It All Comes Down to Inflation

“And they’re off!!” is the typical way horse-racing announcers start their call of a race. And after the year that was 2022, it perhaps shouldn’t be surprising that investors tried to “shoot out of the gate” in January like a jockey riding Secretariat in the first leg of the Triple Crown. Credit either a weak end to last year, short positioning, FOMO or simply the turning of the calendar and New Year’s resolutions to be more bullish this year, markets began 2023 on some much welcome stronger footing. To be fair, the combination of moderating inflation and resilient economic activity has boosted optimism that the elusive “soft-landing” might be achievable. Coupled with the hopes associated with the expected end of monetary tightening and enthusiasm surrounding the potential for rate cuts in H2, 2023 and the start-of-the-year rally looks explainable. Now if it’s justified and sustainable and not a case of “too much, too soon” remains to be seen. In stark contrast to early last year, 2023 started with the proverbial “rising tide” lifting most asset classes. The S&P 500 Index jumped 6.2% on the month, the Nasdaq Composite popped 10.7%, with the S&P/TSX gaining over 7% Month-over-Month. Generally speaking, it was the best start to the year for North American equity markets since 2019. In our primary market of focus, after yields pushed higher at the end of last year, a strong bid for both government and corporate bonds emerged in January. The Canadian Universe bond market rose 3.1% on the month (Chart 1).

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, since Q3, 2021 positive monthly total returns in the Canadian bond market have been few and far between. Potential catalysts for renewed upward pressure on yields and thus downward pressure on returns still exist, but for now, fixed investors have enjoyed 2023.

In January, the bell-weather UST 10-year yield fell 37 bps from 3.88% to 3.51%, after having tested the 3.35% level mid-month. At its month end level, the yield was 73 bps lower than its late-Oct peak but was still 200 bps higher than where it started 2022. So, the good news on a short-term basis is that yields appear to have put in a peak and have stabilized, the good news on a medium-to-longer term basis is that “income” is back in fixed income compared to the yield environment of the past many years. In Canada, our 10-year GOC yield fell a similar 38 bps in January to 2.91%, leaving it 77 bps lower than its October peak and 148 bps higher than year end 2021. After yielding as much as +35 bps more than its UST 10-year counterpart in July, ‘22, the GOC 10-year yield ended the month at a level 60 bps below the US, strongly outperforming the US market in H2, ‘22.

Over the month and 1-year, Canadian Federal bonds returned 2.48% and -4.87%, respectively, while the overall Universe Bond Index returned 3.09% and -5.75%, respectively. Corporate bonds outperformed their government counterparts in January, returning 2.98% on the month, and -4.37% over the past year. With their longer average term-to-maturity, Provincial bonds rose the most on the month, gaining 3.81%. The sector continues to be the worst performing sector over the past year (-7.50%).

Rates Markets

The roller-coaster ride that the benchmark UST 10-year yield has been on since mid-’22 continued in January (Chart 2). After a year-end selloff pushed the yield back up to ~3.9%, it rallied almost all the way back to 3.3% by mid-January. It closed the month well off its lows. Remarkably, it was only early-August that the yield tested the 2.5% threshold after a strong 6-week rally. In dramatic reversal, by mid-October it tested the 4.35% level intraday, capping a sharp move higher, only to test levels ~100 bps lower intra-month in January. While the MOVE volatility index has declined recently from its post-pandemic highs (Chart 3), intraday volatility remains high and overall bond market volatility remains elevated by historical standards.

Domestically, the Canadian benchmark 10-year yield has endured a similar challenging path, at least in terms of ebbs-and-flows, but has enjoyed significantly less pressure than what has been witnessed in the US market over the past 8 months or so. At present, the Government of Canada (GOC) 10-year yield is testing the 3.05% level, while the US market is trading almost 60 bps higher.

With the outlook for policy in Canada and the US having diverged since the Bank of Canada (BOC) surprised markets with its 100-bps rate hike in June, so too have longer-term yields in the two markets. The GOC/UST 10-year yield spread had been trading in a narrow range for the 1st half of 2022 but has since experienced elevated volatility and historical levels of relative performance divergence. In June, ‘22 the spread widened to its highest level of the year (Chart 4), but this proved to be short-lived, with Canada dramatically outperforming since then. This strong relative performance has been driven by weaker domestic employment and inflation data, which has lowered expectations for the path of policy rates here in Canada. At time of writing, policy rates in Canada are expected to remain on hold, while those in the US are expected to rise another 50 bps, potentially more. From an historical perspective, Canada is now looking a little rich but given the higher interest-rate sensitivity in the domestic economy, the Canadian market may stay expensive in the near-term. That said, we have added a US versus Canada position in recent months and will look for opportunities to build our US exposure further.

