Between a Pause and a Hard Place

Financial markets continued to enjoy the post-banking sector turmoil stability witnessed in April throughout the month of May. That said, the combination of that relative calmness and the ongoing resiliency in the North American economy, put upward pressure on yields, the rates market re-racking to a higher trading range. The same factors that were headwinds to yields – better than consensus Q1 earnings, pushing out of recession timelines and expectations Fed policy is now on a conditional "pause" – acted as tailwinds to risk assets such as equities and credit. The S&P 500 rose ~0.5% on the month and is up over 9.5% YTD to the end of May (with the rally continuing here in early June). The Nasdaq was the outstanding performer again in May, jumping ~5.9% MoM, taking its YTD rally to ~24%. The S&P/TSX struggled amidst a challenging environment for energy and commodity prices, falling ~4.9% MoM, which trimmed its YTD gain to ~2.3%. gained almost 3% MoM and 7.5% YTD. While much has been written about the lack of breadth in market returns this year, despite the headline risks in the financial sector, at the overall index level, equity markets have performed well. In our primary market of focus, the Canadian Universe bond market declined 1.7% on the month (Chart 1) and is up 2.5% YTD.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, since the start of 2022, monthly total returns in the Canadian bond market have had 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 -1.8%, 1.7% and 0.1%, respectively, while the overall Universe Bond Index returned -1.7%, 2.5% and 0.9%, respectively. Corporate bonds outperformed their government counterparts again in May, returning -1.4% on the month, 2.8% YTD and 2.4% over the past year. Provincial bonds fell 1.8% on the month but have returned 3.0% YTD and 0.5% over the past year.

Rates Markets

As mentioned, North American yields appear to have reset into a higher trading range over the past month. 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 about the 3.60% level and looks to have settled into a 3.60%-3.90% range over the past few weeks. Note, this yield hit a recent peak of 4.06% in early March.

The “drama” in the rates markets continues to be focused at the front-end of the yield curve. Over the course of the month, the UST 2-year yield rose from 4.01% to 4.41%, having hit a trough of 3.79% in early -May and peaked intra-month at 4.56% on a closing basis on May 29^th. The 10-day rolling change in the UST 2-year yield topped 63 bps in late May (Chart 2), While the yield has since settled in +/- 10 bps range around the 4.50% level, the uncertainty over the near-term path of monetary policy is likely to see volatility return as markets navigate around upcoming Fed meetings.

Chart 2:

Source: Bloomberg

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield ended May at 3.19%, up 34-bps MoM, with an intra-month trading range of 2.76% to 3.33%. Note the recent peak in this yield was 3.47% in early March.

While the two North American rates markets are highly correlated, the Canadian market has underperformed following the flight-to-safety witnessed during the US banking turmoil. The GOC/UST 10-year yield spread has recently tested the tight end of its -0.4-0.8% range during May’s rates sell-off, with further underperformance in the domestic market following the BOC’s surprising 25-bps rate hike In early June (Chart 3). Near-term relative performance between the two markets will likely be driven by the market’s expectations of which central bank maybe forced to more aggressively pursue further rate hikes.

Chart 3:

Source: Bloomberg

At their policy setting meeting in early May, the Federal Reserve delivered a further 25-bps rate hike, as was broadly anticipated. What held greater intrigue for investors was any indications from the Chairman on the future path of monetary policy and if in fact the central bank was prepared to signal its willingness to "pause" additional tightening. In what many have described as an "hawkish pause", Chair Powell did just that, contingent on the economy evolving in line with their forecasts. Powell also stressed that the Fed would not hesitate on additional rate hikes if they deemed them necessary. A "conditional pause" as it were. Since then, while many of the forward-looking survey data has continued to point to a weak economic outlook for later this year, the current hard data has shown surprising strength, particularly with respect to the labour market. In short, the US economy has been stronger than expected in the first half of the year. While inflation has moderated, particular the headline numbers, the level and persistency of core measures of inflation continues to be a concern for the central bank. These concerns led to Chairman Powell’s characterization that the current inflationary environment was not consistent with rate cuts this year. Further, it has led the market to anticipate that the Fed will not so much "pause" in June, but that it will "skip" raising rates at that meeting, only to raise rates again at the July confab. After pricing in rate cuts later in 2023 for most the past few quarters, investors are now discounting the "higher for longer" scenario, with the Fed Funds rate expected to remain above 5% into next year. Prior to SVB et al. market participants were generally of the view and the US terminal policy rate would likely raise to 5.75%-6%, with upside risks. In the immediate aftermath of the banking turmoil, the expected effective terminal rate fell back to where it is currently at ~5.125%. Current expectations have one more 25-bps hike priced in before a true "pause" takes place. (Chart 4)

Chart 4:

Source: Bloomberg

Therefore, with most yield levels across the curve well below policy rates, it does appear that further declines in bond yields will be limited. That said, with inflation expected to continue to moderate and bank sector risks ongoing, upward pressure on yields also appears limited, Thus, in the near-term, we look for bond yields to remain range-bound (3.5%-4% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and evolution of core inflation.

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

Credit Markets

While not wanting to sound too sanguine, there is some comfort to be felt by how well credit markets have regained their positive momentum following the quick sell-off caused by the regional banking saga. As we have mentioned in the past, credit spreads built up reasonably positive momentum early in the year – through the end of February, both Canadian and US IG corporate bonds had outperformed their government counterparts by approximately 100 bps. Understandably, credit spreads widening materially as risk aversion took hold of markets in March. 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 caused the spread to widen over 20-bps in a matter of a week, reaching a YTD high of off 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 135 bps in Canada and the US, respectively (Chart 5), levels not far off where they started the year. Therefore, thanks to their higher yields, IG corporate bonds have outperformed on a YTD basis by ~125 bps and ~60 bps in Canada and the US, respectively. Very solid relative returns in a difficult and uncertain macro environment.

Chart 5:

Source: Bloomberg

While some degree of confidence and calm has returned to credit markets in April, the resurgence of regional bank concerns in early May highlight that risks remain. Lending standards had already begun to tighten, and lending volumes had started to slow even prior to the banking turmoil. These trends are expected to accelerate given recent events, which likely increases the probability of recession and at the margin increases its expected severity. That said, I don’t believe the macroeconomic fundamental are all doom-and-gloom. The US unemployment rate is currently 3.7%, only marginally up from its post-war low in April. US Non-farm Payroll have increased on average by over 280,000/month over the past 3-month. While this measure has declined from an unsustainably high level, it still points to solid employment growth. There remains over 10mn job openings in the US – yes this is down from a peak of 12mn, but still represents 1.7 job openings-per-unemployed person in the economy. Average hourly earnings in May were up 4.3% YoY, again down from a recent peak of 5.9%, but still very solid. Strong labour markets, solid wage gains and continued excess saving should all provide support to consumer spending. Overall, while economic activity is expected to slow further, and could ultimately contract, a severe downturn is not our base case scenario. 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.

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. That said, confidence has certainly been shaken by the ongoing dislocations in the regional banking sector in the US. In contrast, the supply side of the equation has underwhelmed both demand and expectations. While picking up pace somewhat recently, 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. 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 1^st half of the year, current valuation levels could present a challenge later in the year. As we have pointed out in the past, spreads at or slightly above 150 bps 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 into the end of the year. Thus we have started to reduce risk in the portfolio, but still maintain 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.