The Return of "Higher-For-Longer"

In what appears to have been the "calm before the storm", North American fixed income markets were relatively stable in March. This follows a turbulent couple of quarters and precedes what has been a challenging start to Q2. Despite a modest rebound in returns on the month (Chart 1), Q1 performance ended in the “red” after Q4's strong results (Table 1). The broad Canadian bond market returned ~0.50% on the month, reducing its YTD loss for -1.22%. Similarly, the aggregate US bond market rallied 0.84% MoM, trimming its Q1 drawdown to 0.66%. On a positive note, investors continuing to benefit from historically attractive yield levels with the aggregate Canadian and US bond markets yielding 4.21% and 4.89%, respectively. This compares to 3.93% and 4.42%, respectively a year-ago and 2.91% and 2.89%, respectively 2 years ago. Risk assets continued to push higher, with many of the major indices at or near record levels. The S&P 500 rose ~3.2% on the month and jumped ~10.6% in Q1. Following suit, the Nasdaq composite was rose ~1.9% in March, taking its YTD gain to 9.3%, while the Dow Jones Industrial Average gained 2.2% MoM and 6.1% YTD. The S&P/TSX outperformed its US counterparts, rising ~4.1% on the month pushing its Q1 return to ~6.6%.

Chart 1:

Source: FTSE/Russell; Bloomberg

Over the month, 3-month and 1-year, Canadian Federal bonds returned +0.5%, -1.3% and +0.5%, respectively, while the overall Universe Bond Index returned +0.5%, -1.2% and +2.1%, respectively. Corporate bonds continued to outperform their government counterparts in March, returning 0.5% on the month, and returns of +0.1% over 3-months and +5.5% over the past year have far outpaced government debt. Provincial bonds rose 0.4% on the month and have returned -2.2% over 3-months and +1.1% over the past year – underperforming due to their longer average term-to-maturity in a rising yield environment.

Rates Markets

The pendulum of narratives and investors sentiment appears to be shifting yet again in fixed income markets. As we highlighted, the themes of "persistent inflation" and "higher-for-longer policy rates" quickly shifted to "moderating inflation" and "material rate cuts" in Q4 on the back of the Federal Reserve's surprise "dovish pivot" at their December meeting. At one point in early January, the market was discounting ~6 rate cuts from the Federal Reserve in 2024, twice as many as the central bank has said is likely this year. After numerous stronger than expected inflation prints and given on-going strength in the US labour markets, sentiment has swung back to the "persistent inflation" and "higher-for-longer policy rates" camps.

The change in messaging from Fed and growing policy optimism from investors at the end of last year was driven primarily by a notable moderation in US inflation. US Core Consumer price index peaked at 6.6% in September 2022 and started 2023 at 5.7%. The rate fell steadily over the course of last year, ending at 3.9% - close to 300 bps below its peak. Further, some of the shorter time horizon measures, such as the 3-month annualized rate, had dipped below 3% pointing encouragingly to further progress toward the central bank's 2% target (Chart 2). Unfortunately for the Fed, borrowers and interest-rate sensitive assets, that progress has stalled here in early 2024. The March reading for US Core CPI was 3.8%, just marginally below where it started the year and worrisomely, the 3-month a.r. has risen back to almost 5% from a low of 2.4% at the start of Q4 last year. Is this simply a "bump" (as Chairman Powell has described it) on the road to the 2% target or something more concerning? While the conventional wisdom has been that the "final mile" in the inflation journey was always going to be the most difficult, and the Fed has stated that thus far the path of inflation continues to evolve inline with their expectation, the market is not as convinced. US inflation-breakeven rates have been rising and policy cuts have been priced out. At the time of writing, markets' are pricing less than 2 rate cuts this year, with the first cut now not expected until September or even November – a far cry from the 6 cuts and March starting point investors were looking for as recently as January! I still believe that inflation will resume its slow path lower and that will provide central banks to deliver rate cuts this year (likely 50 bps in the US and 73 bps in Canada, starting in September and July, respectively), but the recent data has not been supportive on that view.

Chart 2:

Source: Bloomberg

The bell weather UST 10-year yield started the year at 3.88% after its strong Q4 rally off a peak of 4.99% on Oct 19^th. After a sell-off in January, the yield retested its 2024 starting point on February 1st. Since however, the pricing out of rate cuts from the Fed has put upward pressure on yields, with the UST 10-year ending Q1 at 4.20% (Table 2) and breaking above 4.5% in early-April. Given this sell-off and the rate cut outlook priced into markets now below central bank guidance, we are getting more constructive on interest-rate risk. We will likely look to use any further backup in yields to add duration in portfolios. As highlighted, North American yields have experienced a “bust/boom/bust” cycle since 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 March at 3.47% and is currently trading at ~3.7%. Thus, the Canadian market has outperformed the US market across the yield curve in early 2024.

Chart 3:

Source: Bloomberg

As Table 2 & Chart 3 shows, yield curves in Canada and in the US moved in slightly opposite directions in Q1, with the Canadian curve steepening while the US curve flattened, albeit in both cases only marginally. Yield curve in both countries have steepened or normalized over the last year, but remain negatively sloped (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. That said, further repricing lower of rate cut expectations could be near-term flattening pressure on curves. After having 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. The Government of Canada/US Treasury 10-year yield spread is currently near -0.85% (Chart 5), retesting its recent low and very wide by historical standards. Therefore, we believe the Canadian market looks expensive and hold 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 despite the recent rise in longer-term yields. 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 (4.0%-4.75% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and the evolution of core inflation. We reduced our duration position following the strong Q4 rally and are comfortable with less interest-rate risk at present. However, we will look for opportunities to add duration on any further backup in yields.

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 bonds have enjoyed a strong start to 2024, picking up where they left off last year. Risk premiums have continued to tighten, generating notable excess returns for corporates over their government counterparts in Q1. Yield spreads are now near their narrowest levels in 2-years. The average yield spread in the Canadian IG market ended October at 155 basis points, finished last year at 134 bps and are currently trading at ~120 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 90 bps (Table 3; Chart 6).

Over the past year, 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 8 bps and 56 bps, respectively. In Q1, and over the last year, Canadian and US IG corporate bonds have generated excess returns of 114 bps and 103 bps, respectively, and 488 bps and 522 bps, respectively. These are exceptional 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. Employment markets in both Canada and the US remain strong, although we have seen some signs that demand and supply of labour is becoming better balanced. The unemployment rates in both counties have risen slightly, with the US rate increasing from a low of 3.4% to 3.8% at its last print, while here in Canada the rate moved from 5% in early 2023 to 6.1% in March. This is a good sign for moderation in wages and inflation, and thus is likely welcome news for central banks on both sides of the border. Overall, the labour story is still one of “moderation” rather than “contraction” in both Canada and the US. Thus, the North American economy continues to show resilience to higher policy and borrowing rates, and recession fears have waned as a result.

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 past 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 Q1. 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. Further, unlike last year when higher bond yields presented a challenge to risk assets, including corporate bond spreads, to this point, higher yields have actually prompted increased buying as investors look to deploy cash at more attractive all-in yield levels. 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 are still expected be to lower rates, the expectations for the timing have been pushed out. In addition, the lagged impacts of the most aggressive tightening cycle since the early-1980’s creates significant macroeconomic uncertainty and potential headwinds to risk premiums later this year, particularly if longer-term bond yields remain elevated. 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.

Chart 7:

Source: ICE/BofA; Bloomberg

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. Looking back over the past two decades, Canadian IG risk premiums have traded tighter than current levels about 50% of the time, so while spreads have tightened material, they don’t look extreme in an historical context.

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.