rates options trader at Wells Fargo, where I used to work for five years in my last night, at least.
Blake has been on the rates desk at Wells since 2013, initially starting in sales, but has now been trading US dollar options for more than a decade. Blake, thank you so much for coming on NoMore Risk Better. Thanks for having me, Zach. Before we get into what's going on in the markets and your views on positioning and where we go from here, why don't you give us a brief overview of what products you primarily trade and who the key players are.
Yeah, sure. So like you said, I've been on the dollar options desk for about 10 years now. Right now, I'm responsible for the vanilla dollar options market making books. So that's swappions, both long dated and short dated caps and floors, Bermuda options, listed options on SoFern, Treasury Futures, a couple other variants in there, but those are kind of my main roles on the options side.
I also do a little bit for our synthetic funding portfolio as well. So with that, my role usually involves finding ways to net down balance sheet, deploy extra sheet if we have it. It's a little less of a day to day market making part of that, but some of the management of it. So those are my current hats.
So the space I typically break our clients down into is really the simplest end users and then speculators. So the end users in my space are corporations, banks, insurance companies, small businesses who use my products to hedge some form of interest rate risk. So for corporates or if you're a middle market bar or somebody like that, usually you're hedging loan payments or bond issuance or some other type of funding exposure. Banks and insurance companies usually are hedging using option products to hedge something in their portfolio that has a negative convexity or a positive convexity to it.
So on the negative convexity side, that's usually mortgages, variable annuity products, deposit sensitivities, things like that. The speculators are going to be your money managers, your hedge funds, and they're using our products to take a view on what they think is the directions. The direction of a particular rate will be or two rates relative to one another. So the strategies can be systematic macro-directional relative value.
They can be cross-market across currencies. And there's clearly some kind of overlap and gray area between the two sides, but that's sort of how I think about things. Great, thanks, Blake. That's helpful framing up the discussion, thinking about the key players, thinking about the different pools that they have, whether it be on the hedging side in terms of the specifics or on the speculating side.
And it's a great time to have you on the show as interest rate volatility has certainly picked up fairly dramatically following Liberation Day. I think there are a lot of narratives going on in the market, whether it is foreign selling of US treasuries and other US dollar assets or an unwind of the basis trade. The other big one I think that's in the rates market is swap spread tightening amid broad-based expectations for spread widening due to SLR reform. So we could probably spend several podcasts on each of these topics.
But maybe what I'd like to do is get your perspective on all of these and maybe breaking out sort of what the narrative is out there versus what the reality of the flows and positioning you're seeing and how you think about some of these things, ultimately what they mean for the direction of rates both short and long going forward. Yeah, sure. So I think one thing to start with is really what the difference is between kind of the basis trade that you hear about and then the swap spread trade that has gotten a little bit more attention, particularly post-Glibberation Day. So the basis trade that most people are talking about is it's typically held by hedge funds money managers who own cheap off-the-run treasuries that have rolled down the curve against being short treasury futures traded on the exchange.
So the investor is going to take advantage of the liquidity premium of the future versus some cheapness in the bond. And some of this is kind of developed as money managers have become more and more reliant on using futures to extend out their duration. But the benefit for the investor is going to be the hedge funder whoever it is. It's going to be Kerry plus some other features embedded in the future contracts.
So over time holding this basis has been relatively high sharp, so relatively good performance versus the day-to-day volatility it adds largely due to some kind of forced convergence between the derivatives side of the trade and the cash side of the trade. So the concern that's often raised with these is because it's a lower volatility spread, the holders of the long-positioned basis, the long cash, short futures tend to be very highly levered. So one stat, for example, just to kind of give a sense of this is in the CME's Ultra Bond contract, the largest eight short positions in the contract are make up 80, I think it's somewhere between 80 and 85% of the open interest. So that works out to be something in the neighborhood of 125 billion notional with eight people being responsible for those positions.
So the positions can be very highly concentrated, very highly levered. They're reliant on strong liquidity and funding availability in the treasury market. Historically, when the market enters periods of stress, like in 2020 or maybe to a much lesser extent during SBB, investors tend to liquidate cash holdings. When they start doing this dealer balance sheets fill up really quickly, basis positions usually suffer, even though they're ultimately somewhat forced to converge because it's a physical delivery contract.
