Keep connected
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.
Financial markets, including bonds, reversed course in February. January’s optimism regarding interest rate cuts later this year switched to a realization that rates were likely to stay higher for longer. As a result, bond yields moved sharply higher, and bond and equity prices declined. The shift in investor expectations was fueled by data that showed economic activity was holding up and inflation was not slowing as hoped in spite of the past year’s monetary tightening. The prospect of interest rates remaining relatively high increased the risk of a serious recession, which led to equities retracing some of the gains enjoyed in January, but corporate yield spreads were little changed. The FTSE Canada Universe Bond index returned -1.99% in February.
In Canada, labour market data continued to show considerable strength. Early in the month, job creation of 150,000 new positions was announced, 10 times the expected amount. The unemployment rate held at the low rate of 5.0%, rather than declining, because the participation rate jumped to 65.7% from 65.4% the previous month. The increase in the participation rate left it essentially in line with pre-pandemic levels. The strong labour market encouraged consumers, and retail sales accelerated. The only sector of the economy that struggled was the housing sector, with housing starts and sales of existing homes even weaker than forecasts. Late in the month, it was announced that Canadian GDP growth stalled in the fourth quarter of 2022. The lack of growth was linked to a large drop in inventories following outsized gains the previous two quarters. Other details in the GDP release were more positive, showing household consumption grew at a 2.0% pace, while the savings rate increased from 5% to 6%. As well, the lack of growth in the fourth quarter was offset somewhat by StatsCan’s preliminary estimate that showed growth rebounding in January.
The Bank of Canada did not have a rate setting meeting in February but was likely pleased with a larger than expected drop in year-over-year inflation. Canadian CPI decelerated from 6.3% to 5.9%, although several measures of core inflationary pressures showed much less improvement. Also, the one month increase in prices of 0.5% indicated that inflation was not yet under control. The Bank’s next rate announcement is scheduled for March 8th, and it is widely expected that there will be no change at that time.
In the United States, the labour market was also very strong. The unemployment rate declined to 3.4%, the lowest rate since 1969, while job creation was robust, average hourly earnings rose more than expected, and the number of unfilled job openings jumped higher. The manufacturing sector had some indications of slowing growth, but the much larger services sector appeared to strengthen. As in Canada, the healthy labour market conditions led to a large gain in retail sales. Growth in U.S. GDP during the fourth quarter was estimated at an annual rate of 2.7% despite the large increase in interest rates since last March. Inflation also showed a disappointingly small reaction to the rate hikes, as it edged lower to 6.4% from 6.5% the previous month.
At the beginning of February, the U.S. Federal Reserve met expectations and raised its target range by 25 basis points to 4.50% to 4.75%. Subsequent Fed speakers and strong economic data in the month reinforced expectations that the Fed would need to raise rates two or three more times in order to slow inflation.
The selloff in Canadian and U.S. bonds during February pushed yields of almost all maturities in both countries above the levels at the end of 2022. In Canada, the yields of 2-year and 30-year Canada bonds jumped 45 and 23 basis points respectively, resulting in the yield curve further inverting. The yield of 5-year bonds jumped even more, rising 48 basis points, as expectations of falling rates later this year were unwound. In the United States, the prospect of the Fed increasing interest rates three more times caused bond yields to rise even more than in Canada, especially for shorter maturities. The yield of 2-year Treasuries soared 62 basis points higher in the month, while the 30-year Treasury yield rose 27 basis points.
Higher yields in the month led to bond prices declining, which was only partially offset by interest income. The federal and provincial government sectors returned -1.96% and -2.39%, respectively. Investment grade corporate bonds fared slightly better, returning -1.50% in the period. Non-investment grade bonds earned -0.32% as their higher coupon income offset more of the decline in their prices. Real Return Bonds declined -2.59% in the month, which was better than nominal government bonds with similarly long durations. Preferred shares again outperformed both bonds and equities as they returned -0.96% in February.
The next several months in the bond market will be determined by the path of inflation and whether it falls back close to the 2% target rate. The year-over-year rate of inflation is likely to decline further in the next few months as the very large increases in CPI in early 2022 fall out of the calculations. However, the key question is whether monthly increases going forward will be sufficiently constrained. 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.
Unfortunately, we are not optimistic that inflation can be reined in in the next few months. It is our belief that it has become entrenched and the complexity of the economy makes controlling it using only interest rate increases a very challenging exercise for the Bank of Canada. We anticipate inflation is going to resemble the arcade game of Whack-a-Mole, with price increases popping up in some sectors, then being followed by increases in other sectors as the initial ones recede, perhaps only temporarily. The recent transition from goods inflation to service inflation is an example of the shifting nature of the problem.
We also see a number of factors that should add to the inflationary pressures over the next year. Among these is the reopening of China’s economy with the lifting of its Zero-Covid policy this past December. Already some measures of economic activity in that country, including subway usage and domestic airline flights, have rebounded to above pre-pandemic levels. A resurgence in the world’s second largest economy will result in increased demand for imports that will lead to higher global commodity prices. Another concern is that Canadian fiscal policies are not being coordinated with monetary policy but are instead diluting the fight against inflation. Examples include payments by some provincial governments to taxpayers to offset price increases (particularly for energy), and the federal government’s drive to increase immigration when affordable housing is in very short supply (leading to higher rents). In addition, the Bank of Canada’s decision to pause rate increases while the Fed continues to raise them may result in our exchange rate weakening, which will cause import prices to move higher.
In the near term, we are keeping portfolio durations defensively positioned, shorter than the benchmarks because we believe the market is still coming to grips with interest rates staying higher for longer. Should there be indications that the rate increases over the last year are having wider impact than is currently apparent, we will look at increasing durations again. With regard to the yield curve, the inversion appears to be close to its maximum, so we are planning to reduce the barbell structure of the portfolio. We are mindful, however, that mid term issues have discounted rate cuts coming sooner than is likely, so we are being cautious in shifting back to that term sector. With the risk of a recession elevated, we are reducing corporate exposure particularly with lower quality issuers. If a recession does occur, corporate yield spreads will widen significantly and we will be able to back to the corporate sector allocation at much more attractive levels.