What a Difference a Month Can Make

What a difference a month can make in financial markets! After suffering their worst monthly losses since September of last year on renewed volatility and a spike higher in bond yields, North American fixed income markets rebounded nicely in May (Chart 1) – posting their best month of the year so far. The broad Canadian bond market returned 1.77% on the month, recouped most of the 2.00% loss suffered during April’s “showers”. May’s “flowers” helped to lessen the YTD downdraw to -1.49% and push the YoY gain to 2.57%. Similarly, the aggregate US bond market rose 1.70% MoM, improving its 2024 performance to -1.41% and 1-year return to 1.34% (Table 1). On an ongoing positive note, investors continuing to benefit from historically attractive yield levels with the aggregate Canadian and US bond markets yielding ~4.3% and 5.0%, respectively. Risk assets enjoyed another strong month with many of the major indices testing record levels. The S&P 500 rose ~5.0% on the month and is up ~11.3% YTD. Following suit, the Nasdaq composite jumped ~7% in May, pushing its YTD gain to ~11.8%, while the Dow Jones Industrial Average gained ~2.6% MoM and up 3.5% YTD. The S&P/TSX trailed its US counterparts, rising ~2.8% on the month, bringing its YTD return up to ~7.6%.

Chart 1:

Source: FTSE/Russell; Bloomberg

Over the month, YTD and 1-year, Canadian Federal bonds returned +1.42%, -1.66% and +1.41%, respectively, while the overall Universe Bond Index returned +1.77%%, -1.49% and +2.57%, respectively. Corporate bonds continued to outperform their government counterparts in May, returning +1.39% on the month, with returns of +0.20% YTD and +5.67% over the past year, far outpaced government debt. Provincial bonds rose 2.37% on the month and have returned -2.81% YTD and +1.23% over the past year – outperforming on the month due to their longer average term-to-maturity in a falling yield environment.

As we discussed in last month’s commentary, as financial market participants we are always looking at “what ifs”, analyzing different scenarios, and trying to identify catalysts – both positive and negative – that could move markets. We were prescient last month to have started with reasons to be positive for both the Rates and Credit markets. This month I will take the other side of the trade.

Rates Markets – Reasons for Vigilance

To paraphrase the old adage about real estate, concerns surrounding the rates markets are all about “inflation, inflation, inflation”. From transient to elevated to moderating to sticky, the pandemic/post-pandemic evolution of inflation has driven policy decisions and in-turn, as we showed last month, longer term bond yields. The optimist in me will point to progress already made in the path toward central banks’ targets and forward-looking signs of further improvements, such as shelter costs rolling over. But the realist simply needs to look at the recent data to see that, for the most part, progress on inflation in the US has stalled. It was always thought that the first stage of declining inflation, say from peak to 3.5%, would be much easier than the “last mile”, from 3.5% to 2%. Recent experience would appear to bear out those expectations. US headline CPI peaked at 9.1% in June 2022. A year later it was 3%. At it May reading, the measure stood at 3.3%, having spent almost a year in a 3-3.7% range – i.e. “sticky”. The fluctuations in US Core CPI have been more muted, as you expect, the narrative is the same. After peaking at 6.6% in September 2022, core prices fell to 4% about a year later. But since October of last year, the measure has only moved from 4% to 3.4% - moving in the right direction certainly, but at a pace that is disappointing. In order to achieve a 2% annual rate, monthly prints need to average ~0.17% on average over the year. So far in 2024, only May’s Core reading has been in line with at target – the rest of the prints have been 0.3 or 0.4%. The result has been an increase in the 6-month annualized rate of US Core CPI rising from 3.7% in November to 5% in May – obviously this measure has been moving in the wrong direction (Chart 2). Similarly, US PCE for Core Services excluding Housing, a measure the Federal Reserve has called out on occasion, last stood at 4.9%. This is down from its peak (6.5% Sept. 2023) but still elevated historically. One last piece of data mining, long-term inflation expectations in the US, as measured by the University of Michigan survey, were 3.1% at its last reading, up from ~2.5% prior to the pandemic. With readings such as these, it is easy to understand why the Federal Reserve does not yet have the confidence to say that inflation in on a sustainable path to its target and thus does not yet have the flexibility to cut policy rates. Hence why the central bank has changed its outlook from 3 rate cuts this year to only one, starting in the fall.

Chart 2:

Source: Bloomberg

Credit Markets – Reasons for Vigilance

In a word, “valuations”. When looked at in an historical context, US investment-grade corporate bond yield spreads are at the expensive end of their range (Chart 3). The story is less extreme here in Canada, with Canadian investment-grade corporate bond risk premiums looking better value, but as we know, the US market will dictate future direction, if not magnitude, of the next move in credit spreads. The past 2 years have seen a massive outperformance of corporate bonds over their government counterparts. On a YTD, 1-year, and 2-year basis, US IG corporate bonds have delivered excess returns of 1.63%, 5.54%, and 3.70%, respectively. Canadian IG corporate bonds have enjoyed excess returns over those periods of 1.55%, 4.08% and 3.09%, respectively. These impressive relative returns have been driven by a combination of the incremental income earned and the narrowing of yield spread between corporate and government bonds (think of this as the bond equivalent to multiple expansion in the equity world). As the yield spread declines, corporate bond yields decline more than government bond yields, and corporates outperform. Just in the last year or so, we have seen a material decline in corporate yield spreads. During the US regional banking turmoil in March 2023, US IG spreads widened to their post-pandemic wides of ~165 bps. In the 15-months since, that measure has fallen to ~90 bps. Thus, on average, US IG corporate bond yields have declined ~75 bps more than their government bond equivalent and therefore significantly outperformed. Canadian IG corporate yield spreads have had a similar, albeit less dramatic, experience, falling from ~175 bps to ~120 bps. Looking at Chart 3, while there have been periods where US IG corporate spreads have traded at levels lower than today, current spreads are certainly at the tight (i.e. expensive) end of their historical range. Now, we have often argued that expensive valuations alone are not usually a catalyst, in and of themselves, for spreads to move wider and thus to be bearish on credit. In fact, we remain constructive on corporate bonds based on positive fundamental and technical factors (as we highlighted last month). But expensive valuations can result in larger losses when and if we do see a selloff in credit, hence with today’s valuations there are reasons for vigilance.

Chart 3:

Source: Bloomberg

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 May 31st)