That's kind of the anxiety people tend to have around it is just the overall resilience of the holders of these positions. So ultimately, I think over the last few weeks, we really haven't seen that much stress. There's been a few days where you had a little bit of a down take, you saw some lightning up on positions, but the repo market hasn't really had too much stress. I don't think dealer capacities have been overly strained in basis type positions.
Really, we haven't seen too much of an issue from these at least up until now. And when I say that the top eight holders, it's not like these are small mom and pops, these are, they're going to be more resilient than your average investor. So thus far, the basis trade itself has not been too much of an issue. The swaps rate is a bit of a different story.
It's similar in that it's a cash treasury versus a derivative, but in this case, it's treasuries versus interest rate swaps. So the investor is going to buy the cash treasuries, pay fix on interest rate swap versus receiving floating. So the fixed coupon of the bond and the fixed leg of the swap somewhat offset, and then the so for floating leg of the swap and the repo funding of the treasury leg somewhat hedge each other. There's certainly noise in between, we can do another podcast getting into the technicalities of so for versus general collateral repo.
But when you're talking about 90 basis points, 95 basis points in 30 year treasuries, maybe that's a little bit less important. So the trade this year has really been based on an assumption that the administration is going to prioritize bank reform, one of which is the supplementary leverage ratio that was implemented as part of Basel 3. And it poses some limitations on how much leverage, basically how much leverage treasury positions bank portfolios can hold. So the idea was that if that gets some relief, bank portfolios would have capacity to buy more treasuries against swaps.
Banks typically have very short dated liabilities versus longer dated assets. So they have to use swaps to match up their assets and liabilities. And it would create a greater demand for treasury products on asset swap. There's been a few problems with this trade so far.
So unlike the basis trade, there isn't really so much of a theoretical lower bound on the price of swaps spreads. So this is going to make all of the credit folks listening to this irritated. But we tend to talk about treasuries and swaps from the opposite direction of how you would want to think about it. So treasury yields in 30s, for example, are 90 basis points higher than 30 year swap rates.
So but we talk about them in negatives because back in the day before so far when there was some credit sensitivity due to LIBOR for a good portion of their history swaps rates traded positive, which would mean the swap rate was higher. But anyway, like I said, there's a few problems with the trade so far. There isn't so much of a theoretical lower bound. It's really based on supply and demand.
So as treasury supply either increases or doesn't look like it's going to decrease. And on top of that, corporate issuance is fairly high. And meanwhile, there's concerns around foreign demand, be it China, Europe, the typical sovereign holders of treasuries. The general supply of treasuries becomes too much to bear and you can easily grow the imbalance.
And then the second issue is as market volatility increases, speculators typically need to reduce risk because they're far constrained. They're not cash constrained like an unlevered investor would be. So you can end up with circular effects where the more swaps rates move, the more difficult they become to hold for a lever investor. So those have been the issues so far.
Another issue I would throw out there is there's a lot of people I think in the market who maybe don't even realize they're as exposed to swap spreads as they are. If you run a loan portfolio, you run a mortgage portfolio, typically those instruments are priced against treasuries, but they're very frequently hedged against interest rates swaps, be it for hedge accounting reasons, for something like that. And you can find that the market has a little bit more sensitivity to spreads than one would think. I just thought there for Zach to jump in.
Thanks, Mike. That was really helpful for me going through and thinking about all of the factors that play. So my key takeaway to the extent of narrative out there right now, looking at the financial press is basis trade unwinds have pushed cash treasury yields higher or cheaper. It seems like your argument would be, has it been an unwinding of positions in swap spreads or has it just been an outright cheapening of treasuries versus swaps making that spread more negative?
When you think about what has driven spreads even more negative, and again, you made this very clear, but basically interest rate swaps, the received fixed portion that rate is much lower than treasuries. So one way to think about that is there's more demand to receive fixed in swaps than there is to buy treasuries, or at least there's less of a supply demand in balance. So when you think about the big move higher in treasury yields that we saw recently post liberation day, what would you characterize as the biggest driver of that move? Yeah, sure.
