The Fed's Easing Cycle Begins

“Laissez les bons temps rouler” is a famous New Orleans expression for keeping the party going! And following their 4^th consecutive up month In August (the first time in 3 years), North American fixed income markets have definitely been feeling the Mardi Gras vibes this summer. While late to the party, Jay Powell and the rest of the Federal Reserve arrived with an extra-large pizza in the form of a 50-bps rate cut at their September meeting to help keep the good times rolling. We bond investors are an inclusive group and were more than happy to invite our equity friends to the celebrations, with most major US stock indices reaching new highs. For the month in August, the Canadian Universe Bond index was up 0.3% (Chart 1), pushing its 4-month winning streak to 5.7%. Overall YTD and 1-year returns were 2.3% and 7.9%, respectively (Table 1). Further, at the time of writing (August 19th), the Canadian bond market has enjoyed a strong September so far, up 1.7% MTD. Similarly, the aggregate US bond market rose 1.4% MoM in August, pushing its 3-month gain to 4.8%. YTD and 1-year returns were 3.3% and 7.4%m respectively, while in September it is up 1.6% thus far. Even with the recent decline in yields, investors continuing to benefit from historically attractive yield levels with the aggregate Canadian and US bond markets yielding ~3.5% and 4.2%, respectively. As mentioned, risk assets broadly have also enjoyed a strong run recently, despite some bouts of uncertainty and volatility. YTD (again to the time of writing) the S&P 500, Dow Jones Industrial Average, and Nasdaq composite have rallied 22.6%, 14.1% and 22.8%, respectively. The S&P/TSX has lagged somewhat, with a YTD return (to Aug 19th) of 13.9%. So, with returns in Canada and the US of approximately 10% and 15.5%, respectively, 60/40 balanced fund investors have enjoyed the 2024 market celebrations to this point.

Chart 1:

Source: FTSE/Russell; Bloomberg

Over the month of August, YTD and 1-year, Canadian Federal bonds returned +0.40%, 2.27% and +6.98%, respectively, while the overall Universe Bond Index returned +0.33%%, 2.32% and +7.88%, respectively. Corporate bonds slightly underperformed their government counterparts, returning +0.26% on the month. Yet with returns of +3.68% YTD and +9.61% over the past year, Canadian investment-grade corporate bonds have far outpaced government debt. Provincial bonds rose 0.29% on the month and have returned 1.37% YTD and +7.62% over the past year.

Monetary Policy

Without a doubt, the focus of financial markets in recent weeks has been the Federal Reserve. It had been long telegraphed that September would mark the start of an easing cycle following an historic 4-year period of monetary tightening. In the run up to the central bank’s September meeting however, the debate began to intensify as to what magnitude of rate cut would they deliver: 25 or 50 bps. Just a few days out from the meeting, the markets had discounted a ~38-bps decline in the policy rate – exactly a 50/50-coin flip between a cut of 25 or 50-bps. This was in fact, the highest degree of investor uncertainty heading into a policy decision in over a decade. And with good reason, compelling arguments could be made for either decision with mixed data points of late and balance of risks with respect to the Fed’s dual mandate of price stability and full employment moving in opposite directions. While my expectations were sightly shaded towards 25-bps, I can understand the decision. With US inflation clearly trending towards target, albeit still above it, and with the labour market slowing, albeit from strong levels, Chairman Powell appears to have wanted to get a fast start at “recalibrating” policy rate towards neutral – which the Federal Reserve current thinking believes is around 3%. Thus, with policy rates at 5.5%, the central bank felt it was in the economy’s best interest to get out of easing “blocks” quickly. So where do US policy rates go for here? The Fed’s “dot plot” projections have 2 additional 25-bps cuts pencilled in for this year and a further 100-bps of rate cuts in 2025. This would take the Fed Funds rate to a range of 3.25-3.5% by the end of next year, or a total of 6 25-bps cuts. Market expectations continue to be more dovish, with almost 3 cuts priced in for the remainder of the year (Chart 2) and a further 5 cuts in 2025 – so in total the market is looking for almost 8 cuts by year end 2025 or 50-bps more than current central bank guidance. This divergence and the slightly more hawkish guidance, proven to be somewhat disappointing to longer-term bond yields, with the bell weather UST 10-year yield up (at the time of writing) almost 15 bps from it pre-FOMC low (~3.75% vs ~3.60%).

Chart 2:

Source: Bloomberg

Despite this backup and the rate cut, the 10-yr yield still remains well below policy rates (Chart 3), which may continue to put upward pressure on yields in the near term. That said, the onset of a meaningful easing cycle should be supportive of lower bond yields over the medium-term. Here in Canada, the market is now looking for a further 75-bps of rate reductions this year, and another 100-bps in the first half of 2025. This would take the overnight rate to the 2.5-2.75% area by next summer – a welcome relief to Canadian borrowers.

Chart 3:

Source: Bloomberg

Market Snapshot

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.