June was an event-filled month that saw bonds initially rally strongly but subsequently give up over half their gains. The Bank of Canada and some other global central banks began easing monetary conditions with interest rate cuts while other central banks, including the U.S. Federal Reserve, chose to leave their rates unchanged. Subsequent to the Bank of Canada’s rate reduction, Canadian inflation surprised to the upside, putting in doubt additional rate cuts. As well in June, there was substantial new supply of corporate bonds that included the largest issue in Canadian history. Political events also impacted the market as snap elections were called in Great Britain and France, and an early presidential debate in the U.S. raised doubts about President Biden’s competency for another term. The Bloomberg Canada Aggregate and FTSE Canada Universe indices earned 1.29% and 1.13%, respectively, in the month.

Following four consecutive months of better than expected inflation news, the Bank of Canada on June 5th lowered its target overnight interest rate from 5.00% to 4.75%. The subsequent CPI release, however, showed a monthly increase in prices of 0.6% that pushed the annual rate to 2.9% versus the month earlier 2.7% rate and the expected 2.6% pace. The worse than expected inflation news means investors will be focussed on the next CPI release on July 16th, which will come eight days before the Bank’s next interest rate announcement. Another negative surprise will likely mean the Bank will not lower its rates. Other economic data received in June tended to be stronger than expected and did not increase the urgency with which the Bank of Canada needed to ease monetary policy. For example, growth in Canadian GDP during April was estimated to be 0.3%, rebounding from weaker growth in February and March. On a year-over-year basis, GDP grew 1.1%, not robust but also not close to a recession. In addition, both retail sales and housing start data in June were better than expected.

As noted above, the Fed chose to leave its interest rates unchanged at its June meeting because it wanted to see more progress on reducing inflation. In addition, several Fed officials spoke during the month, trying to persuade investors that the bond market was anticipating too much easing over the balance of this year. While the market was pricing in as many as three rate cuts by the end of the year, the Fed speakers suggested there would only be one or two, if they cut at all. U.S. economic data was mixed during June, with stronger than expected industrial production offset by weaker retail sales and housing starts. Importantly, the U.S. inflation rate only edged lower to 3.3% from 3.4% the previous month, and until the Fed believes it is sustainably below 3.0%, it is unlikely to cut interest rates. The presidential debate late in the month led to a selloff in Treasuries because Donald Trump’s policies of tax cuts would increase an already massive fiscal deficit and potentially boost inflation.

Internationally, the European Central Bank and the Swiss National Bank both lowered their respective interest rates by 25 basis points. The cut by the ECB was its first this cycle, while the SNB’s move followed a similar reduction in March. In other news, both the British and French governments called snap elections for early July. The French election was a particular surprise, and the potential shift in power to an untried right wing party caused French government bonds (OATs) to significantly underperform other European government issues. The British election was less surprising and British Gilts performed in line with other European Sovereigns. The Bank of Japan remained an outlier among central banks as it continued to consider whether to raise its interest rates while the Yen fell further, hitting its lowest value in 38 years. Another possible strategy, albeit less likely, would be for the Japanese central bank to sell U.S. Treasuries to fund purchases of the Yen.

The Canadian yield curve became less inverted in June as shorter term yields fell more than longer term ones. The initial reaction to the Bank of Canada’s rate cut was a little surprising as 30-year bond yields dropped almost as much as 2-year yields, despite already being substantially lower. However, a selloff late in the month impacted long term bonds more, causing their yields to reverse much of their earlier declines. Over the entire month, 2-year bond yields fell 18 basis points while 30-year bond yields declined 8 basis points. At 4.00% and 3.40%, respectively, bonds of both terms are pricing in substantial future rate reductions by the Bank of Canada. In the United States, the lack of a rate cut by the Fed left 2-year Treasury yields only 5 basis points lower in the month. But longer term Treasury yields fell more than comparable Canada bonds with 5-year and 30-year Treasury yields dropping 18 and 14 basis points, respectively.

The federal sector returned 1.03% in June as lower yields resulted in rising bond prices. The provincial sector earned 1.35%, helped by a longer average duration but hurt by a 2 basis point widening in yield spreads. Investment grade corporate bonds returned only 0.96% in the month, as $21.4 billion of new issues helped push corporate yield spreads wider by an average of 4 basis points. (June’s was the second largest monthly total on record.) Noteworthy among the new issues was a massive $7.15 billion, 11-tranche financing for Coastal GasLink, the largest corporate issue in Canadian history.  Non-investment grade corporate bonds earned only 0.05%, as Corus bonds fell sharply in response to the loss of several Discovery brand channels. Real Return Bonds gained an average 1.60%, helped somewhat by the higher than expected inflation report. Preferred shares were little changed in June as profit taking was offset by large redemptions.

While Bank of Canada Governor Tiff Macklem said following the June rate reduction “it is reasonable to expect further cuts to our policy interest rate”, the disappointing increase in inflation made a follow up cut at the Bank’s July 24th meeting less certain and dependent on whether the CPI release on July 16th shows a reversion to the downward trend in inflation. We are not sufficiently optimistic that inflation has indeed been brought under control, as we note that rent and mortgage service costs, the two factors keeping CPI elevated, are unlikely to slow soon and we wonder if food costs will continue to decline or start to rise again. Until we have greater clarity regarding inflation, we are keeping portfolio durations close to benchmark levels.

In addition, as we have noted in the past, the current yield curve inversion has already anticipated substantial rate cuts by the Bank of Canada. Relative to previous experiences with inverted yield curves, this cycle has built in far more potential rate cuts far earlier. With the Bank’s overnight target at 4.75% and yields of bonds maturing in 5 years and longer at 3.50% or less, there is a risk that the bond market has anticipated too much from the Bank. Accordingly, we are reluctant to extend portfolio durations substantially longer than the respective benchmarks. Indeed, we believe the Bank of Canada will not lower interest rates as much as the market expects. For several years, the Bank estimated the “neutral” interest rate, which is neither stimulative nor restrictive, to be between 2.00% and 3.00%. More recently, though, the Bank indicated that the neutral rate has probably increased. Our view is that the Canadian economy can sustain significantly higher interest rates than prevailed in the 2009 to 2022 period. And if money market yields do not fall below 3.00%, we do not see a lot of value in 30-year bonds currently yielding roughly 3.40%. Instead, we are focussed on identifying the opportunities in maturities in 5 years and less where there is the most potential for the yield curve to normalize (i.e. to eliminate the inversion).