North American bond markets generated negative returns in both 2021 and 2022. However, Canadian and U.S. bond markets have never had three consecutive years of negative returns, which is likely one reason why investors were bullish on bonds to start 2023. As central banks approached their terminal policy rate levels, investors believed that the economy would slow, and inflation would return to appropriate levels by the end of 2023. Consequently, they believed the next move of monetary policy would be towards lower interest rates and therefore, current elevated bond yields looked attractive.  The Canadian bond market saw all its components rally in January as Canada bond yields declined and agency, provincial and corporate credit spreads tightened. The FTSE Canada Universe Bond Index returned 3.09% in January.

As expected in January, the Bank of Canada raised its overnight rate by 25 basis points, however signalled that it was likely to pause additional rate hikes while it waits to see the full impact on the economy of the monetary tightening it initiated in March 2022. The increase brought the overnight rate to 4.50%, the highest level since December 2007. A pause in rate hikes indicates that the Bank is anticipating that this level of monetary tightness is sufficiently restrictive to slow the economy and return inflation to the official target of 2%, despite the relatively marginal decline in inflation so far. 

Canadian economic data in January showed solid growth. Employment increased substantially by 104,000 new jobs and the previous months jobs number was revised higher by 26,700. The strong job creation helped push the unemployment rate down to 5.0%, just above the all-time low level of 4.9%. The year-over-year increase in GDP was 2.8% which was a small decline from the previous level, but still a solid level of growth.  Retail sales declined during the period but were still better than expected. Canadian inflation declined by 0.5% to 6.3% which still left inflation at a historically elevated level.

U.S. economic performance remained strong. Job growth was again higher than expected at 223,000 which lowered the unemployment rate back to the all-time-low level of 3.5%. U.S. annualized quarter-over-quarter GDP was revised lower, but still registered a solid growth number at 2.9%. Retail sales declined more than expected during the period which was likely driven by high inflation, higher interest rates and the belief of a future economic slowdown. Year-over-year inflation declined more than expected to 6.5%, which marked inflation down 2.6% from its peak of 9.1% in June 2022. While this could be considered appropriate progress toward the 2% target, inflation remained too high. That combined with strong employment numbers, will keep the U.S. Federal Reserve motivated to raise interest rates further. As this is being written, the U.S. Federal Reserve has raised the Fed Funds rate by 25 basis-points at its February 1 meeting. Unlike the Bank of Canada, the Fed is expected to raise rates again at its next meeting in March.

In January, the yields of 2-year and 30-year Canada bond each declined about 30 basis points. The yields of mid term bonds fell even more as investors anticipated interest rates falling and the inverted yield curve normalizing. However, with economic activity remaining strong, central banks are likely feeling frustrated that despite their interest rate increases financial conditions have eased as bond yields declined and risky assets rallied. Ironically, the rally in anticipation of lower interest rates likely means they will need to stay higher for longer as the central banks try to slow their respective economies.

In January, the federal bond sector returned 2.48% as yields declined and bond prices rose. The provincial sector returned 3.81%, with the longer average duration of provincial bonds resulting in larger price increases as yields declined. Investment grade corporate bonds returned 2.98% and corporate credit spreads narrowed 17 basis points on average due to investor demand for risky assets being strong. Non-investment grade bonds earned 2.06%, underperforming investment grade bonds due to their shorter maturities. Real Return Bonds returned 1.72%, underperforming nominal federal bonds. Investors apparently believed inflation would continue to decelerate, reducing the need for RRBs. The preferred share market generated a return of 7.27%, rebounding from its oversold condition at the end of last year.

It is not uncommon to see central banks around the globe cut interest rates or ease monetary policy at the same time. Events like the Financial Crisis (2008-2009) and the recent pandemic saw central banks globally cut interest rates to fight deflationary pressures. However, it is rare to see central banks move together when raising interest rates or tightening monetary policy. But that is exactly what happened as inflationary pressures swept around the global economy in the last two years. Both major and minor central banks were active in tightening monetary policy at the same time. While monetary policy usually works with a lag, it is likely that this combined and powerful global monetary policy tightening will eventually create a substantial contraction in aggregate demand and possibly recessions across the globe that should lead to a reduction in inflationary pressures. The key question is how quickly inflation slows. We are concerned that returning inflation to the desired levels will take longer than the markets are currently assuming. The experience of the last major inflation fight in the 1980s suggests that a period of prolonged economic weakness may be required.

A major concern for Canadian bond investors is whether the Bank of Canada and the Fed have the fortitude to hold current monetary policy levels until inflation returns to their target level of 2%. Currently the market is expecting both the Bank of Canada and the Fed to pivot and begin lowering interest rates when the economy slows later this year. However, we believe the Bank of Canada and the Fed are unlikely to ease monetary policy and lower interest rates until inflation has subsided for several months so as to avoid a resurgence that would require even higher interest rates. 

The persistent inversion of the yield curve supports the view that a recession is likely to occur in Canada. Currently, the only sector showing real weakness is housing, with data released in January showing annual home sales down 39% country wide, the steepest decline since 2009. While inflation has declined from its peak, it remains historically high and far above the 2% target. With unemployment remaining low and the economy continuing to grow, inflation has too far to decline in a relatively short period for the Bank of Canada to begin easing rates in 2023. Also, both the Bank of Canada and the U.S. Federal Reserve are allowing their holdings of federal bonds to run off through maturities. This Quantitative Tightening (QT) will put upward pressure on bond yields as the sizable amounts of maturing bonds are refinanced.

With the bond market rallying strongly in January, we made a short term strategic decision to bring the portfolio durations to neutral with their benchmarks. We are monitoring the market with regard to reducing durations again to shelter portfolio values from the potential impacts of QT and investors realizing interest rates will need to stay higher for longer. Ultimately, a recession will likely cause bond yields to decline, but we do not believe that the timing is right to extend durations yet.

The barbell position that we established by selling mid-term bonds and adding holdings of cash, short term issues and long term bonds has performed very well over the past year as the yield curve first flattened then eventually inverted. With the Bank of Canada appearing to approach its terminal policy rate level with what could be its final rate hike in January, we believe it is unlikely that the differential between short and long term bond yields will invert substantially more. Accordingly, we have begun to reduce our barbell curve position and transition back into mid-term bonds with the expectation of eventual yield curve normalization.

We are mindful that the risk premium for investing in corporate bonds is smaller than what we have seen prior to previous economic slowdowns or recessions. Indeed, corporate credit has performed strongly for the past several months as investors believed North American central banks would be pivoting to easier monetary policy in the near future. We believe that this view is premature, and while we remain moderately overweight corporate bonds, we have reduced the weight and duration of corporate holdings in the portfolios. We are focussing on strong creditworthiness in our corporate holdings given our view that higher rates will eventually slow growth and reduce profit margins. We are being patient about adding new positions so that we can take advantage of wider credit spreads should they occur when the economy slows.