What a Difference a Month Can Make

Well then, what a difference a month (and a few US regional bank failures and the “shotgun wedding” of two household names in the European banking aristocracy) can make!! In last month’s commentary, we teed-up what was expected to be an all-important economic calendar In March. These pieces of data soon took a backseat to the turmoil in banking sector! There is a common refrain in financial markets that during monetary tightening cycles, central banks will continue to raise rates until something “breaks”. In the days following the collapse of Silicon Valley Bank in mid-March, it certainly felt like we had reached that breaking point. The front-end of the US yield curve rallied by historic proportions, financial sector equities – particularly smaller US players – fell off a cliff, and many wondered if this was the start of the GFC 2.0. Thanks to quick actions from the Federal Reserve and other global policy makers, and “cooler heads” from investors, relative stability appears to have returned to the banking sector and financial markets more broadly. Not to say that additional fragilities in the financial system won’t come to light, or that increased cautiousness from lenders won’t tighten credit conditions further, but for now, any potential “crisis” has been averted. Before we take a closer look at how various markets and measures fared in the recent turmoil, here is a brief re-cap of Q1, 2023 performance. The S&P 500 rebounded ~3.6% in March, boosting its YTD return to almost 7.5%. The Nasdaq continued to be the class of the field, jumping ~6.8% on the month and up a very strong 17% so far this year. Here in Canada, the S&P/TSX lagged its US counterparts, falling 0.2% MoM, leaving its YTD return near 4.5%. In our primary market of focus, a very strong flight-to-quality bid lifted returns for both government and corporate bonds over the past month. In US fixed income markets, Treasuries rallied 3.0% in March, while IG corporates returned 2.6%. In Canada, Federal bonds rose 2.5%, outpacing high-quality corporates that returned 1.3%. As a result, the Canadian Universe bond market overall gained 2.2% in March (Chart 1) and is up 3.2% on the year.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, the stiff headwind to total returns in the Canadian bond market that we experienced for most of 2022 has abated somewhat in recent months. The rolling 6-month return on the Canadian bond market has turned positive and is at its highest level since the pandemic crisis (Chart 2). With government yields on average near 3.3%, high-quality corporate yields averaging around 5.0%, and the end of the global tightening cycle in sight, the forward-looking environment for fixed income has improved dramatically from where it has been in recent years.

Chart 2:

Source: FTSE/Russell; Bloomberg

Looking at the brief return summary above, you could be forgiven if you didn’t know that anything worrisome or crisis-like had occurred at all in March. While this potential complacency might be concerning to many, I think it speaks to the enduring power of the “don’t fight the Fed” mantra with investors. In this most recent example, the Fed immediately put in place measures to support the banking system and contain the issue to a relatively small numbers of players. Idiosyncratic risks were not allowed to become systemic. And with financial stability risks now likely tempering the central bank’s obsession with inflation and thus their aggression with respect to further tightening, the Fed “pivot” narrative can provide a tailwind to risk assets.

Now while some parts of the financial markets appear to have experience limited impacts from the banking sector turmoil, there are others where the effects have been more keenly felt. Here are a few markets and measures worth highlighting, some of which are notably changed over the past month and others that are notable in their stability.

Fed Funds Expectations & UST 2-Year Yields:

The re-acceleration in North American economic activity data and the on-going strength in labour markets over the first 2 and-a-half months of 2023 provided support to many risk assets. Conversely, the resilience of the economy and the persistence of inflation presented a challenge environment for central bank policy and by extension the front-end of the yield curve. Market expectations for the terminal policy rate peaked in early March near the 5.75% level, up from the 5-5.25% level where it had started the year (Chart 3). In addition, optimism over potential rate cuts later in the year waned as “higher for longer” appeared inevitable on the back of the stronger than expected macro environment. These policy expectations shifted dramatically as a result of the banking sector turmoil. The speed and magnitude of tightening was threatening the stability of the financial system and thus financial stability risks were now seen as an offsetting risk to inflation for the Fed – the central bank now needing to weigh the threat of persistently high inflation with the destabilizing effects their fight against inflation was having on the banking system. Chairman Powell’s early estimation was that the impact of tightening credit conditions on the back of the banking stress was the “equivalent” to 25-50 bps of policy hikes and thus the market’s rate expectations quickly shifted lower.

Chart 3:

Source: Bloomberg

The policy sensitive benchmark UST 2-year yield has “enjoyed” a similar 2023 rollercoaster ride. Starting the year at ~4.4%, the yield fell early in the year before moving quickly higher in Feb and early March - peaking at ~5.1%. The impact of the US regional bank failures was acutely felt shortly thereafter, with the front-end of the UST market reacting more dramatically than almost any other major financial market. The UST 2-year dropped over 100 bps in just 3 trading sessions (Chart 4), and from its intraday peak to its recent intraday trough it had plummeted over 150 bps. This was the most significant move since the early 1980’s. To highlight the extreme nature of the moves another way, the rolling 10-day movement in UST 2-year yields reached levels greater than 7 standard-deviation below their 10-year average – quite remarkable (Chart 5).

