Andrew Pyle
April 14, 2022
Are we entering the sugar-coating phase of tightening?
To say that the fixed income market has gone through a rapid transformation would be an understatement. Depending on the segment of the bond market we are looking at, we have either seen the worst quarterly performance since the 1980s or the worst on record. The US aggregate bond total return index was down 8.3% on Monday from the start of the year and Canada’s index was off about 8.6%.
The market has not only shifted quickly from a view that central banks would take a modest and steady approach to raising rates to a position where rate hikes will be large and front-loaded. Confirmation of that new reality came this week as the Bank of Canada and Bank of New Zealand increased their official rates by half a percentage point.
Neither of these moves came as a surprise, just as no one will be shocked if the Federal Reserve lifts rates by half a point at its meeting in May. Market participants have listened to the rhetoric from both the Bank of Canada and Fed and are now pricing in at least two increases of half a point and perhaps more. What has happened to create such a dramatic turnaround from just a few months ago is a continued deterioration in the inflation landscape and realization by central banks that a shift to lower inflation doesn’t look like it will take place naturally. In the case of Canada, there is also an acknowledgement by the Bank of Canada that economic growth is running hotter than originally projected, thanks to the support of higher commodity prices in the country’s resource sector.
Along with the Bank’s rate decision, it also published its revised projections. Real GDP growth was revised up to 4.2% from the January forecast of 4%, though 2023 was marked down to 3.2% from 3.5%. The more significant revisions were on the inflation front, however, with this year’s CPI inflation forecast moved up to 5.3% from 4.2% and the 2023 pace increased by half a percentage point to 2.8%, and that is for this reason that the Bank taken out the big guns on rates. The Bank made clear that it is not aiming to take its overnight rate target to a level higher than where it might have originally wanted (the so-called neutral rate). It just wants to get there faster.
The neutral rate is not a hard number, and it moves around depending on economic conditions, but for now the estimate put out by the Bank is somewhere between 2% and 3%. From its current rate of 1%, that suggests we are going to see another 1-2 percentage points of tightening and over a short period of time. There are five more meetings left this year, so there is definitely scope for the Bank’s rate to get up into the middle of that range by the second half. The median economist forecast is for the Bank to raise rates by a quarter point at its next four meetings, but these forecasts were made prior to Wednesday’s decision. A greater number have already marked up their estimates for the June 1st meeting to another half-point hike.
The Bank is also cognizant of how concerned Canadians are with respect to the economy and financial markets, in light of inflation, the war in Ukraine, shutdowns in China and what is happening to interest rates. So, there was a little sugar-coating of the message this week. BoC Governor Maklem indicated that the Bank sees supply bottlenecks easing up, which means greater output to meet a perhaps softening demand. That would allow prices to stabilize, bringing inflation down from its lofty levels. If that materializes, then one would assume the Bank could back away from large-scale rate hikes and even take a pause. That would offer some relief for bond yields, which have spiked in anticipation of aggressive tightening.
The spread between the 2yr Government of Canada bond yield and the Bank of Canada overnight rate target had jumped to almost 2% before the Bank’s meeting this week. That was the widest the spread had been since 2002, though that period was one where the Bank was cutting rates to get out of recession. The 2yr yield got up to around 2.43% last Friday but has come back to 2.33%. The 5yr yield is holding around 2.5% - just above the peak we saw in 2018.
The move higher in bond yields, against a backdrop of continued tightening, will influence deposit and mortgage rates higher. Lower rated GIC issuers, for example, have already had to push their 5yr GIC rates up towards 3%. As the overall GIC curve nudges up, then mortgage rates typically follow. The impact on Canada’s housing market is unclear given that there are some opposing forces. On the one hand, rising borrowing costs and decreased home affordability will weigh on demand, with some individuals and families looking to downsize in order to afford higher payments. But immigration growth is expected to improve this year as the pandemic subsides, which should fuel demand.
No doubt, the Bank of Canada has factored in these possibilities into its projections, which is why growth is seen moderating back to trend and inflation comes back to the Bank’s target of 2% over the near-term. From an investment perspective, we have basically taken the 2-3-year time horizon and truncated it. Risks of weaker growth and/or recession that we saw beyond 2022 are now front-loaded. That doesn’t mean we get a recession, and the Bank may very well pull off a soft landing. It does suggest that we have probably seen the worst in terms of the pace of correction in bonds, even if we haven’t necessarily seen the highs for yields. Ally and I believe this provides an opportunity to piece back into lower risk bonds as a hedge against potential equity market weakness.
On behalf of the Pyle Group, have a wonderful weekend.
Happy Easter and Happy Passover.
Andrew