Central Banks Nearing End of Tightening Cycles

After a universally painful September, returns in North American financial market were somewhat mixed in October, with the Canadian fixed income market showing remarkable resilience. The main story continued to be the move higher in US Treasury yields and the destabilizing effect it is having on global assets. Risk assets continued their recent slide, with a few indices dipping into correction territory having declined 10% from their recent highs. The S&P 500 fell ~2.1% on the month, which took its 2-month drop to ~6.8%. From its recent peak on July 31st to its recent low on Oct 27th the index was down 10%. Similarly, the Nasdaq composite was down ~2.8% in October and down ~8.4% over the past 2 months. Its recent peak to trough decline was just over 12%. All is clearly not lost however for 2023 to date, with the broad US indices up ~10.7% and ~23.6%, respectively. The S&P/TSX fell ~3.2% on the month, slightly weaker on a relative basis due to its higher sensitive to energy and financials. YTD, the Canadian benchmark has underperformed significantly with a gain of less than 1%. 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 rose 0.4% on the month (Chart 1), cutting its YTD loss to -1.1%.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, while October saw some stability in the Canadian fixed income space, the past 6 months have been challenging. The rolling 6-month return for the Canadian bond universe was -5.2%, its worst half-year performance since September of last year, and some of the weaker 6-month returns experienced since the GFC (Chart 2). That said, investors continuing to benefit from historically attractive yield levels.

Chart 2:

Source: FTSE/Russell; Bloomberg

Over the month, YTD and 1-year, Canadian Federal bonds returned 0.5%, -1.2% and -0.7%, respectively, while the overall Universe Bond Index returned 0.4%, -1.1% and 0.0%, respectively. Corporate bonds slightly underperformed their government counterparts in October, returning 0.4% on the month, but returns of 1.1% YTD and 3.0% over the past year have far outpaced government debt. Provincial bonds rose 0.2% on the month and have returned -2.6% YTD and -1.5% over the past year.

Rates Markets

As highlighted, North American yields appear to have moved in a “step function” to sequentially higher trading ranges since putting in a local bottom during the US regional banking turmoil this past spring. 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. After breaking above 4% in August, the yield tested the 2022 peak around the 4.35% level, before moving quickly towards the 5% level (Table 2 & Chart 3).

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield ended October at 4.06%, up 3-bps MoM, with an intra-month trading range of 4.03% to 4.24%. The Canadian market outperformed the US market across the yield curve on the month.

Chart 3:

Source: Bloomberg

As Tables 2 & 3 shows, the front-end of the yield curve, both in Canada and in the US, continued to outperform longer-date maturities in October. This caused the shape of the yield curve to steepen or normalize after having been extremely inverted over the past year and a half. However, the curves remain negatively sloped and still at levels that would be outside of the normal historical range (Chart 4). Given central banks are nearing the end of their tightening 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. Thus, we have taken profit on our curve flattening position and returned to neutral.

While the two North American rates markets are highly correlated, the Canadian market has outperformed significantly of late. The GOC/UST 10-year yield spread is currently at the low end of it -0.3-0.8% range and has clearly been trending lower in recent weeks (Chart 5). 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 4:

Source: Bloomberg

Chart 5:

Source: Bloomberg

With the sharp increase in most yield levels across the curve, the gap between market rates and policy rates has narrowed significantly. The gap is still negative however, and thus the scope for yields to decline meaningfully appears some 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 (4.25%-5% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and the evolution of core inflation. We had previously covered our short duration position and remain neutral at present.

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 have risen modestly since testing their YTD tights in July. The average yield spread in the Canadian IG market ended October at 155 bps, approximately 12 bps wider than the YTD low. This spread started the year at 162-bps above underlying Government of Canadas, thus despite consensus calls for a recession this year, risk premiums have been steady to marginally lower. In the US market, the IG spread started the year at 130 bps, with a YTD range of 115 - 163 bps. It currently sits at ~129 bps, basically unchanged so far this year (Table 4; Chart 6), as we enter a typically strong seasonal period for risk assets.

Therefore, thanks to their higher yields and steady/lower risk premiums, IG corporate bonds have outperformed government bonds this year. On a MoM basis, Canadian and US IG corporate bonds underperformed their Federal counterparts but have outperformed strongly both YTD and over the past year. YTD IG corporates have outperformed by ~225 bps and ~235 bps in Canada and the US, respectively, and ~335 bps and 470 bps in Canada and the US, respectively. Extremely 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. Beyond that horizon, the outlook appears less clear. The labour market has shown some tentative signs of slowing. US non-farm payroll growth was 150,000 In October, down from 297,000 a month earlier. The 3-month average has declined to just over 200,000 from 430,000 a year ago, and the unemployment rate has risen from 3.5% to 3.9%. A better balance in the labour market has been cited by the Federal Reserve as a key driver of continued moderation in wages and inflation, thus solid but not red-hot employment data is welcome to both rates and credit markets. A similar dynamic has unfolded in the Canada labour market, with the unemployment rate rising to 5.7% from 4.9% and the 3-month average for job creation slowing to 40,000 from a YTD peak of 82,000 in January. Overall, the labour story is still one of “moderation” rather than “contraction” in both Canada and the US.

US GDP expanded at 2.9% a.r. in Q3 and is forecasts to growth 1.0% and 1.8% 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 be relatively weak for the rest of the year (0.4% Q3 and 0.1% Q4). Growth is forecast to expand 0.6% 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 this year. Simply put, demand has been very strong thus far in 2023. 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, the supply calendar being lighter than most market participants had expected. So based on the fundamental and technical backdrop, there are reasons to believe that the market could remain firm into yearend.

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 7) 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 into next year. Thus, we have continued to reduce risk in the portfolio, but still maintaining an overweight.

Chart 7:

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.