So I think there's a few points there. So one, I would definitely think of it as much more of a swap spread move or just a treasury holdings move than a basis move. It's really the concerns ultimately lie around demand for long-dated treasury products. That can be for a variety of reasons.
So if I don't think it's controversial to say there's a lot of concerns around stagflation, if you are expecting lower growth in the short term, and therefore easier monetary policy, you run the risk of higher inflation over the long term, which ultimately devalues long-dated fixed income assets. So you tend to get a lot of these moves that are just rotation where two your treasuries may drop and yield, and 10 or 30 your treasuries may rise and yield at the same time like they are today. So I think it's much more about trying to reduce positions in treasury holdings than kind of the more technical basis trade. I think whether you're selling futures or you're selling cash treasuries, you're trying to reduce your treasury holdings just due to a degree of uncertainty there, regardless of whether it's in derivative or cash form.
And then I think on top of that, there has been some duration reduction. I mean, I think anecdotally we've heard selling out of foreign accounts. I haven't personally seen it, but I think whether the selling is really there or it's just an anticipation of reduced demand, there's certainly concerns about it. And we had a few really strong auctions.
I think that certainly helped the market some, but I think there's some skepticism as to whether that can really persist. Thanks, Blake. That's a really helpful perspective. And I think the foreign selling, and maybe it doesn't even need to be selling, but reduced marginal demand going forward is enough to move the market.
And I think we're seeing that. So it's easy to conflate a lot of these moving pieces that can be related and somewhat unrelated, at least in terms of the key drivers. But when I think about what our clients and listeners are probably most interested in, it comes down to what does this mean for rates going forward from the perspective of if I hold a portfolio of bonds and I'm a total return focus investor, if treasury yields are going higher, particularly at the one end of the curve, that's going to hurt the return of my portfolio. So you make note that today we're seeing yields moving in opposite directions at different parts of the curve.
And we're recording this on April 21st. When you think about what you see priced in to the market now in terms of expectations for rate costs, I think there's probably about 95 basis points priced this year. How do you think about that? And one of the ways that you can see the variety of positioning or variety of expectations in the market is through swappions that you trade at the very front end.
Is anyone pricing in a material possibility of a hike this year from your perspective? Yeah, sure. So right now there's definitely a skew towards pricing for cuts and slower growth, the Fed needing to intervene. I think like you said right now, we're somewhere in the 75 to 100 basis points of cuts range.
I don't think of it so much as I tend to not worry as much about pinning what's going to happen exactly at each meeting and whether they go one meeting earlier, one meeting later. To me, the much bigger concern is that you're looking for is do they do 200 dips and do they do 300 dips, the kind of degree of magnitude that you're looking for. So I think that's what you really see the front end of the curve pricing is you have a lot more room to fall to the downside and rates than you do to the upside. It hasn't been, there's historical precedent for 300 basis points over a weekend or being a bit hyperbolic.
But during COVID, for example, I think it took two cuts to get us down to zero. And that's what people tend to remember, especially between the financial crisis and COVID events like that. So what you're really seeing is kind of the probability of either lots of cuts or nothing is how I think of it. I think it would be really, really strange to see an outcome with 50 bits of cuts or 25 bits of cuts.
You get some a little bit of relief for borrowers, but I don't know that that's going to really move the needle a ton on the economy when you're talking about tariffs in the north 100% range. So I think to me, the more interesting part of the conversation I think is that in the same sentence you and I are talking about an options distribution that can price some probability of hiking and some much larger probability of cutting in the next six to eight months. And I think if you were going to price out the kind of binary probability of a hike this year, you end up by December with somewhere in the five to seven percent range. Obviously just from looking at the curve a cut is quite a bit more likely.
But just the sheer degree of unknown is pretty staggering in the front end. And you have a Fed, a political environment, an economic environment that are really conducive to, not conducive to kind of a smaller tighter distribution. Thanks Blake. I think before we go to the next question, thinking about that five to seven percent range in terms of the probability of a hike priced in, how does that compare to let's say pre-election?
Well, off the top of my head I think pre-election it was a fair bit higher. I think we were, I can't quote it to be off the top of my head, but maybe it was a 10 to 20%, something like that. I think you can, you know, you can't price an option at zero, so you can always find a probability for something. But certainly the degree of optimism over, you know, height cuts, to me it's really a question of does the hike come first or does the cut come first?
