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December is typically a quiet month in the bond market with most of the activity taking place at the beginning of the month and trading becoming very light approaching yearend. This year was no different, although volatility was elevated in the month. The bond market, which had a sharp rally in November as inflation data began to turn lower, reversed direction and sold off in December as investors realized that inflation was still historically high and central banks would continue to raise interest rates. This became clear as several global central banks, including the Bank of Canada and the U.S. Federal Reserve, each raised their trendsetting interest rates by 50 basis points in the month. The FTSE Canada Universe Bond Index returned -1.65% in December.
The Canadian economy exhibited strong performance in December. Employment increased by 10,100 jobs which pushed the unemployment rate down to 5.1%, just above the all time low level of 4.9%. Retail sales rebounded strongly, and year-over-year GDP growth was estimated at 3.1%. While that pace was the slowest since last January, it was still well above the ten-year average. This put the Bank of Canada in an awkward position. With its increase in December, the Bank has raised interest rates by 4.00% since March but the economy has not slowed significantly. In addition, Canadian inflation at 6.8% has slowed only 0.2% in the last four months despite the Bank’s aggressive tightening. The Bank is betting that its interest rate increases to date will slow aggregate demand in 2023 enough to reduce inflationary pressures and eliminate the need for many more rate increases. However, given the strong current performance of the Canadian economy and the minimal downward movement of inflation, the Bank of Canada may be forced to rethink its monetary policy stance and consider additional rate hikes.
The U.S. economy also saw decent growth in December. Job creation was higher than expected and lowered the unemployment rate to 3.7%, just above the all-time-low level of 3.5%. U.S. annualized third quarter GDP growth was 3.2%, which was higher than expected and reflected solid economic growth. Year-over-year CPI inflation declined more than expected to 7.1%, which showed a 1.2% decline in inflation over the past four months. As mentioned above the Fed raised interest rates by 50 basis-points in December bringing its target range to 4.25% to 4.50%. The Fed’s projections were fairly hawkish, as 17 of its 19 participants anticipated that its range would rise above 5.125% in 2023, suggesting further rate increases are likely. In September, none of the Fed committee members had forecast rates to rise above 5.00%.
Internationally, several central banks raised their respective interest rates by 50 basis points including the European Central Bank, the Bank of England, and the Swiss National Bank. The Australian and Norwegian central banks also tightened monetary policy with 25 basis point rate increases. The Bank of Japan continued to be an outlier keeping rates close to zero, however it appeared to be preparing to tighten monetary conditions because it announced that it would allow 10-year government bond yields to rise 25 basis points above the previous limit of 0.25%. Japanese Government Bond yields quickly moved higher, reducing the relative attractiveness of international bonds, including Canadian ones, for Japanese investors.
Notwithstanding the various central bank moves, the most important international economic development was China’s decision in early December to end its zero-Covid policy. That policy, which included widespread draconian lockdowns of some large cities and forced quarantines, had caused the Chinese economy to slow very sharply and recently had led to unusual widespread civil protests. However, the decision to move away from zero-Covid was abrupt and appears to be poorly planned. The Chinese population has low acquired immunity and relatively low vaccination rates, and the surge in infections that has resulted since restrictions were lifted has put significant strain on the country’s insufficient medical facilities.
In December, the federal bond sector returned -1.46% as yields climbed and bond prices fell. The provincial sector returned -2.31%, with the longer average duration of provincial bonds resulting in larger price declines as yields rose. Investment grade corporate bonds returned -1.03%, outperforming government bonds as investor demand resulted in corporate yield spreads tightening about 5 basis points. Non-investment grade bonds earned +0.74%, substantially outperforming investment grade bonds due to their shorter maturities. Real Return Bonds returned -0.62%, doing better than nominal federal bonds due to Canada’s inflation rate remaining sticky and elevated. The preferred share market generated a return of -1.75% as prices were negatively impacted by the volatility in common equity markets and likely tax-loss selling into yearend.
In December, the 2-year Canada bond yield climbed 18 basis-points while the 30-year yield increased by 28 basis points. As a result, while 2-year yields remain higher than longer term yields, the yield curve became less inverted by 10 basis points. The U.S. yield curve experienced a similar reduction in its inversion in the month. With the respective central banks raising rates again in the month and economic activity remaining fairly positive, investors appeared to realise that rates were likely to remain higher for longer and the relative value of longer term issues was therefore diminished.
Canadian bond yields will also be under upward pressure this year as the Bank of Canada continues to allow its holdings of Canada bonds to run off through maturities. In a process referred to as Quantitative Tightening (QT), the Bank reduced its holdings of federal bonds by $56 billion in 2022, and QT is expected to increase to $88.5 billion in 2023. As the bonds mature, the federal government must refinance them by issuing new bonds to buyers other than the Bank of Canada. Accordingly, we are keeping portfolio durations defensively positioned, shorter than benchmarks.
In the summer of 2021, we established a barbell position in the portfolios by selling mid-term bonds and increasing holdings of cash, short term issues and long term bonds. That position has performed well over the past year as the yield curve first flattened then eventually inverted as the Bank of Canada aggressively raised interest rates. While inflation remains unacceptably high and may be slow to fall, we think it unlikely that the differential between short and long term bond yields will increase substantially more. Accordingly, we have begun to reduce our barbell curve position and transition back into mid-term bonds with the expectation of eventual yield curve normalization.
It is difficult to forecast the severity of a pending recession. We are mindful that while credit spreads have widened this year, the risk premiums for investing in corporate bonds are smaller than what we have seen in previous recessions. 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.