The bond market enjoyed its fifth consecutive monthly gain in September as numerous central banks around the world lowered interest rates in efforts to stimulate their respective economies. Of particular note, the U.S. Federal Reserve began reducing rates as U.S. inflation continued to decelerate. The prospect of easier monetary policy in the coming months prompted buying of government bonds that pushed yields lower and buying of corporate bonds that caused yield spreads to narrow. Equity markets also rallied on the prospect of declining interest rates. The Bloomberg Canada Aggregate and FTSE Canada Universe indices earned 1.69% and 1.90%, respectively, in the month.

On September 4th, the Bank of Canada made its third 25 basis point reduction in interest rates since it began easing its fight against inflation. The inflation data released later in the month supported the Bank’s decision as prices declined 0.2% in August and the annual rate fell more than expected to 2.0% from 2.5% the previous month. The unemployment rate also supported the Bank’s decision, as it jumped to 6.6% from 6.4%, with a higher participation rate and surging population growth dominating reasonably strong job creation. Other data gave a more positive impression of the Canadian economy as retail and manufacturing sales were stronger than expected, building permits were up strongly, and capacity utilization was much better than forecasts.

In the United States, there had been considerable speculation about whether the Fed would cut rates by 25 basis points or by 50 basis points at its September meeting. In the end, the committee chose 50 basis points as it emphasized the weakening and downside risks to the employment side of its dual mandate while expecting inflation to continue to moderate. The Fed had its first dissent since 2022 at this meeting as one participant voted for a smaller 25 basis point rate cut. But the Fed’s dot plot, updated in its new Summary of Economic Projections, suggests dissent was much greater. As many as nine of the Fed’s 19 policymakers may have raised objections to some degree, with two participants favoring no more rate reductions this year, and another seven seeing the need for just one 25 basis point cut later this year.

U.S. economic data remained resilient despite the Fed’s concern about the labour market. The unemployment rate declined (prior to the Fed’s decision) to 4.2% from 4.3%, and the second quarter growth in GDP was confirmed at the robust pace of 3.0%. Industrial production grew more rapidly than expected and new claims for unemployment benefits remained low. However, consumer confidence measures fell sharply on concerns about the labour market and the outlook for the economy, and the manufacturing sector appeared to be struggling somewhat.

Internationally, several central banks were active in September. The Bank of China lowered its short term interest rates and reduced banks’ reserve requirements as part of the government of China’s efforts to stimulate its economy. Measures of factory output, consumption and investment in that country all slowed more than economists had forecast, while the jobless rate unexpectedly rose to a six-month high.  The Chinese efforts led to some brief weakness in global bond markets as investors were concerned that faster growth in the world’s second largest economy would lead to increased demand for commodities, such as oil, and thereby increase inflationary pressures. Elsewhere, the European Central Bank, Sweden’s Riksbank, and Swiss National Bank each lowered their respective interest rates by 25 basis points to offset slowing economic growth. The decisions, though, had been anticipated by investors and had little subsequent impact on the bond market.

The Canadian yield curve inversion continued to unwind in September. The yield of 2-year Canada bonds plunged 41 basis points in the month, while 30-year bond yields declined only 13 basis points. As a result, the 2-year yield moved below the 30-year yield for the first time since July 2022. Interestingly, all the declines in bond yields occurred in the first half of the month, before the surprisingly weak CPI data. Yields were flat to slightly higher over the balance of the month. In the United States, the yield curve inversion also dissipated as shorter term bond yields fell more than longer term ones. However, despite the Fed lowering its interest rates by twice as much as the Bank of Canada, the declines in U.S. bond yields were more muted than in Canada. Yields of 2-year Treasuries, for example, dropped 27 basis points, while 30-year yields fell only 6 basis points.

The federal sector of the Canadian bond market earned 1.63% in September as lower yields resulted in higher prices. The provincial sector gained 2.07%, helped by its longer average duration that offset the impact of a small widening in provincial yield spreads. The investment grade corporate sector returned 2.12%, as the prospect of lower interest rates improved investor optimism regarding the economy and stimulated demand for corporate bonds despite robust new issue supply. After nine months, the supply of new corporate bonds has already surpassed the total for all last year. Non-investment grade corporate bonds earned 1.88% in the period, helped by speculation regarding a potential acquisition of Corus Entertainment. Real Return Bonds returned 1.94% despite the sharp drop in Canadian inflation, but RRBs underperformed nominal bonds of similarly long duration. Preferred shares slowed their robust pace of gains so far this year, rising only 0.48% in September.

With both the Bank of Canada and the Fed in the midst of easing their respective interest rates, many bond market participants are considering the potential pace and number of future rate cuts. The Fed’s 50 basis point reduction in September has encouraged some Canadian observers to call for the Bank of Canada to shift to 50 basis point moves from its current 25 basis point pace. We disagree because there has not been a recent deterioration in the Canadian economy that would necessitate greater urgency on the Bank’s part. In addition, the Bank has already lowered rates three times and the full impact of those moves is still working its way through the economy. We also believe the Fed will probably shift to 25 basis point moves, given the resilience of the U.S. economy.

We expect both central banks will lower interest rates at each of their remaining two scheduled announcement dates this year, barring a significant resurgence in inflation. Should inflation pick up, the central banks are likely to only pause their easing cycles, rather than begin raising rates again. We note that Canada’s annual rate of inflation may experience upward pressure over the balance of this year due to base effects. The final four months of 2023 saw prices decline, so unless that happens again the annual rate will rise from its current 2.0% level.

Of greater importance than the pace of interest rate reductions by the Bank of Canada and the Fed, is the levels at which they each stop, otherwise know as the terminal rates. The bond market in each country is anticipating several more rate cuts because bond yields are well below the central banks’ targets. In Canada, the Bank’s overnight target is 4.25% while most federal bonds are yielding 3.00% or less. In the United States, the Fed’s target range is 4.75% to 5.00%, while most Treasuries are yielding between 3.50% and 3.75%. In our opinion, unless the terminal rates are at least 150 basis points lower than the current target rates (and below today’s bond yields), the bond market appears overvalued. Given the rate reductions to date, we are not convinced there will be an additional 150 basis points of rate cuts this cycle. Accordingly, we are cautious about the bond market rallying further and are keeping portfolio durations close to benchmark levels.

We also believe there is room for the yield curve to normalize further, with shorter term bond yields moving further below longer term yields. As a result, we are maintaining the emphasis on mid term issues which should outperform a combination of short and long term bonds. With regard to the sectoral mix, we believe corporate yield spreads are historically tight so we are keeping that sector’s allocation roughly in line with the benchmark, waiting for better opportunities to add corporate holdings. In addition, we have increased the holdings of pension fund bonds because we believe these highly rated issues will continue to outperform provincial bonds.