And I really struggle to see how the hike can come first. And you know, I think as GDP forecasts reduce for this year, as you start to see a little bit of stress in some of the economic data we're getting, that path seems more and more difficult to me. So I think that, you know, it's, you kind of have to go through the mechanics of how do you come about a cut? You know, what does that pressure look like?
And obviously, you know, we're recording this on Monday. The story over the weekend was kind of questioning the Fed's independence and, or what the path of the Fed's independence looks like. And so I think right now the, there will certainly be pressure to cut. You know, I think the Fed is in a really tricky spot with, you know, wanting to wait and see confirmed that inflation is coming their way before they can really act.
You know, I'm not sure whether they're going to get that to answer not, but I guess we'll see. Yeah, it's a big question. I think the Fed independence question is a big one seems to be the growing course. It's pretty wild to me.
I've read some reports that indicate President Trump is aware of the possibility that the Fed's that firing Fed Chair Powell could cause another very intense market reaction. And he's cognizant of that, but he continues to talk about it a lot, which it's one of those binary outcomes where it's either a zero or one and trying to probability wait something like that can be very frustrating. I feel like that's something that you deal with in your role quite a bit. When you think about how are your clients thinking about that?
Are they discussing it? Do they choose to focus on it? When we get asked this question, my thought process is you probably see an extremely powerful steepening of the curve with front and rates coming down as you have effectively a politicized Fed Chair that's going to take rates down to try and boost the economy. Because at the long end, you have to deal with rising inflation expectations and the re-pricing of US treasuries in terms of having a central and independent central bank backing them.
What are the client conversations you're having right now and how do you think about that situation and trying to price it out in the options market? Yeah, I think as a whole, I've really been surprised by the variety of opinions. I've definitely been in the camp that I kind of tend to start with the path of the short rate will be. And then does that include a policy mistake of some kind?
I tend to be biased towards the Fed will need to cut or will choose to cut depending who's making decisions. And it will likely be interpreted as a policy mistake, which will probably ultimately lead to higher rates in the long end. I think on top of that, part of what the price action we're seeing today is if you do, like you said, you move that Fed independence or let's say a risk factor to Fed independence, you expect a steeper curve because if you don't keep those functions independent, the administrations tend to be more likely to follow their kind of follow their whim or what kind of suits their agenda, which generally most presidents are seeking a stronger opinion. They're economy in the four to eight years they're in office.
A nice short term fix and boosting things can be lower rates. So I think the market naturally prices a steeper for that as you up the eventuality of that. But back to your original question. In the client conversation, I've had in the last week, let's say, I've had everything from, I actually think they can need to hike sooner rather than later to how could they not be cutting and really everything in between.
And I think that's the volatility you're seeing is really either a lack of conviction or kind of hesitancy that's causing people to kind of flip in and out of positions. I think what you would want from institutional investors is a more certainty and we're just not seeing that. And most of them have solved it by reducing risk by increasing long-fall positions. And what we're really dealing with here is a pretty major change to the broader global financial framework.
I mean, it's not an environment that's conducive to short volatility and kind of longer-term being more than a weak, aggressive views. I think most people are trying to be nimble. I heard one person say it's a traders environment, not an investor's environment, which is, it doesn't feel great when you're talking about the largest equity market and the largest bond market in the world. I think that's a great point about it being a traders environment and a little bit more difficult perhaps for longer-term investors, which certainly is the preponderance of our clients.
And I'm sure listeners that aren't necessarily credit sites direct clients. And so I think it creates a lot of tactical opportunity and that's not some people's mandate. And so the uncertainty and the volatility just makes them jittery. It doesn't create possibilities.
And if you think about bringing in economic growth, it makes business leaders more wary and consumers more wary about bigger purchases. And you have an elevated interest rate environment for that. I think the big risk to our call and for listeners that need a reminder, we have slower than potential growth, the 10-year yield finishing year at 475 and the Fed on hold. So to your point, Blake, either a lot of cuts this year or none, we're in the none camp.
