Global bond yields rose, and bond prices declined, in September, as central banks around the world continued to raise interest rates to fight inflationary pressures. The Bank of Canada and the U.S. Federal Reserve were both active in September raising their respective monetary policy rates by 75 basis points each, which brought both of their administrated rates to 3.25%, the highest policy levels since 2008. While bonds sold off in both countries, the Canadian bond market substantially outperformed its U.S. counterpart. The smaller selloff in Canada bonds was driven by a change in consensus to a lower expected terminal rate for the Bank of Canada’s overnight rate versus the U.S. Fed Funds rate. The market is now expecting the Fed Funds rate to reach 4.50% while the Canadian overnight rate is only expected to touch 4.00%. The FTSE Canada Universe Bond Index returned -0.53% in September.

Canadian economic data mostly contracted in September. Employment fell by 39,700, which was the third monthly decline in a row. (We note some concern about the reliability of the recent jobs data because over 70% of the job losses have occurred in the education sector, which seems improbable.) The decline in jobs pushed the unemployment rate up off its all time low of 4.9% to a level of 5.4%. Retail sales contracted 2.5%, as consumers struggled to deal with rapid inflation and higher interest rates. Canadian inflation slowed to 7.0%, down from 7.6%, but was still near a multi-decade high. This level of inflation will keep the Bank of Canada actively tightening monetary conditions. Higher interest rates appear to have subdued the housing market causing monthly home sales to decline 1%. Canadian housing sales have now declined 14.4% below their 10-year average. Year-over-year GDP showed growth at 4.3%, but month-over-month GDP was only 0.1% and suggested slower growth ahead. The Bank of Canada is expected to raise the overnight rate by 50 basis points at their October 26 meeting.

U.S. economic data was generally stronger. U.S. job creation was substantially higher than expected at 315,000, which helped to hold the unemployment rate at 3.7%, just above the all-time low level of 3.5% achieved last month. Retail sales grew above expectations despite inflation declining only moderately to 8.3%. Notwithstanding the strong labour situation, rapid inflation and higher interest rates put pressure on growth. U.S. annualized GDP in the second quarter shrank -0.6% which was the second consecutive negative quarter. A simplistic definition of recession is two consecutive negative quarters of GDP, which the U.S. has now met, although the National Bureau of Economic Research is unlikely to declare an official recession given the tight labour market. When the Fed announced its rate increase in September, it indicated that it expected to raise rates by an additional 1.25% to 1.50% by the end of this year. The Fed also indicated that it is willing to raise rates even if the economy slips into a recession. The Fed’s next meeting is on November 2, when they are expected to raise the Fed Funds rate by 75 basis points.

In September, the federal bond sector returned -0.17% as yields moved higher causing bond prices to decline. The provincial sector returned -0.57%. Provincial bonds suffered from a combination longer average durations and spread widening in longer maturities. The investment grade corporate bond sector earned -0.97% as it suffered from higher yields combined with spreads widening by an average 16 basis points. Non-investment grade bonds earned -1.03%, underperforming investment grade bonds due to concerns about lower creditworthiness as a recession became more likely. Real Return Bonds returned -2.46%, as the decline in Canada’s inflation rate reduced demand for inflation protection. Preferred shares fell 6.88% in the month, hurt by equity market volatility and illiquid market conditions.

The Canadian yield curve inverted further with 2-year Canada bond yields increasing 15 basis points while 30-year yields rose only 6 basis points. In September, the spread between the 2-year and 30-year bond yields reached a level of -82 basis points, which is as inverted the Canada yield curve has been since 1990. In the United States, the yield curve also inverted further as 2-year Treasury yields increased 79 basis points while 30-year yields rose 49 basis points. The much greater increase in U.S. yields than in Canadian ones was somewhat surprising and left most Canadian yields 60 to 70 basis points below comparable U.S. yields. While that scale of differential is not unprecedented, it does suggest Canadian bonds may be somewhat overvalued versus U.S. ones.

With North American central banks raising interest rates by 3.00% so far this year, it is possible that we are beginning to approach their respective terminal rate levels (the highest interest rate in the monetary tightening cycle). As mentioned above, the market is currently pricing a terminal rate for the Bank of Canada of 4.00% and 4.50% for the U.S. Federal Reserve. When North American central banks reach those levels, or even before it, the respective yield curves will likely begin to cease inverting and may even begin to re-steepen. Given the aggressive stance that North American central banks have followed tightening monetary policy, the risk of recession beginning by the end of 2022 or the beginning of 2023 has risen significantly. However, while an inverted yield curve has historically been an indicator of a pending recession, it is important to remember that the Bank of Canada and the Fed are committed to returning inflation back toward their 2% policy levels, regardless of the pace of economic activity.

Over the past year, we have held an overweight allocation to short and long term bonds, versus an underweight allocation in mid term issues. This has benefited the portfolios as the yield curve flattened and eventually inverted. Given that the market is beginning to price in a nearby terminal rate, and given the extreme amount of inversion that has occurred, we are now closely monitoring the yield curve and looking for an opportunity to reduce or neutralize our yield curve positioning.

At the beginning of September, we re-established a short duration position to protect the portfolios from the impact of rising yields. Central banks around the globe are tightening monetary policy to fight inflation. This global tightening is a powerful force and will likely lead to a decline in aggregate demand and a global recession which will eventually result in declining inflationary pressures. We are mindful, however, that monetary policy works with a lag, and so we are comfortable maintaining an underweight duration position until we begin to see inflation fall from its current multi decade high levels.

Since both the Bank of Canada and the U.S. Federal Reserve will continue to hike interest rates into the fourth quarter, the risk of a recession commencing by the end of this year or the beginning of 2023 is high. Corporate credit has been under pressure throughout the year, but we expect to see credit spreads continue to widen and volatility increase should a recession develop. Consequently, we have reduced the corporate sector allocation and duration, and we are maintaining high quality in our corporate holdings in the portfolio. We are also being very conservative in adding new positions and we will be patient about taking advantage of wider credit spreads as they occur in a slowing economy.