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The bond market experienced considerable volatility in June as the market sold off sharply in the first half of the month, then recovered somewhat in the second half. The initial selloff was driven by both the Bank of Canada and the U.S. Federal Reserve continuing to raise interest rates as inflation reached multi-decade highs in both countries. The Bank of Canada raised its overnight rate by 50 basis points for a second consecutive time, bringing it to 1.50%. The Fed surprised the market with a 75 basis-point increase, the first time it has increased rates by that amount since November 1994. In addition, several Fed officials hinted that it was likely to raise rates by a similar amount at its July meeting. The more aggressive stance of the Fed raised concerns that it would lead to a recession, which prompted bond prices to rally and yields to fall over the balance of the month. The FTSE Canada Universe Bond Index returned -2.18% in June.
Canadian economic data released in June showed continued strength. April’s GDP showed year-over-year growth of 5.0% and May’s unemployment rate fell to 5.1%, the lowest level in the history of that statistic. Canadian inflation continued to climb higher, reaching an annual rate of 7.7% in May, the highest level since 1983. This level will keep the Bank of Canada actively raising interest rates in order to return inflation to the Bank’s 2% target.
U.S. economic data released in June also remained strong, as employment increased by 390,000 in May and the unemployment rate held at 3.6%, marginally above the all-time lowest level. U.S. annual inflation rose to 8.6% in May, its highest level in 40 years. Similar to the Bank of Canada, high inflation will keep the Fed aggressively tightening monetary policy going forward.
The yield on 10-year Canada bonds has been higher than the yield on 30-year Canada bonds for most of the last 3 months, however the sharp rise in yields in the first half of June caused this inversion to increase from 5 basis points at the beginning of the month to 22 basis points mid-month before finishing the month at 9 basis points. In addition, the yield between 5-year Canada bonds and 30-year Canada bonds briefly inverted, with 5-year Canada bonds yielding 18 basis points more than 30-year bonds. However, in the subsequent rally, shorter term yields fell more rapidly than longer term yields and 5-year yields finished slightly below 30-year yields. Over the entire month, the Canadian yield curve shifted higher in a near parallel manner with 2 and 30-year yields increasing 33 and 29 basis points, respectively. In contrast, the U.S. yield curve flattened significantly as 2-year Treasury yields rose 39 basis points while 30-year Treasury yields increased only 7 basis points. The sharp rise in shorter term Treasury yields was due to the larger than expected rate increase by the Fed.
Canadian federal bonds returned -1.75% in June, as rising yields caused bond prices to fall. Provincial bonds returned -3.10% as their longer average durations increased the price declines as yields rose. In addition, provincial yield spreads widened by 9 basis points due to the increased recession concerns, and despite significantly better budget balances reported at several provinces. Investment grade corporate bonds returned -1.53%, with corporate yield spreads widening only moderately especially compared to U.S. corporate counterparts. Non-investment grade bonds declined -1.87%, underperforming investment grade credit, due to higher risk securities seeing more volatility during the period. Real Return Bonds declined -3.56%, but outperformed nominal federal bonds on a duration-equivalent basis. The preferred share market returned -5.27%, hurt by equity market volatility and effectively reversing the positive performance generated in May.
The Bank of Canada and the Fed have stated their intensions to return inflation to their respective 2% target levels. Consequently, we believe the Bank of Canada will increase its interest rates by 75 basis points at its July 13th announcement date and the Fed will follow with a similar sized increase on July 27th. Notwithstanding the more aggressive moves by the central banks, inflation may prove stickier than investors currently anticipate, leading to more rate increases than expected. Of note, we believe neither the Bank of Canada nor the Fed will stop tightening monetary conditions if a recession develops but inflation does not fall back towards their 2% targets. The pace and scale of the rate increases may decline, but tighter monetary conditions will continue until inflation is under control. In addition, both central banks have begun Quantitative Tightening (reducing their respective holdings of bonds), which will over time put upward pressure on bond yields. In this environment, we believe that higher bond yields are likely and we are comfortable with lower than benchmark durations to protect the value of assets in the portfolios.
The Government of Canada plans to focus its bond issuance on shorter terms (i.e. 2 years to 5 years). This combined with further monetary tightening by the Bank of Canada in the coming months will likely extend the flattening trend and may eventually result in an inverted yield curve, with shorter term yields trading higher than longer term yields. Therefore, we continue to structure the portfolios to preserve value, with higher cash levels and underweighted holdings of mid-term issues. Although an inverted yield curve is often considered as an indicator of a pending recession, we believe that economic growth in Canada will remain positive for the remainder of this year.
June was a relatively stable month for Canadian corporate credit spreads. While U.S. corporate credit widened dramatically during the month, Canada credit spreads have remained effectively flat during the period. This was likely driven by lower primary corporate new issuance in Canada, a higher relative weighting of high quality financial bonds in the Canadian market and the fact that the Fed hiked 75 basis-points versus the Bank of Canada hiking only 50 basis-points. Despite the Canadian corporate relative outperformance this month, we believe corporate creditworthiness may be at risk as the Bank of Canada tightens monetary conditions to fight inflation. Indeed, it is our belief that North American central banks are willing to accept a recession in order to return inflationary pressures to appropriate policy levels. Currently, credit spreads do not yet appear to be at recessionary levels. If a recession does occur, we would expect corporate yield spreads to widen substantially more. Consequently, we are monitoring creditworthiness closely, and we are being very cautious about adding to current holdings in the portfolios.