And so we have a much higher yield environment and flatter curve this year. And I think the biggest pushback we get on that is, so we're focused on the sticky inflation side of things and we think that's going to set policy. And if the market represses to our view, that's going to push rates higher and the curve flatter the thing that I'm coming around to or starting to question is, is the uncertainty of trade policy the first transmission mechanism to markets and economy, the change in the price level or potential sustained inflationary impact that we're expecting, that's actually the second order instead of first order. And then finally, both of those things lead to slower growth.
And I think you are seeing that price into the market. So when you hear our call for 475 on the 10-year, but the two-year yield also moving a lot higher on our more hawkish Fed call, how does that fit with the view that you formed in your seat seeing the flows that you do and talking to the clients that you do? Yeah, sure. So I think it's an impact there.
So I'll go back to where you were saying, I think clients are kind of holding on making larger purchases, larger decisions, not unlike the rest of what we would call the real economy, or manufacturers or anybody who has to make some broader decision. The end user category that I alluded to earlier in the podcast has been very, very quiet. And I think the degree of uncertainty has kind of frozen them in their tracks. And typically, I think most of them are just kind of waiting to see, for some degree of certainty before making a decision that's not going to be a decision.
So I think putting on a hedge can ultimately be just as expensive a decision as choosing not to hedge if kind of the rest of your peers are not doing the same thing. So I think there's a lot of dragging feet to see what other people's peers are doing before acting. To the sticky inflation call, I think it very well could be. My concern all along has been, once you start to get really, really bad growth, and that starts to flow through unemployment, I think that the Fed's historical reaction function is pretty clear.
And I think it will, I obviously can't tell this in the future, but I think it would be easy for the Fed to pivot and say, okay, unemployment spiking, growth dropping, this typically leads to lower inflation, which is not unreasonable. I mean, lower spending power, lower less employment, I can see that. I think that's something they could sell. And the reaction function will be to cut.
And I don't think S&P going below 5,000 or some kind of equity trigger triggers this Fed put or Trump put or any of the puts that we've hoped for in the last over the course of my career. But I think once you start to see some form of defaults, whether it's kind of in middle market or corporate or high yield space or even in credit cards and somewhere, once if you start to get something that breaks and then you start to see unemployment spike, I think at that point it becomes very hard for a Fed to not enact monetary policy of some kind. And to me, that's the biggest risk to your, to your, your end call of no cuts. I think barring that, you're probably right.
I think, and that's where I go back to, you know, it's almost a digital outcome to me. I think the 50-bit cut, the 75-bit cut is really tricky. I think you're much more likely to either get nothing or a lot. So, you know, as, as somebody who trades options, like I can, I can bet on both.
I can't really bet on one half way in between. So I, I don't necessarily disagree with you. I think, you know, I think that position is defensible. And I think, you know, I've told this point, like, how has it been very adamant that they have signed, they want to be patient, see, see more progress on inflation.
But you do have this pretty, pretty large, exogenous risk that to, to growth to unemployment, things like that. All right. So you think that the 475 on the tenure is plausible, but it might come alongside more substantial cuts. So when I think about what historically has really caused the Fed to ease aggressively, there's crises like the COVID pandemic or the GFC, those are hopefully relatively unique in the long term of history, certainly in the past and going forward.
But really it comes down to, to a big flowing economic growth. And when you think about how the curve, at least first react to that, it's, it's a bull flattener with people piling into the safety of longer term treasury. So when you think about the idea of the Fed cutting aggressively, but the 10 year staying high or even rising from where it is today, what do you think the key driver of that deviation from what I would consider to be historical norms would be? Yeah.
So I think the, the real issue is we've, we're in an environment where we're really questioning the safety of longer term treasuries. And, you know, what is a haven asset right now? Is it any point on the treasury curve? Is it bills?
Is it a different currency? It's certainly gold so far. You know, maybe it's yen, something in, I don't want to go off in the crypto space, but, but, you know, digital assets are something that you have to consider, although they, they, I think you have to think of those as kind of some percentage gold like commodity and some percentage of NASDAQ like, you know, levered equity position. The real issue, I think is the safety of long term treasuries.
