Expectation Recalibration

After rising slightly in January, North American government bond yields continued to push higher in February. This further retraced some of the return gains enjoyed at the end of last year as the market continued to recalibrate its monetary policy expectations. Risk assets extended their positive start to year. The S&P 500 jumped ~5.3% on the month, which took its 2-month gain to ~7.1%, reaching new record highs. Similarly, the Nasdaq composite was rose ~6.2% in February and is up ~7.3% YTD. The S&P/TSX gained ~1.8% on the month, weaker on a relative basis due to its higher sensitive to energy and financials and lack of the mega-cap leadership seen in US markets. YTD, the Canadian benchmark has underperformed significantly with a gain of ~2.4%. The lack of breadth in market returns, particularly within the US indices remains an issue, with large gains still concentrated in a relatively few large cap companies. In our primary market of focus, the Canadian Universe bond market fell 0.3% on the month (Chart 1), pushing its YTD loss to -1.7%.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, in the past 6 months fixed income markets have seen both highs and lows. Despite the negative returns to start the year, the rolling 6-month return for the Canadian bond universe was 3.8% through the end of February – a far cry from the -5.2% at the end of October (Chart 2). While bond market volatility will likely continue, over the medium-term, investors continuing to benefit from historically attractive yield levels. The average yield in the Canadian bond market was almost 4.3% at month end.

Chart 2:

Source: FTSE/Russell; Bloomberg

Over the month, YTD and 1-year, Canadian Federal bonds returned -0.5%, -1.7% and +2.8%, respectively, (Table 1) while the overall Universe Bond Index returned -0.3%, -1.7% and +3.8%, respectively. Corporate bonds outperformed their government counterparts in February, returning 0.2% on the month, with returns of -0.5% YTD and +6.3% over the past year far outpacing government debt. Provincial bonds rose -0.6% on the month and have returned -2.6% YTD and +3.1% over the past year. Provincial bonds have longer terms to maturity on average and thus will underperform the broader market when yields rise.

Rates Markets

The early narrative in the rates market in 2024 has been the recalibration of monetary policy expectations and the impact felt further out the yield curve. The unexpected timing of the “dovish pivot” from the Federal Reserve at their December meeting fueled a massive repricing lower in policy rate expectation, pulling longer-term bond yields down with them. Push back from the central bank on this market optimism and stronger than expected employment and inflation data to start the year, has tempered some of the market’s enthusiasm. Both policy rate expectations and bond yield have moved higher as a result and now look better in tune with central bank guidance. The bell-weather UST 10-year yield traded in a ~45 bps range between ~3.90% and 4.35% in February, while UST 2-year yields rose ~40 bps MoM (Table 2 & Chart 3).

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield ended February at 3.49%, up 27-bps MoM, with an intra-month trading range of 3.27% to 3.65%. The Canadian market outperformed the US market across the yield curve on the month.

As Tables 2 & 3 shows, the front-end of the yield curve in Canada and in the US diverged modestly on the month, with the Canadian 2-year yield rising less than its US counterpart. This caused the shape of the Canadian yield curve to steepen or normalize, while the US yield curve flattened slightly. Despite this short-term divergence, both yield curves are materially less inverted than they were in mid-2023. However, curves remain negatively sloped and still at levels that would be outside of the normal historical range (Chart 4). Given central banks are nearing the end of their tightening 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.

Chart 3:

Source: Bloomberg

While the two North American rates markets are highly correlated, the Canadian market has outperformed of late. The GOC/UST 10-year yield spread (-75 bps) is currently at the low end of it -0.3-0.8% range and has been trending lower in recent weeks (Chart 5). As a result, Canada has moved into historically rich territory and thus we have reduced our Canada weight and increased our US exposure.

With the YTD increase in most yield levels across the curve, the gap between market rates and policy rates has narrowed significantly. The gap is still negative however, and thus the scope for yields to decline meaningfully appears somewhat limited. That said, with inflation expected to continue to moderate and central banks nearing the end of their tightening cycles, upward pressure on yields also appears limited. Thus, in the near-term, we look for bond yields to remain range-bound (4.0%-4.5% 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 previously covered our short duration position and remain neutral at present.

Rates positioning: (i) neutral duration; (ii) yield curve neutral; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) underweight Canada versus US

Chart 4:

Source: Bloomberg

Chart 5:

Source: Bloomberg

Credit Markets

Corporate bond risk premiums continued to grind lower in February helping to extend credit’s YTD outperformance. The average yield spread in the Canadian IG market ended the month at 118 bps, its tightest level in 2-years. This spread started the year at 134 bps above underlying Government of Canadas. In the US market, the IG spread started the year at 99 bps and currently sits at ~96 bps, basically unchanged so far this year (Table 4; Chart 6).

Thanks to their higher yields and steady/lower risk premiums, IG corporate bonds have outperformed government bonds this year. On a MoM basis, Canadian and US IG corporate bonds underperformed their Federal counterparts 72 bps and 7 bps, respectively. Over YTD and 1-year, IG corporates have outperformed by ~105 bps and ~48 bps in Canada and the US, respectively, and ~364 bps and 420 bps in Canada and the US, respectively. Extremely strong relative returns in a difficult and uncertain macro environment.

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. US non-farm payroll growth was 275,000 In February, after a downwardly revised, but still strong 229,000 in January. The 3-month average has increased to 265,000. While down from the 2023 peak (727,000) it has increased from a recent low of 198,000 and remains strong by historical standards. 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 at 28,000, up from 13,000 last July. While we believe that labour markets should resume the moderation seen in H2, 2023, at present they appear strong and resilient.

Chart 6:

Source: Bloomberg

The medium-term outlook, however, still has some uncertainty. Core inflation is still running well above central bank targets. While most inflation measures have shown good progress retracing toward those targets over the last year, the last few months inflation has proved to be “sticky”. At this point, markets appear comfortable that recent stronger-than-expected prints are temporary and that the moderation toward targets will resume. If that does not prove to be case however, further recalibration of rate cut hopes will be required, putting both yields and risk asset under pressure.

In addition to resilient macro and credit fundamentals, supply and demand technical factors have been a primary driver of the better credit market performance. Simply put, demand has been very strong thus far in 2024, despite record new issuance. Factors including short investor positioning, less headwinds from central banks, high cash holdings to be put to work, asset allocation shifts into fixed income – all of which have contributed to reasonably steady demand despite all the negative headlines. With in the rally in rates in late-2024, issuers were quick to try and take advantage of lower funding costs in early 2024, resulting in record corporate bond supply. Somewhat counterintuitively however, greater supply has been met with even greater demand, leading to tighter corporate spreads. Supply is expected to decline over the course of the year, thus the demand/supply imbalance should provide a positive tailwind to the credit sector for the remainder of the year.

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 have moved materially 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 potentially weakening macro fundamentals as we move through the year. Thus, we have reduced risk in the portfolio, but still maintaining an overweight.

Chart 7:

Source: ICE/BofA; Bloomberg

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