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The bond market appeared to be in holding pattern for much of April. Yields fluctuated in a narrow range as investors tried to discern, as they have for several months, when either inflation would fall sustainably back to 2% or the economy would lapse into a serious recession causing the Bank of Canada to loosen its monetary policy. In the end, slightly weaker economic news led to a small decline in benchmark yields. Not all financial markets shared the economic pessimism, though, as equity markets in both Canada and the United States rallied in the month and corporate bond yield spreads narrowed. Clearly, not all investors were worried about a possible recession. The Bloomberg Canada Aggregate index gained 0.97% in April, while the FTSE Canada Universe rose 0.98%.
Canadian economic data received in April was mixed. On the positive side, unemployment held steady at the low rate of 5.0% and job creation remained very good. As well, retail sales fell less than expected in February following an upwardly revised surge in January. On the negative side, late in the month it was revealed that Canadian GDP grew by only 0.1% in February, following the 0.6% expansion in January. In addition, StatsCan’s advance estimate for March showed the economy contracting 0.1%. For the first quarter as a whole, the pace of growth was roughly 2.5% per annum, but there appeared to be little momentum going into the second quarter. As expected, the 12-month increase in CPI fell to 4.3% from 5.2% a month ago as large price increases from early in 2022 fell out of the calculation. However, the monthly increase in March was 0.5% and that followed 0.5% in January and 0.4% in February. So, inflationary pressures still remain.
At its April rate setting meeting, the Bank of Canada left its trendsetting interest rates unchanged. It was subsequently revealed that at that meeting the Governing Council considered raising rates again because inflation was not slowing enough. However, it chose to wait until the next meeting in June to decide on additional rate increases.
The economic data released in the United States was also mixed but, on balance, slightly more bearish than in Canada. Signs of weakness included lower factory production, lower business spending, and a sharp drop in the number of job openings although they remained historically high. GDP growth in the first quarter of the year was well below forecasts, although much of the shortfall was due to a sharp drop in inventories that may be reversed in subsequent quarters. The unemployment rate declined to 3.5% from 3.6% the previous month and job creation, while slower, was still strong. Consumer spending, a major part of the U.S. economy, was up strongly. Fallout from the bank failures in March was scarce, but most banks reported using tighter lending standards in response to the crisis. Another large regional bank, First Republic, failed at the end of the month and was taken over by J.P. Morgan. The annual rate of inflation dropped to 5.0% from 6.0%, however the core measure of inflation edged up to 5.6% from 5.5%. The U.S. Federal Reserve did not meet in April to set interest rates but was widely expected to raise them by 25 basis points on May 3rd.
Internationally, the Reserve Bank of New Zealand and Sweden’s Riksbank both raised their interest rates by 50 basis points in April. Other central banks, including the European Central Bank, the Bank of England, and the Reserve Bank of Australia, are expected to raise their respective rates in May. The Bank of Japan, which had a new governor appointed in April, kept its outlier status by leaving its monetary stimulus and ultra-low interest rates in place. As a result, Japanese investors are being encouraged to look at higher yielding foreign bonds, including those of Canada and the United States.
Canadian bond yields fluctuated around their starting levels for much of the month before a late rally left the yield curve slightly more inverted. Yields of 2-year Canada bonds were unchanged in April, while 30-year bond yields declined 9 basis points. The stickiness of shorter term yields reflected expectations that the Bank of Canada would leave rates at current levels, or higher, for several months. The decline in longer term yields followed the weak advance estimate for Canadian GDP and month end buying by index funds to offset a small increase in the benchmark duration. Interestingly, expectations of slowing growth led to a different reaction in the U.S. bond market. Yields of 2-year Treasury bonds fell 22 basis points, while 30-year yields declined only 2 basis points. Investors believed that the Fed’s expected rate increase in early May would be the last of its tightening cycle and a weak economy would require rate cuts before year end.