Chart 2:

Source: Bloomberg

Chart 3:

Source: BofA/ICE; Bloomberg

Monetary Policy Expectations:

Chart 4

Source: Bloomberg

At the end of last year, Chairman Powell’s “focus on the destination, not so much to journey” message with respect to monetary policy pushed expectations for the US terminal rate toward the Fed’s guidance of ~5%. The messaging also pushed it slightly further out and flattened the curve (i.e., higher for longer). At their meeting in early-February, the Federal Reserve continued to slow the pace of tightening, raise rates by 25 bps versus 50 bps in December, but continued to stress that “the job is not yet done” and that further rate increases (note plural) would still be necessary. The “destination” or terminal rate guidance remained unchanged at somewhere just north of 5%. They also made the point that if the economic data evolves as they currently forecast, that the terminal rate will remain in place through 2023, once again pushing back on market expectations of rate cuts in the 2nd half of the year. While the statement that accompanied the rate decision was consistent with recent meetings, the Chairman’s press conference brought with it a few more fireworks. He dismissed concerns over the recent easing of financial conditions and highlighted that the process of disinflation had begun. While steadfast in his belief that the labour market is extremely tight, he expressed seemingly greater confidence (or perhaps hope is a better word) that their inflation targets can be met without a meaningful economic downturn, aka a “soft-landing”. Market participants had been expecting the Chairman to deliver a much more hawkish message, something more akin to his Jackson Hole speech, and were surprised by his dovishness. This resulted in a sharp rally in yields and risk assets. The bullishness however, did not last long. An extraordinarily strong US labour market report just two days later brought the central bank’s perceived dovishness sharply into question, pushing policy expectations and bond yields higher and risk assets lower (Table 1). At present, the Fed Funds rate is expected to peak at ~5.2% in July 2023, falling to 4.85% by year end and 4.65% in January ‘24. As the table shows, the policy expectations curve has shifted up and to the right since the Non-Farm Payroll print. The Fed remains sharply focused on the battle with inflation, likely willing to risk weaker economic growth in order to avoid inflation becoming “entrenched”. That said, their acknowledgement that they still believe that inflation can be forced back to target without a recession as a necessary condition, does leave open the potential for rate cuts sooner than current Fed guidance.

Source: Bloomberg

They are closely watching inflation expectations, employment, and wages as they gauge the risks that pricing pressures will fail to moderate as they are forecasting. With many leading indicators of inflation rolling over and the aggressive policy response thus far expected to temper demand, there is reason for optimism that the moderation to date in inflation can continue. The Fed has constantly stressed that they were willing to err on the side of caution with more aggressive policy responses than risk “entrenched” inflation, even if that results in a sustained period of weaker labour markets and economic growth. So it was seen as a notable softening in tone when the Chairman mentioned (i) the onset of the “disinflationary process” 11 times during his post-rate decision press conference; (ii) the ongoing belief that target inflation can be reached without a contraction in activity; (iii) the view that financial conditions had tightened considerably, despite measures to contrary; and (iv) that the main driver of the divergence between the market’s expectations for policy and Fed guidance was differing views on the future path of inflation – leaving open to interpretation whether the Fed might be willing to adjust policy more quickly than their guidance would imply if inflation moderates faster than they anticipate.

So as it has been for the past year, it’s all about inflation! On the bullish side, shorter-term measures of inflation are tracking inline or only slightly above the Fed’s target; housing costs (largest component of core inflation) are expected to continue to fall (Chart 5); goods prices disinflation has begun; and year-over-year comparisons will get easier in H1, ’23. On the bearish side, demand and supply remain out of balance in the US labour market (Chart 6); wages remain elevated as a result; service sector prices (outside of housing) remain high; and the reopening in China and the resiliency of activity globally. My bias is that in the absence of a contraction in activity and deterioration in the labour market, i.e soft-landing, the market’s expectation of a quick decline back to target for inflation is unlikely. However, even a relatively mild recession and increase in the unemployment rate (currently at its lowest level since 1969) could put the target in reach well before the Fed’s forecast of YE ’24.

