A Strong Q4 For Fixed Income

After facing a challenging environment in late-summer and early-fall, fixed income markets "flipped a switch" early in Q4 2023 and rode a wave of monetary policy optimism right into year end. This quick shift in sentiment fueled the strongest quarter of returns in decades and turned what had looked like the first 3-year losing streak in bond market history, into a strong year of total returns across the fixed income landscape. The broad Canadian bond market returned a remarkable 8.3% in Q4! This managed to pull the market out of the “hole” it had dug itself over the first nine-months of the year to finish 2023 with a total return of 6.7%. Similarly, the aggregate US bond market rallied 6.6% in the last quarter to post a 5.4% return on the year. Therefore, it is perhaps not surprising to see fixed income investor enthusiasm wane slightly to start the new year after such an impressive, historical even, year end rally. Risk assets in contrast continued to push higher, with many of the major indices at or near record levels. The S&P 500 rose ~1.7% on the month, reaching a new record high on February 2nd. Similarly, the Nasdaq composite was rose ~1.0% in January and is approaching its November peak, while the Dow Jones Industrial Average gained 1.3% Month over Month (MoM), moving back into record territory. The S&P/TSX lagged its US counterparts, rising ~0.5% on the month. In our primary market of focus, the Canadian Universe bond market fell 1.4% on the month (Chart 1), cutting its 3-month gain to a still stellar 6.4%.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, while the year end rally was sizable, the past year or so as been up and down. The rolling 6-month return for the Canadian bond universe was a respectable 3.9% (Chart 2) but over the last year, the return has been a more muted 2.1%. That said, investors continuing to benefit from historically attractive yield levels.

Chart 2:

Source: FTSE/Russell; Bloomberg

Over the month, 3-month and 1-year, Canadian Federal bonds returned -1.3%, +5.3% and +1.1%, respectively, while the overall Universe Bond Index returned -1.4%, +6.4% and +2.1%, respectively. Corporate bonds outperformed their government counterparts in January, returning -0.7% on the month, and returns of +6.5% over 3-months and 4.5% over the past year have far outpaced government debt. Provincial bonds fell 2.1% on the month and have returned +7.9% over 3-months and +1.3% over the past year.

Rates Markets

Investors views on the two key narratives driving North American fixed income markets over the past 2 years appeared to change materially in Q4. “Persistent inflation” and “higher-for-longer policy rates” quickly shifted to “moderating inflation” and “material rate cuts” as the notable market themes for 2024. Both changes in views were given considerable support by much more dovish messaging from the Federal Reserve, particularly at their December meeting. The dovish pivot from the US central bank included expectations that inflation is on track to return to their 2% target and projections for rate cuts starting this year. The start of the new year brought with it a somewhat less dovish US central bank – or perhaps more accurately, a less dovish than markets were expecting. During the press conference following the Federal Reserve’s January 31^st meeting Chairman Powell stated explicitly that he did not feel that a March rate cut was likely. At the time, the market had the probability at 50% after having priced in a 100% in late December. At the time of writing, investors are discounting an ~20% chance there is a cut in March, with the likely starting point for this rate cut cycle to start in either May or June. Further, the market is expecting 5 rate cuts in 2024 versus the Fed’s guidance of 3. The bell weather US Treasuries 10-year yield peaked at 4.99% on Oct 19th. At the time, the market was expected the US policy rate to be ~4.75% at the end of 2024. On Dec. 31^st, those expectations had shifted 100 bps lower, with the market looking for a YE24 US policy rate of ~3.75%. At present, the market is looking for ~4.1%. These shifts in policy expectations have been a key driver in longer-term US Treasury yields (UST). The UST 10-year finished last year at ~3.88%, more than 100 bps lower than its Oct peak, ended January at 3.91% (Table 2) and is currently trading near 4.15%. Given this still optimistic rate cute outlook priced into markets, we have reduced our interest-rate risk. However, we will likely look to use any backup in yields to add duration given the shift in central bank thinking and a still cloudy forecast for growth. As highlighted, North American yields experience an historical “bust/boom” cycle in late-2023 (Chart 3).

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield peaked in October at ~4.25%, ended last year at 3.1%, finished January at 3.3% and is currently trading at ~3.5%. Thus, the Canadian market has underperformed the US market across the yield curve in early 2024.

Chart 3:

Source: Bloomberg

As Tables 2 & 3 shows, the front-end of the yield curve, both in Canada and in the US, continued to outperform longer-date maturities in January. This caused the shape of the yield curve to steepen or normalize after having been extremely inverted over the past year and a half. However, curve remain negatively sloped and still at levels that would be outside of the normal historical range (Chart 4). Given central banks are nearing the start of a new easing cycles and where curve levels are in an historical context, we believe the next big move in the yield curve will be to steeper levels. Thus, we have taken profit on our curve flattening position and returned the neutral. We will now look for opportunities to position for a steeper curve.

While the two North American rates markets are highly correlated, the two markets have traded leadership on a number of occasions over the past year. To start the year, the US market has shone brighter. The GOC/UST 10-year yield spread is currently near -0.7% (Chart 5). This is off its recent low of -0.85%, but still quite wide by historical standards. Therefore, we believe the Canadian market looks expensive and have added long UST/short GOC exposures in the portfolios.