Chart 4:

Source: Bloomberg

Shorter-term yields appear to have stabilized following their initial exaggerated moves, with the UST 2-year yield trading in a range around the 4%-level. Investors will be closely watching for signs of additional banking sector stresses and will be assessing the impact of tighter lending conditions on the broader economy – both of which have the potential to push yields lower. That said, with the UST 2-year yield now 100+ bps below the Fed Funds rate and likely one more 25 bps rate hike to come in May, it would seem a more significant moderation in inflation and the labour market than has occurred thus far will be needed to drive front-end US yields materially lower.

In Canada, our 2-year GOC yield has had a similarly volatile period so far YTD. After starting 2023 at 4.05%, an early January rally pushed the yield almost 60 bps lower after the Bank of Canada paused its rate hiking cycle. Tracking the US market higher in yield, the GOC 2-year yield rose through February and early March to a peak of ~4.35% before rallying sharply on the banking debacle to a recent low of ~3.40% - this represents a 175-bps roundtrip move from trough-to-peak-trough in Q1 – again, really a remarkable move in a “risk-free” asset.

Chart 5:

Source: Bloomberg

Corporate Credit Spreads:

Risk premiums in the corporate bond market also felt a material impact from the banking sector tremors in March. After having benefitted from the general positive tone to financial market in January and February, credit market suffered as you would expect in the flight-to-safety that resulted from the surprising developments in global banking. US IG yield spreads on average began the year at ~130 bps over UST, having rallied in Q4, 2022 from an October peak of 165 bps. The positive spread momentum continued in January and early February, reaching a recent tight of 115 bps, with US IG corporate bond outperforming UST on a total return basis by ~148 bps. From the February tights, the yield spread widened 48 bps during the quasi-banking crisis, with corporates underperforming ~250 bps versus UST. As calm and stability has returned to financial markets, risk premiums in corporate credit have retraced a little over half of their widening, currently sitting at ~137 bps. On a total return basis, is equates to an outperformance from their lows of ~152 bps. Overall YTD, US IG has outperformed UST by ~44 bps and generated absolute returns of ~4% - a very solid performance in light of all that has been going on!

Canadian IG spreads have experienced similar movements directionally, although the magnitude of the moves has been more muted, as they typically are here north of the border (Chart 6). YE22-trough-peak-current credit spreads levels in Canada: 162 bps/142 bps/172 bps/160 bps, respectively. Overall YTD, Canadian IG corporates have outperformed GOC bonds by ~53 bps and generated absolute returns of ~2.7%. Thus, Canadian credit has delivered similar outperformance versus government bonds as their US counterparts but have underperformed substantially on an absolute return basis.

In absence of additional “skeletons” coming out of the banking sector closet or an unexpectedly draconian falloff in economic activity, we believe that the resilience of the North American economy and the impended end of the rate hike cycle, should be supportive for risk premiums in the short-to-medium-term.

Chart 6:

Source: Bloomberg

S&P 500:

As highlighted earlier when reviewing the recent performance of some key asset classes, the broad US equity market (as measured by the S&P 500 Index) as been amazingly resilient through the recent banking sector upheaval (can you tell I am running out of different ways to describe it!!). Year-to-date, the S&P 500 index’s closing daily level has been within +/-5% around the 4000 level every-single trading day. What is perhaps more interesting, is that it has closed within that range on 80% of trading days (201 of 250 trading days) since the end of April of last year! (Chart 7) – So the recent stability has actually been in place for almost all of the past year. This despite the most aggressive monetary tightening cycle since the early 1980’s and the biggest US banking failure since the GFC. Now granted, the index is down over 12% from its early 2022 high, but since the selloff in Q1 of last year, the broad US equity market has shown remarkable durability in the face of stiff headwinds and heightened uncertainty.

Chart 7:

Source: Bloomberg

US Inflation:

To paraphrase the famous real estate expression, the outlook for monetary policy and thereby asset prices continue to be driven primarily by “inflation, inflation, inflation”. The hopes and expectations for a policy “pivot” rest in large part on whether moderating pricing pressures will afford central banks with the flexibility to lower rates. In order for the Fed to conclude that rates have been “sufficiently restrictive” for a long-enough period of time, and thus some accommodation being warranted, they will need to see continued progress toward their inflation targets. On that front, there has been some positive developments in a few of the inflation measures, notably headline CPI (Chart 8), PPI and the Owners Equivalent Rent component of Core CPI & PCE. These are the pieces of “good news” on the inflation front. Still being filed under the “more work to be done” banner is the persistence in a number of the core measures that have been flagged by the Fed as a priority – Core CPI, Core Services and “Supercore” Services (Core Services ex. Shelter – Chart 9). These measures have shown only slight moderation and will need to fall further and faster if the central bank is going to be in a position to contemplate rate cuts on a time horizon that would be even close to the market’s current expectations. Both the Fed and the BOC have stated their intentions to keep rates at current elevated levels for the foreseeable future i.e. well into 2024. Based on current core inflation levels that would seem appropriate. That said, if inflation were to moderate toward their YE23 forecasts of ~3.5% or beyond, a policy rate of ~5%, it could be argued, might be considered overly restrictive. This could prompt the start of a rate cut cycle, particularly if the labour market shows any signs of weakness.

Chart 8:

Source: Bloomberg

Chart 9:

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 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.