The modest decline in yields helped fuel the federal sector return of 0.59%. Provincial bonds earned an average 1.12%, benefitting from the decline in longer term yields and a modest tightening of yield spreads. Investment grade corporate bonds earned 1.36%, as good investor demand coupled with moderate new issue supply resulted in their yield spreads narrowing by 10 basis points. Non-investment grade bonds lagged higher quality corporates in the month, gaining 0.61%. Real Return Bonds earned 0.94%, underperforming nominal bonds of similar duration despite the relatively high monthly inflation rate. Preferred shares, as measured by the S&P/TSX Preferred Share Index, returned 0.27% in April.
The divergent economic outlooks pervading government bonds and equity markets during April extended a trend dating back to the middle of last year. Since last June, bonds and equities have been essentially treading water, waiting to see the outcome of the monetary tightening cycle. One school of thought has held that inflation will quickly fall back to the 2% targets so that the central banks will be able to lower interest rates, easing monetary conditions, before significant economic pain occurs. The so-called soft landing outlook was initially embraced by central bankers who wanted to avoid being blamed for causing a recession. Over time, though, the stickiness of inflation and the resilience of the economy has led central banks and many investors to realise that interest rates will need to stay high for an extended period. That means ventures initially funded when interest rates were much lower will have to cope with much more expensive funding for a longer period. Examples of the financial strain already occurring include the drop in home prices in Canada since the peak in early 2022 and the rising defaults in U.S. commercial real estate.
Weakness in commercial real estate is particularly noticeable in office buildings, with several high profile projects in the United States defaulting. The pandemic-induced move to hybrid work has led to a sharp fall in demand for office space and a resultant jump in vacancy rates. Combined with sharply higher interest rates, the higher vacancies mean rents are no longer covering landlords’ expenses including borrowing costs. As a result, some landlords, including major ones such as Brookfield Office Properties, are choosing to default on uneconomic properties. In the United States, small and medium sized banks provide up to 80% of real estate backed loans, so it’s possible that the weakness in real estate will cause the banking crisis to be extended with additional failures. But it is difficult to anticipate that weakness in commercial real estate will be sufficient to push the U.S. economy into recession.
The resilience of the Canadian and U.S. economies following very substantial interest rate increases has surprised many. Last summer, many economic forecasts called for a slowdown by the end of the year, but economic activity has continued to be positive. Labour markets are historically tight, with very low unemployment and large numbers of unfilled positions. Spending on goods has declined following the pandemic disruptions, but there remains significant pent-up demand for services such as travel. Higher interest rates don’t seem to have diminished consumer demand. In large part, that is because of the massive government transfers during the pandemic that allowed personal savings to build up, and those extra savings are slowing the reaction to higher rates and high inflation. In addition, even interest rate sensitive sectors such as housing appear to be stabilizing. In both Canada and the United States, home prices are no longer falling, and sales have begun picking up. In the United States, as can be seen in the following chart, there has been little discernable impact from the massive increase in interest rates since March 2022.
Slower economic growth may yet result from the rate increases to date, but the key question is whether inflation will also fall, and fall sufficiently and sustainably enough for the Bank of Canada and the Fed to ease monetary policy and begin lowering interest rates. We remain cautious in our outlook for inflation because the experience of the 1980’s suggests that once inflation is embedded it is difficult to eradicate. In addition, fiscal policy in Canada, the United States, and other countries is currently quite expansionary and at odds with monetary policy. As well as large fiscal deficits, policies such as Canada’s to encourage immigration are exacerbating our housing shortage and limiting the potential correction in that sector.
We believe the bond market is somewhat overvalued because economic growth is not slowing as rapidly as is expected and more importantly because inflation has not yet been controlled. As large increases from a year ago fall out of the calculation (prices jumped 1.4% in May 2022 for example), we anticipate that the annual rate of inflation will fall further in the next couple of months, however recent monthly increases remain problematic. In addition, investors lacking the experience of working when central bank previously fought inflation are assuming a quick resolution, which is increasing the volatility of market moves.
With interest rates expected to remain at or above current levels until 2024, we believe the risk of a hard recession is increasing. Accordingly, we are gradually reducing the exposure to corporate bonds because their yield spreads are not properly reflecting their elevated risk levels.