And if we start to question kind of the, the fabric of that framework that we've built over over, you know, I guess, I guess post war, that would to me would really be the driver. And also, you know, if, if the common belief is that inflation is going to be sticky, regardless of whether we cut and regardless of the path of unemployment and, and, and, you know, all these things we were just talking about, you know, that's how you pretty easily stay in a 475% range, something like that. And I don't have a problem with that call at all. I think I think if we, you know, it's like most things that will be data dependent, I think the impulse will be to will be the long data treasuries are not going to be where you want to be.
If we start, if we, if we somehow get a rapid turn inflation, which seems tough to me with prices being driven higher, very directly, maybe you can, I could see a bull flatten or type move. The other thing that, you know, can, I think we will get blips of bull flattening the, you know, a steepening trade. If you, if you are the type of investor where you can, you know, you can either underweight the long end or you can be short the long end versus long, shorter data treasuries does carry negatively. And if the positioning gets crowded, if people start to look at their carry and, and you know, we're not moving much at all, but you can get kind of flushes into a flatter curve.
But I think the, I generally think that this, you know, the steepening is the right move. The entry point is tough. It's, it's, you know, you're certainly, we're at the steeps and, and you're, you know, it's not an easy trade to put on at this level and looking at the carry and roll down things. But I think that you really have to think of the two parts of two ends of the curve, let's say shorter than sevens and longer than sevens as really separate instruments and not sort of interchangeable like they, they have been in the past.
All right, like I have one last question for you that kind of fits into some of our prior discussion, but to me thinking about treasury supply in the second half of this year, it does seem like maybe at the last refunding of this year, maybe in early twenty twenty six, they're going to have to boost coupon auctions unless treasury secretary bussain wants to do exactly what he accused the yelling treasury of doing, which is relying more heavily on bills than perhaps the ultimate funding need and the recommendations of the treasury department. And so, I think that's a very important thing to say about the treasury supply, but I think that's a very important thing to say about the treasury supply. And so, I think that the, the treasury secretary of borrowing advisory committee would suggest, are you worried about treasury supply and all becoming a bigger driver of yields in the curve more broadly? And if so, what point on the curve, what would you say is potentially the most at risk?
I think if the choices between continuing to issue bills and issuing ten year notes or thirty year notes at rates higher than his predecessors, I think he will pretty quickly go back on his on his word on some of these things and wait for a better opportunity. You know, if he's patient, I suppose there's a chance that you do get some drag lower in inflation and you do ultimately get longer points on the curve to lower rate levels. But yeah, the short answer is I am concerned about treasury supply because if he, I believe if they get the opportunity to issue at lower rate levels, the supply will be there. And that is, that he's, you know, doesn't is certainly a markets person and will, I think act as the market kind of informs him.
He's able to. So you, I think you do probably have to be somewhat concerned about that on top of, you know, on top of corporate supply, on top of supply coming out of China, on top of supply coming out of Germany. So if it's not the US or it's not specifically the treasury, you know, I think, I think issuance projections are fairly large. You know, this is a heck of a lot better than I do, but issuance projections in IG are fairly large.
Germany is issuing more than they haven't in, you know, in a very long time. And, and China as well has a lot of debt to issue. So I think supply certainly an issue. I think the 10 year point, you know, maybe seven to 10 year point is where I would probably be most concerned.
You know, I think 30s, 30s are a really tricky place to wager too much in either direction for me because the supply and demand can be very technical. And a lot of the buying there can be non-economic. If you're a, you know, if you're an insurer or you're somebody with long-day liabilities, for example, you have to buy that far out of the curve to lock in your liabilities, the discounting for your liabilities. So I tend to focus a little bit less on that because you can get very technical moves there.
The seven to 10 year point is probably where really the belly of the curve is where I'd be concerned. Blake, we covered a ton. I learned a lot. I really appreciate you coming on the show.
I'm sure our listeners appreciated your perspective. I feel like there's a half dozen key themes going on in, I guess, the US rates market, but every financial market right now. So getting the chance to unpack at least a few of those with you has been very helpful. So thanks for coming on No More Risk Better.
Thanks a lot, Zach. And thank you all for tuning in. We will catch you next time on No More Risk Better. Good luck out there.
Good luck.