Chart 4:

Source: Bloomberg

Chart 5:

Source: Bloomberg

The gap between market rates and policy rates is still very negative however, and thus the scope for yields to decline meaningfully appears somewhat limited, at least in the near-term. That said, with inflation expected to continue to moderate and central bank nearing the start of their easing cycles, upward pressure on yields also appears limited. Thus, in the near-term, we look for bond yields to remain range-bound (3.75%-4.25% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and the evolution of core inflation. We had reduced our duration position following the strong Q4 rally and are comfortable with less interest-rate risk at present.

Rates positioning: (i) short duration; (ii) yield curve neutral; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRBs; (v) overweight USTs.

Credit Markets

Investment-grade corporate bond risk premiums have continued to tighten and are now near their narrowest levels in 2-years. The average yield spread in the Canadian IG market ended October at 155 bps, finished last year at 134 bps and are currently trading at ~127 bps. In the US market, the IG spread saw a recent peak in October of ~130 bps, ended 2023 at 99 bps and is currently trading near 95 bps (Table 4; Chart 6).

Therefore, thanks to their higher yields and lower risk premiums, IG corporate bonds have outperformed government bonds over the past year. On a MoM basis, Canadian and US IG corporate bonds outperformed their Federal counterparts by 34 bps and 42 bps, respectively. Over the past year, Canadian and US IG corporate bonds have generated excess returns of 346 bps and 380 bps, respectively. These are strong relative returns in a difficult and uncertain macro environment.

Chart 6:

Source: Bloomberg

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. Despite a very strong January US non-farm payroll print, the labour market has shown some tentative signs of slowing. The 3-month average has declined to under over 300,000 from 430,000 a year ago, and the unemployment rate has risen slightly from 3.5% to 3.7%. A better balance in the labour market has been cited by the Federal Reserve as a key driver of continued moderation in wages and inflation, thus solid but not red-hot employment data is welcome to both rates and credit markets. A similar dynamic has unfolded in the Canada labour market, with the unemployment rate rising to 5.8% from 4.9% and the 3-month average for job creation slowing to 14,000 from a local peak of 82,000. Overall, the labour story is still one of “moderation” rather than “contraction” in both Canada and the US.

US GDP expanded at 3.3% a.r. in Q4 and is forecasts to growth 1.5% and 1.7% in 2024 and 2025, respectively. After GDP in Canada contracted 1.1% a.r. in Q3, it rebounded into positive territory in Q4 (0.5%). Growth is forecast to expand 0.5% and 1.7% in 2024 and 2025, respectively. Overall, while economic activity is expected to slow further, and could ultimately contract, a severe downturn is not our base case scenario.

In addition to resilient macro and credit fundamentals, supply and demand technical factors have been a primary driver of the better credit market performance over the year. Simply put, demand has been very strong. Factors including short investor positioning, less headwinds from central banks, high cash holdings to be put to work, asset allocation shifts in fixed income – all of which have contributed to strong demand despite all the handwringing regarding risk assets and negative headlines on the economy. On the supply side of the equation, the start of 2024 was expected to be very heavy. And corporate issuers have delivered with record issuance in January. But counterintuitive as it may seem, greater supply has begot greater demand. Investors that had sold in anticipation of supply have been joined by those that were underweight and those with cash to invest in chasing both the new issue and secondary markets, push spreads tighter. The “pain trade” to start the year has clearly been for tighter spreads and based on the fundamental and technical backdrop, there are reasons to believe that the market could remain firm in the first half of the year. Thus, after having reduced our overweight credit positioning slightly in Q4, we have added back corporate exposure to start 2024.

The medium-term outlook, however, still appears to warrant close attention. Core inflation is still running almost twice the central bank targets. Central banks have been clear on their focus and commitment to bringing prices down. Therefore, while the next policy moves will be to lower rates, the expectations for the timing of those cuts appears aggressive at present. In addition, the lagged impacts of the most aggressive tightening cycle since the early-1980’s creates significant macroeconomic uncertainly and potential headwinds to risk premiums later this year. Therefore, while we believe the overall fundamental environment for credit will likely remain constructive, we continue to exercise prudence via a higher quality bias in our corporate bond holdings.

While we believe that the combination of constructive credit fundamentals and strong investor demand will keep spreads supported in the near-term, current valuation levels could present a challenge over the next year or so. As we have pointed out in the past, spreads at or slightly above 150 bps in the US and 175 bps in Canada have proven to be attractive risk/return entry points in non-recessionary periods (Chart 7) but that during recessions, spreads can move wider than that key level. Credit spreads in both markets are now tighter than what would be reasonably expected if we see a meaningful slowdown in economic activity and thus further spread compression is likely limited. While constructive on credit near-term, we remain concerned over the weakening macro fundamentals as we move through the year. That said, tight valuations are not normally a catalyst, in and of themselves, to wider spreads, so we remain positive on credit for the time being.

Chart 7:

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.