As The Fed Turns

As we highlighted last month, Q1 appeared to end in a relative “calm”, “before the storm” at the start of Q2. Along with significant showers (at least in central and eastern Canada), April brought with it renewed volatility and upward pressure on bond yields. North American fixed income markets resumed their monthly print in the red after a brief respite in March (Chart 1). The broad Canadian bond market returned -2.00% on the month, pushing its YTD loss to -3.20%. Similarly, the aggregate US bond market fell 2.41% MoM, dragging its 2024 drawdown to 3.05% (Table 1). On a positive note, investors continuing to benefit from historically attractive yield levels with the aggregate Canadian and US bond markets yielding ~4.5% and 5.1%, respectively. Risk assets gave back some of their recent gains after many of the major indices testing record levels in Q1. The S&P 500 declined ~4.1% on the month but remains up ~6% YTD. Following suit, the Nasdaq composite fell ~4.4% in April, dropping its YTD gain to 4.5%, while the Dow Jones Industrial Average dropped ~4.9% MoM but is up only 0.9% YTD. The S&P/TSX outperformed its US counterparts, falling ~1.8% on the month, which dragged its YTD return down to ~4.7%.

Chart 1:

Source: FTSE/Russell; Bloomberg

Over the month, YTD and 1-year, Canadian Federal bonds returned -1.76%, -3.03% and -1.74%, respectively, while the overall Universe Bond Index returned -2.00%%, -3.2% and -0.91%, respectively. Corporate bonds continued to outperform their government counterparts in April, returning -1.24% on the month, with returns of -1.18% YTD and +2.79% over the past year, far outpaced government debt. Provincial bonds declined 2.91% on the month and have returned -5.06% YTD and -2.93% over the past year – underperforming due to their longer average term-to-maturity in a rising yield environment.

In our business we are always looking at “what ifs”, analyzing different scenarios, and trying to identify catalysts – both positive and negative – that could move markets. As an eternal optimist and a glass ¾ full person, I am going to start with reasons to be positive for both the Rates and Credit markets. Next month I will take the other side of the trade.

Rates Markets – Reasons for Optimism

“As the World Turns” was a US soap opera that aired for almost 55 years and still holds the record for longest total running time of any TV show (according to the ever-trustworthy Wikipedia!). Over the last year, and in particular the last 8-9 months, North American rates markets have really been driven by “As the Fed Turns” – with every basis point change in policy expectations seemingly causing a bps changed in 10-year yields. Well actually, the correlations between the number of rate cuts expected in 2024 and the US Treasury (UST) 10-year yield has been 80% since Sept 1, 2024, so I guess it is not quite 1-to-1, but very close. In any event, the influence of policy expectations on longer-term bond yields has been very strong (Chart 2). In the fall of last year as the Federal Reserve (Fed) turned more dovish, investors ramped up their forecasts for rate cuts in 2024. At year-end 2023, the market collectively was looking for 6.3 rate cuts this year, up from just 2.1 cuts in mid-October. The massive repricing of the policy optimism fueled the strongest rally in the US bond market in decades which saw UST 10-yr yields rally from ~5% to 3.8% in less than 50 trading days! The narrative so far in 2024 has swung the other way. On Jan 12th, 2024, rate cut expectations peaked at 6.7 and the UST 10-year yield stood at ~3.95%. At the end of April, investor optimism had dissipated to only 1.1 cut and as a result yields sold off to 4.68%. The drivers of this change in sentiment and yields are well documented: persistent, sticky inflation and resilient labour markets. These factors have forced the central bank to walk-back some of its dovish messaging from late last year, stressing their data dependency and the need to have “confidence” that inflation is on a “sustainable path” to their 2% target. This is a rationale and pragmatic response from the Fed, yet despite being less dovish, they are still guiding for 3 rate cuts this year. While this is clearly downside risk to their 3 cut outlook, the fact remains that the market is currently discounting less rate cuts than the Fed itself. Hence the reason for optimism. Current policy expectations, and with them longer term bond yields, appear to be in line with the likely path of policy. This is obviously in sharp contrast to when expectations and bond yields with overly enthusiastically hoping for almost 7 rate cuts this year. Further, while we believe that inflation will resume its downward trajectory, giving the Fed the flexibility to cut rates, we recognize that may take longer than previously hoped. That said, we believe the bar for the Fed to raise rates is very high. Thus, even if rate cuts are fewer and start later than currently expected, unless the next move from the Fed is to higher, not lower policy rates, we believe the upside to bond yields is relatively limited.

Chart 2:

Source: Bloomberg

Credit Markets – Reasons for Optimism

We have long talked about the process we use to evaluate the outlook for the credit sector of the fixed income market. In short, we analysis multiple factors across three different lenses: Fundamentals, Valuations and Technicals. We believe that both macroeconomic and credit fundamentals will remain constructive over the next few 2 quarters, with overall economic activity and earnings still well supported. Employment markets in both Canada and the US remain strong and corporate balance sheets, generally speaking, are stronger than they were prior to the pandemic. So, we could have focused on Fundamentals as our reason for optimism in credit market. But what has really driven the very large excess returns in corporate bonds over the past 18 months has very supportive technical factors. Simply put, when we refer to “Technicals” we are really taking about demand and supply factors and the balance of power between them. Over the past number of quarters, demand has strongly outweighed supply – this despite record issuance in early 2024. There are a number of drivers: attractive all-in yields following the move higher in overall government bond yields, record cash levels looking to be deployed, attractive relative yields in North American luring international buyers, insurance companies investing the proceeds from massive annuity sales, pension funds immunizing their liabilities with corporate bonds at higher yields and equity valuation, just to name a few. In the near term, we believe this demand/supply imbalance will persist, supporting credit valuations. Chart 3 highlights the large and consistent flow of funds into US high-grade corporate fixed income funds as a result of the confluence of factors listed above. After large outflows in 2022, there has been a huge reversal with a swing of ~7% of total fund AUM coming into the asset class. Again, we think this continues - Hence the reason for optimism!

Chart 3:

Source: EPFR Global, BofA Global Research

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

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.

Market Review (to April 30th)