You Win Some, You Lose Some

“You win some, you lose some” is an often-used sport-oriented quote that describes quite well the start to the year in financial markets. At the risk of sounding too flippant, the “wins” from an enthusiastic start to the year in January, gave way, at least in part, to much more cautiousness in February. January’s “winning” optimism that the end of the monetary tightening cycle was near, quickly “losing” out to February’s stronger data prints and fears that central banks have even more work to do than had been previously hoped. So where do things stand now? Well, with policy makers “data dependant”, not surprisingly, the data has taken center stage of late, and with the unexpectedly strong numbers to start the year, the release of March’s data prints takes on even greater importance. Whether labour and inflation data confirm the re-acceleration in activity signalled from the January numbers or show that strength to be likely a seasonal blip, will determine the near-term direction of asset prices. Before we tee-up the upcoming economic calendar, here is a brief re-cap of financial market performance through the 1st two months of the year. The S&P 500 gave back ~2.4% in February, leaving its YTD return at 3.7%. The Nasdaq continued to be the class of the field, falling only 1% on the month and up a very solid 9.6% so far this year. Here in Canada, the S&P/TSX fell 2.5% MoM, paring its YTD return to 4.8%. Overall, still solid YTD returns across North American equity markets, but a little “shine” has come off in recent weeks. In our primary market of focus, after a strong bid for both government and corporate bonds out of the gate in January, yields have risen sharply over the past month. As a result, the Canadian Universe bond market fell 2.0% in February (Chart 1) and is up 1.0% on the year.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, since Q3, 2021 there has been a stiff headwind to total returns in the Canadian bond market. That said, with government yields on average near 3.8% and high-quality corporate yields averaging almost 5.2%, the forward-looking environment for fixed income has improved dramatically from where it has been in recent years.

In February, the bell-weather UST 10-year yield rose 41 bps from 3.51% to 3.92%, after having tested the 3.35% level in mid-January. At its month end level, the yield was 4 bps higher than where it started the year and only ~32 bps below its late-Oct peak (Chart 2). That said, the yield is still ~250 bps higher than where it started 2022. So, the bad news on a short-term basis is that yields have moved higher again, the good news on a medium-to-longer term basis is that “income” is back in fixed income and there are attractive opportunities in bond market.

Chart 2:

Source: Bloomberg

In Canada, our 10-year GOC yield rose a similar 41 bps in February to 3.33%, leaving it 35 bps lower than its October peak and 190 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, holding the relative gains it generated versus the US market in H2, ‘22. We continue to look for opportunities to add to our US exposures relative to Canada at these yield spreads.

The repricing of government bond yields has been driven, in large part, by the re-rating of monetary policy expectations. 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 and were surprised by his dovishness. This resulted in a sharp rally in yields and risk assets. The bullish however, did not last long. Starting with an extraordinarily strong US labour market report for January, followed by firmer than expected inflation and retail sales data later in the month, the market began to reprice higher its expectations for the terminal rate and the length of time rates will be kept at those higher levels (Chart 3). The expected terminal rate, which was just below 5% following the Chairman’s press conference in early-Feb, has risen to over 5.5% at the time of writing, while the expected policy rate in early-2024 has risen 120 bps MoM.

Chart 3:

Source: Bloomberg

Over the month, YTD and 1-year, Canadian Federal bonds returned -1.96%, 0.47% and -6.45%, respectively, while the overall Universe Bond Index returned -1.99%, 1.04% and -6.96%, respectively. Corporate bonds outperformed their government counterparts again in February, returning -1.50% on the month, 1.44% YTD and -4.82% over the past year. With their longer average term-to-maturity, Provincial bonds fell the most on the month, losing 2.39%, while still gaining 1.34% YTD. The sector continues to be the worst performing sector over the past year (-8.91%).

As reflected in the relative outperformance of investment-grade corporate bonds over government bonds, credit spreads have continued to narrow in early 2023 – although finished February slightly higher than their tights of the year (Chart 4). The US IG spread ended February at 124 bps, ~9 bps wider MoM, but ~9 bps tighter YTD. This spread peaked in late-Oct at ~165 bps. The Canadian high-quality corporate market has outperformed, finishing February at yield spread of ~145 bps, 5 bps tighter on the month and 17 bps tighter YTD. That said, having peaked at 180 bps, the narrowing of Canadian spreads has lagged the US market overall in the recent months. In September 2022, both Canadian and US IG spreads with ~160 bps, with US spreads now ~20 bps tighter than in Canada.

Chart 4:

Source: Bloomberg

Upcoming Data

As highlighted, with January’s data coming in stronger than expected, particularly US and Canadian job creation, the key economic prints for February (released in March) take on outsized importance in determining the near-term direction of policy and markets. Confirmation of the reacceleration of activity shown in early-year numbers would place continued upward pressure on policy expectations and yields, in turn testing the longevity of the current rally in risk assets. Conversely, a resumption in the moderation in growth and inflation seen at the end of last year would bring into question the validity of January’s data, perhaps signalled that the strength was driven more by statistical quirks related to seasonal adjustments rather than a real pickup in activity and prices. With these binary outcomes in mind, here are some of the key data points to watch in early-March:

Labour Markets

Chart 5: US Non-farm Payrolls

Source: Bloomberg

Chart 6: US Average-hourly Earnings

Source: Bloomberg

Chart 7: Cdn Employment Growth

Source: Bloomberg

Chart 8: Cdn Average-hourly Earnings

Source: Bloomberg

Inflation

Chart 9: US Core CPI

Source: Bloomberg

Chart 10: US “SuperCore” CPI

Source: Bloomberg

We, like all of you, will be watching the numbers closely. Central banks and thereby all market participants are clearly “data dependant” at this point!

Rates positioning: (i) short 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 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.