Fits and Starts

Despite testing recent yield highs intramonth and the long awaiting Jackson Hole Federal Reserve summit, overall, August proved to be “Much Ado About Nothing” in North American fixed income markets. Risk assets continued to face headwinds from higher yields but managed to recover some of their footing by month’s end. The S&P 500 fell ~1.6% on the month but is still up over 18.5% YTD to the end of August. The Nasdaq declined just over 2% in August, paring its YTD gain ever-so-slightly to ~35%. The S&P/TSX fell ~1.4%, marginally better on a relative basis thanks to a better environment for energy and commodity prices. YTD however, the Canadian benchmark has underperformed significantly with a gain of ~7%. 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 declined 0.2% on the month (Chart 1), cutting its YTD gain to 1.2%.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, it’s been a year of “fits and starts” thus far, with the Canadian bond market having difficulty building any sustained positive momentum. That said, relative to 2022, this year has been a more construction environment for fixed income markets, with investors continuing to benefit from attractive yield levels.

Over the month, YTD and 1-year, Canadian Federal bonds returned 0.0%, 0.4% and 0.1%, respectively, while the overall Universe Bond Index returned -0.2%, 1.2% and 0.8%, respectively. Corporate bonds performed inline with their government in August, returning -0.1% on the month, but returns of 2.5% YTD and 2.5% over the past year have far outpaced government debt. Provincial bonds fell 0.5% on the month and have returned 1.1% YTD and 0.2% over the past year.

Rates Markets

As highlighted, North American yields appear to have moved in a “step function” to sequentially higher trading ranges over the past few months. The bell-weather UST 10-year yield traded in 30 bps range between 3.30% and 3.60% from mid-March through mid-May, testing support at the upper end of that range on multiple occasion. The yield finally broke above the 3.60% level in May, settling into a 3.60%-3.90% range until late July. In the past few weeks, the yield has tested the local peak around the 4.35% level and is currently trading near that level (Table 2 & Chart 2).

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield ended August at 3.56%, up 6-bps MoM, with an intra-month trading range of 3.50% to 3.82%. The Canadian market outperformed the US market across the yield curve on the month.

Chart 2:

Source: Bloomberg

As Tables 2 & 3 shows, the front-end of the yield curve, particularly in the US, continued to outperform longer-date maturities in August. This caused the shape of the yield curve to steepen, counter to what we have seen for most of the past year and a half! However, the move was relatively modest and North American yield curves remain extremely inverted (Chart 3). Given central banks are nearing the end of their tightening cycles and where currently curve levels are in an historical context, we believe the next big move in the yield curve will be to steeper levels. Thus, we have taken profit on our curve flattening position and returned the neutral. While our expectation is for a steeper curve going forward, calling for the start of curve steepening has been a bit like “crying wolf” over the past 6-9 months, thus we will remain patient before aggressive positioning the portfolios in the steepening trade.

While the two North American rates markets are highly correlated, the Canadian market has outperformed of late. The GOC/UST 10-year yield spread is currently near the middle of the -0.4-0.8% range in which it has trade for most of the past year (Chart 4). Near-term relative performance between the two markets will likely be driven by the market’s expectations of which central bank maybe forced to pursue further rate hikes, or which will be the first to ease policy in 2024.

Chart 3:

Source: Bloomberg

Chart 4:

Source: Bloomberg

With most yield levels across the curve well below policy rates, it does appear that declines in bond yields will be limited. That said, with inflation expected to continue to moderate and central bank 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 (3.75%-4.35% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and the evolution of core inflation. Given we are currently at the upper end of our expected yield range, we have covered our short duration position and returned to neutral.

Rates positioning: (i) neutral duration; (ii) yield curve neutral; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada but reducing that position on opportunity.

Credit Markets

Corporate bond risk premiums rose modestly in August after testing their YTD tights in July. Outside of the March weakness, credit markets have enjoyed very strong momentum this year despite the chorus of recession calls since late-2022. The Cdn IG corporate bond spread started the year at 162-bps above underlying Government of Canadas, having widened approximately 50-bps over the course of 2022 (Note: the pre-pandemic tight was 88-bps). This spread rallied to the low-140’s in February, as corporates outperformed. The SVB collapse cause the spread to widen over 20-bps in a matter of a week, reaching a YTD high of 172 bps. In the US market, the IG spread widened from a YTD low of 115 bps to a banking turmoil high of 163 bps. Since reaching those highs, spread have rallied back to ~150 bps and ~120 bps in Canada and the US, respectively to the end of August (Table 4; Chart 5), approximately 8-10 bps from their YTD lows but still tighter overall on the year.

Therefore, thanks to their higher yields and lower risk premiums, IG corporate bonds have outperformed government bonds this year. On a MoM basis, Canadian and US IG corporate bonds performed inline with their Federal counterparts but have outperformed strongly both YTD and over the past year. YTD IG corporates have outperformed by ~225 bps and ~262 bps in Canada and the US, respectively, and 246 bps and 418 bps in Canada and the US, respectively. Extremely strong relative returns in a difficult and uncertain macro environment.

Chart 5:

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. Beyond that horizon, the outlook appears less clear. The labour market has shown some tentative signs of slowing. The 3-month average of US non-farm payroll growth has declined to 150,000 from 430,000 a year ago, while the similar measure in Canada has slowed to 31,000 from 82,000 in January. That said, in an historical context, those numbers are still reasonably solid, and with the unemployment rates running at 3.8% in the US and 5.5% in Canada, the labour story is still one of “moderation” rather than “contraction”. US GDP expanded at 2.5% a.r. in Q2 and is forecasts to growth 0.9% and 1.9% in 2024 and 2025, respectively. After a strong Q1 (2.6%), GDP in Canada contracted 0.2% a.r. in Q2 and is expected to show growth of 0.8% and 2.0% in 2024 and 2025, respectively. Overall, while economic activity is expected to slow further, and could ultimately contract, a severe downturn is not our base case scenario.

In addition to resilient macro and credit fundamentals, supply and demand technical factors have been a primary driver of the better credit market performance in recent weeks. Simply put, demand has been very strong to start the year. Factors including short investor positioning, bearish fatigue from last year, 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 reasonably steady demand despite all the negative headlines. In contrast, the supply side of the equation has underwhelmed both demand and expectations. While picking up pace somewhat in July, the supply calendar has been lighter than most market participants had expected. So based on the fundamental and technical backdrop, there are reasons to believe that the market could solidify its recently found firmer footing over the near-term.

The medium-term outlook, however, still appears to warrant caution. Core inflation is still running 2x higher than central bank targets. Central banks have been clear on their focus and commitment to bringing prices down. Therefore, while rate hikes appear to have stopped, at least for now, rates will likely remain higher for longer. Not to mention the lagged impacts of the most aggressive tightening cycle since the early-1980’s. This creates greater uncertainly associated with the removal of policy stimulus that will result in greater volatility in risk premiums this year. In short, tail risks have risen. Looking into next year, growth is expected to moderate, perhaps sharply – leading indicators such as global PMIs and housing have already rolled over, yield curves have flattened significantly, and margins and earnings are starting to face greater headwinds. Therefore, the overall fundamental environment for credit will likely suffer from both weaker macroeconomic growth and weaker income and balance sheet metrics. In absence of any improvement in forward-looking macro fundamentals, we continue to exercise caution via a higher quality bias in our corporate bond holdings.

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 6) 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 the weakening macro fundamentals as we move later in the end. Thus, we have continued to reduce risk in the portfolio, but still maintaining an overweight.

Chart 6:

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.