Chart 5:

Source: Zillow; Bloomberg

Chart 6:

Source: Bloomberg

Chairman Powell has often expressed the view that the risks of doing too little on the tightening front, are greater than doing too much. He has spoken of the lessons learned from the Volker-era of the late-1970’s/early 1980’s where policy rates were eased too quickly, necessitating a painful course reversion to combat a resurgence in inflation – clearly a scenario the central bank would not want to repeat. That said, another interesting shift in focus during the recent Q & A with the Chairman, was that he did not reference those concerns or historical lessons, but rather remarked that the Fed did not intend to keep policy rates restrictive for any longer than necessary. In fairness, he did stress that the FOMC would still take policy rates into “sufficiently restrictive” territory and leave them there until they felt confident that inflation would return to target. So just what is considered “sufficiently restrictive”? While no definitive level of a “neutral” nominal policy rate has been communicated, most analysts believe it to be in the 2.5-3% range. By that calculus, policy rates are certainly now “restrictive”, however the question still remains what the Fed considers “sufficiently” and how long they feel rates need to remain at those levels.

One way to try and calibrate their potential reaction function is to look at the Fed’s Summary of Economic Projections (SEP) and what their forecasts imply for expected “real” policy rates and compare those to market expectations. Based on December’s SEP, at YE23 the Fed forecasts the Fed Funds rate to be 5.1% and Core PCE to be 3.5%, resulting in an expected YE23 “real” FF rate of 1.6%. Thus, based on the Fed’s own forecast, we could infer that a YE23 “real” FF rate of 1.6% would be considered by the central bank as “sufficiently restrictive” – again just our own personal inference. In comparison, the market’s inflation expectation, as measured by 1-yr inflation swaps, is currently ~2.6%. Using the same YE23 FF expectation (5.1%) that gives us a market-based expectation for the YE23 “real” FF rate of ~2.6% (Chart 7). As the Chairman pointed out and we highlighted earlier, the difference in the Fed’s and the market’s expectations for the nominal YE23 FF rate is driven by different inflation expectations. With the current FF rate at ~4.6% and market-based 1-yr inflation expectations, we get a “real” FF rate based on forward-looing inflation of ~2.1%. Comparing this to the Fed YE23 “real” FF projection of 1.6% and we would argue that on a “real” basis, the currently FF rate is in “sufficiently restrictive” territory. If inflation evolves as the market currently expects, the YE23 “real” FF rate would be almost 100 bps above what the Fed’s SEP would imply (2.6% versus 1.6%). In that scenario, would the Fed consider their nominal FF guidance of 5.125% “overly restrictive”, perhaps prompting them to reduce the policy rate but still leave it in “sufficiently restrictive” territory? That would seem to be the argument being put forth by the market in expecting rate cuts before YE23. To state the obvious yet again, it all comes down to inflation!

Chart 7:

Source: Federal Reserve; Bloomberg

Rates positioning: (i) neutral duration; (ii) neutral yield curve exposures; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada but reducing that position on opportunity

Credit Markets

As we highlighted in our commentaries last year, the primary drivers of credit market performance in 2022 were the macro forces of inflation, monetary policy, and their combined upward pressure on yields. While bottom-up credit fundamentals have remained firm, the economic backdrop and rates volatility created a challenging environment for risk premiums. Chart 8 shows the relationship between volatility in the rates market, as measured by the MOVE index and the US IG credit spread. The adverse effects that the turbulence in yields had on credit valuations last year is clear, but also the benefit credit markets have enjoyed more recently from a moderation in rate market volatility.

Chart 8:

Source: BofA/ICE; Bloomberg

Thankfully rates volatility has eased of late, providing a respite to spreads. What has also been lending support to credit markets recently has been investor optimism that central banks are getting closer to end of this tightening cycle. The Bank of Canada has now paused their rate hikes. The Fed has slowed the pace of tightened, and while they have signaled that some additional rate hikes are warranted, they are clearly within sight of their terminal rate guidance. It is perhaps not surprising given the sharp selloff experienced last year, that credit investors are quick to buy into this policy bright spot – if there will soon be no Fed to “fight” perhaps less-challenging times are ahead! The market wants to rally and is perhaps looking at most potential catalyst through rose-coloured glasses, but with the majority of the monetary tightening is behind us; inflation in most developed markets already moderating, while labour markets remain buoyant and consumer balance sheets healthy, perhaps the sky won’t fall as far as had been expected. We believe that both macroeconomic and credit fundamentals will remain constructive over the next 1-2 quarters, with overall economic activity and earnings still well supported.

In addition to resilient macro and credit fundamentals, supply and demand technical factors have been to primary driver of the better credit market performance of the past few months. Simply put, demand has been very strong to start the year. Factors including short investor positioning, bearish fatigue from last year, New Year optimism, less bearishness from central banks, high cash holdings to be put to work, asset allocation shifts in fixed income – all of which have contributed to a notable improvement in investors sentiment and credit risk appetite. In contrast, the supply side of the equation has underwhelmed both demand and expectations. While picking up pace somewhat recently, the supply calendar has been lighter than most market participants had expected. There was very little supply to end last year and many thought that the reopening of the markets post-holidays would bring with it a raft of pent-up issuance. That has not yet been the case. Further, there appears to be increasing concern that the overall level of supply this year will be lower than the market’s needs, fueling heightened FOMO concerns and increasing demand from the credit investor-base. So based on the fundamental and technical backdrop, there are reasons to believe that the market could enjoy its recently found firmer footing over the near-term.

