Since the start of 2022, growing inflation and rising interest rates have contributed to a marked increase in market volatility. […]
Fixed income markets globally are experiencing one of their worst years in decades. As of June 30, 2022, the FTSE Canada Universe Bond Index is down -12.23% so far this year, which marks the worst-performing year for the Canadian Fixed Income market in more than four decades. Investors are surprised by the depth of the drawdown and are asking what’s in store for the future. There isn’t a single definitive answer, but here are three points we think investors should pay heed to:
1) Central banks are focused on preventing inflation expectations from becoming unmoored, while the bond market has pivoted to focus on growth concerns.
Inflation is running very high today and developed markets’ central banks are worried about the risk of long-run inflation expectations becoming disanchored. To mitigate this risk, the Bank of Canada (the Bank), like the Fed, has signalled the need to act aggressively to cool demand and, in turn, dampen inflationary pressures. While it’s not clear if inflation has peaked, the Canadian bond market has, more recently, shifted its focus on the forward-looking data and sees the potential of a recession next year. As a result, bond yields have pulled back by about 30 bps from their highs in mid-June.
2) While the outlook remains cloudy, the pattern of the Bank remaining hawkish while the market looks forward should persist
The Bank and Fed are looking in the rear-view mirror in setting policy, since consumers will react to the monthly releases to anchor their inflation expectations. The Bank is trying to navigate a soft landing – a better demand/supply equilibrium without much collateral damage to the overall economy – and signs of a slowdown should prompt the Bank to be less aggressive to prevent a significant deterioration in the labour market. At the same time, the market knows the Bank cannot raise rates significantly without inducing a further slowdown and, possibly, a recession. As a result, we see two prominent features for the Canadian bond market if the economic data gives conflicting signals:
1.The persistence of a flat yield curve and potential for an inversion. The curve (the difference between the 10yr and 2yr yields) is already relatively flat (a sign of a growth slowdown), but would invert if the market expects the Bank to tighten well above the nominal neutral rate (the rate at which the economy is operating at close to its potential).
2.A benign phase for the bond market near-term that oscillates within a relatively narrow range. The bond market should continue to give more weight to the evidence of demand destruction and growth slowdown, such as falling PMIs (Purchasing Managers’ Index, which measures the prevailing direction of economic trends in the manufacturing and service sectors) or a collapse in hard and soft commodities, cushioning yield backups in response to inflationary data.
3) Market expects inflation to subside – good news
Market breakeven rates are used as an inflation expectation proxy, and they have declined a lot recently. In fact, they account for the bulk of the yield decline since mid-June. Our interpretation is that the market now believes the Bank’s aggressive hikes will be sufficiently pre-emptive and have the desired effect on inflation. Lower long-term inflation expectations is welcome news by the Bank and, if the trend continues or stabilizes around the 2% level, should lead to a slower pace of rate hikes. This would be a more constructive environment for bond returns going forward.
While there has been a material capital depreciation in the first six months of the year, investors now have the potential to reinvest income at higher yields, which may assist in insulating against further capital value volatility across the fixed income market. The yield of 3.92% that investors are receiving now from the Canadian Fixed Income universe is the highest it has been since the global financial crisis back in 2008-09. We believe the utility of core bonds remains high and, at current levels, continues to offer an attractive entry point.
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