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The bond market experienced considerable volatility in November as bond yields across all maturities rose at the beginning of the month then reversed course and declined sharply over the balance of the period. The substantial drop in bond yields coincided with a robust equity market rally as investors reacted to slightly lower than expected inflation data in the United States. If inflation continued to decline, it would allow the central banks to soon stop raising interest rates and potentially begin reducing them again. That would mean less upward pressure on bond yields and less likelihood of a recession. In the bond market, the risk on environment had a large positive impact on corporate bonds which experienced a significant narrowing of their yield spreads. The FTSE Canada Universe Bond Index returned 2.81% in November.
Canadian economic data was generally strong in November. Canadian GDP grew at an annual rate of 2.9% in the third quarter which was much better than expected. However, domestic demand shrank modestly as the impact of higher interest rates and inflation deterred spending. Job creation was robust, particularly for full time positions and as this is being written the unemployment rate was edged lower to 5.1%. Canadian home sales increased, which was the first expansion seen in seven months and the increase in sales was caused by a rise in homes available for sale in the marketplace. Year-over-year inflation held at 6.9%, a level that shows only a 0.1% decline in inflation over the past three months despite the Bank of Canada aggressively hiking rates since March. The Bank of Canada’s next rate decision is on December 7th, when it is expected to raise the overnight rate potentially by 50 basis points to 4.25%. A smaller 25 basis point increase is possible, however, as the Bank has been steadily reducing its increments since it raised rates by 100 basis points in July.
Economic activity in the U.S. remained strong as its GDP grew at a rate of 2.9% which was moderately higher than expected. Job creation was very good, and the unemployment rate held steady at the very low rate of 3.7%. The U.S. inflation rate declined to 7.7% which was still historically high but below market expectations and it showed that U.S. monetary policy may be having the desired effect of reducing inflationary pressures. At the beginning of the month, the Fed made its fourth consecutive 75 basis point increase in interest rates, bringing the Fed Funds rate up to 4.00%. Subsequently, Fed members suggested that they would slow the pace of future increases. When the Fed next meets on December 14th, it is expected to raise the Fed Funds rate by 50 basis points.
During November, the Canadian yield curve inverted more with long term bond yields falling further below short term yields. Yields of 30-year Canada bonds fell 31 basis points in the month, while 2-year yields declined only 2 basis points, resulting in a differential of negative 88 basis points. This is the most inverted the yield curve has been since 1990 when Canada suffered a substantial recession. Indeed, an inverted yield curve has historically been a reliable indicator of slow economic growth and a potential recession. The magnitude of the current inversion suggests the market is anticipating a dramatic slowdown in economic activity in 2023.
In November, the federal bond sector returned 2.04% as yields declined and bond prices rose. The provincial sector returned 3.55%, as the longer average duration resulted in larger price moves as yields fell. Investment grade corporate bonds returned 2.95% benefitting from yield spreads narrowing an average 14 basis points as well as from the overall decline in yields. Non-investment grade bonds earned 1.74%, underperforming investment grade bonds due their shorter maturities. Real Return Bonds returned 2.82%, which was a strong showing, primarily due to Canada’s inflation rate staying elevated. Preferred shares returned -0.65% as they failed to participate in the risk-on sentiment enjoyed in other markets.
It makes sense for the Bank of Canada and the Fed to slow the pace of their rate increases in the coming months. Because the economic impact of higher interest rates takes several months or even a year to be fully felt, the full effect of raising rates by 3.50% to 3.75% since March has not been realised in either economy. However, a slowing of rate increases does not mean that the central banks are soon going to start lowering rates. We therefore believe the recent bond rally was premature.
Economic growth has slowed somewhat, but remains positive, particularly in the United States. Labour markets in both Canada and the United States remain tight, with low unemployment and historically high growth in average hourly earnings. And, crucially, inflation in both countries remains far above the 2% targets. While some factors behind the surge in inflation have improved, others have not. And although inflation may not be as entrenched as in the bad old days of the 1980’s, it has become entrenched. For example, with labour markets tight, employers are being forced to raise wage rates to retain and/or attract staff. Given that wages tend to lag inflation, particularly in negotiated contracts, it is likely that relatively high wage inflation will be present for the next few quarters at a minimum.
And it is critical to remember the Bank of Canada and the Fed are focused on inflation, not economic growth. Until inflation comes down to at least 3%, we think it unlikely that the central banks will want to ease their restrictive monetary policy. With some additional rate increases likely in December and possibly early 2023, we believe the recent large decline in bond yields will be at least partially reversed. As a result, we are keeping portfolio durations defensively shorter than the benchmarks.
For much of the year, we have structured the portfolios in anticipation of short term bond yields rising more rapidly than long term yields. To do that, we reduced the exposure to mid term bonds, and increased the holdings of cash, short term issues and long term bonds. That has proved correct as the yield curve changed from a normal configuration, first flattening and then continuing to invert as the Bank of Canada raised interest rates aggressively. While the yield curve may invert further, we believe that most of the move is complete, so we are beginning to reduce the barbell structure and re-establish more significant holdings of mid term bonds.
The risk of a recession has increased substantially as a result of the interest rate increases this year. The severity and length of a recession are very difficult to predict, but the need for the Bank of Canada to keep interest rates high until it is assured inflation has been brought under control argues against monetary easing until late in 2023, at the earliest. While corporate yield spreads have increased markedly in 2022, they are much narrower than in past recessions. Should a recession begin soon and last through next year, we believe corporate profits will be negatively affected and corporate yield spreads will widen as investors become more cautious. Consequently, we have reduced the weight and duration of the corporate sector of the portfolios, and we are maintaining high quality in our corporate holdings. 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.