The medium-term outlook, however, still appears to warrant caution. Inflation is still running almost 4x higher than central bank targets. Central banks have been clear on their focus and commitment to bringing prices down. Therefore, while the pace of rate hikes will inevitably slow, there is still more tightening to come, and rates will likely remain higher for longer. Not to mention the lagged impacts of the most aggressive tightening cycle since the early-1980’s. This creates greater uncertainly associated with the removal of policy stimulus that will result in greater volatility in risk premiums this year. In short, tail risks have risen. Looking into next year, growth is expected to moderate, perhaps sharply – leading indicators such as global PMIs and housing have already rolled over, yield curves have flattened significantly, and margins and earnings are starting to face greater headwinds. One of the drivers of the better risk sentiment we have seen recently has been the better-than-expected Q2 & Q3 earnings seasons. Investors have been buoyed by the fact that revenues and margins on aggregate held-in stronger than many feared. The problem however, in my view, is that top-line growth was supported by companies’ exercising pricing power in a strongly inflationary environment. It will be much more difficult to repeat those price increases going forward, thus putting downward pressure on revenue and earnings growth going forward. The challenges that tighter monetary policy presents for growth will undoubtedly create headwinds to earnings and profit margins and likely upside pressure on risk premiums. Therefore, the overall fundamental environment for credit will likely suffer from both weaker macroeconomic growth and weaker income and balance sheet metrics. In absence of any improvement in forward-looking macro fundamentals, we continue to exercise caution.

Credit spreads have rallied to kick off 2023 in concert with broader risk sentiment, continuing the rally that began in late-Oct in the US market, with the Canadian market following along in November. For perspective, recall that the average investment-grade corporate yield spread over government bonds in the US started 2022 at ~95 bps. These risk premiums traded close to 170 bps in early July, tightened to test 140 bps in early August, before widened again to again testing that 170 level in October. Since that point, US credit spread have rallied significantly. At present, the Bloomberg US IG Corporate index spread is ~115 bps, a level not seen since early 2022. Similarly, the average Canadian IG credit spread started last year at ~110 bps, peaked at ~180 bps in late-October, and has rallied to ~140 presently (Chart 9). As Chart 9 shows, Canadian IG spreads have lagged their US counterparts as result of outperformance by the underlying Government of Canada yields, relatively heavier supply last year in the domestic market, and the traditional market dynamics that sees US spreads lead Canadian spreads in both directions.

Chart 9:

Source: Bloomberg

While we believe that the combination of constructive credit fundamentals and strong investor demand will keep spreads supportive in the 1st half of the year, current valuation levels could present a challenge later in the year. As we have pointed out in the past, spreads at or slightly above 150 bps have proven to be attractive risk/return entry points in non-recessionary periods (Chart 10) but that during recessions, spreads have moved materially wider than that key level. Credit spreads in both markets are now clearly tighter than what would be reasonably expected if we see a meaningful slowdown in economic activity and thus further spread compression is likely limited. We have added to our net credit exposures in recent months and believe credit will continue to outperform in the short-term, however we remain concerned over the weakening macro fundamentals as we move later into the year. Should we gain higher conviction that the economy will avoid recession, we will look to further add credit. Conversely, should we get more concerned over the potential for a policy-induced economic contraction, we would look to reduce risk in the portfolio. At present, we would argue that valuations are not consistent with a recessionary scenario.

Chart 10:

Source: ICE/BofA; Bloomberg

Canadian investment grade corporate bonds jumped ~2.6% in January, outperforming government bonds by ~60 bps. Over the past year, Canadian corporate bonds have declined ~5.5%, trailing government bonds by only ~7 bps – a massive recover in relative performance over the past 3-months (Chart 11). US IG corporates returned -3.9% on the month, outperforming UST by ~1.1%. Over the past year, US IG corporates have declined ~9.3%, outperforming government bonds by ~0.5% - again, a huge relative return recovery from the underperformance experience for most of 2022.

Chart 11:

Source: ICE/BofA; Bloomberg

Credit positioning: (i) overweight credit; (ii) maintain a quality bias in favour of IG over HY, and more defensive credits within IG; (iii) overweight Cdn corporates, underweight US.