We tell this analogy time after time after time, and just when you think lessons are learned, history repeats itself. I’m referring to when too many investors crowd on one side of the boat, causing it to roll over. Back in January, there was a herd mentality surrounding the notion that central banks would not only cease their tightening efforts in the coming weeks, but offer up rate cuts before the year was over. Resilience in many of the key economic reports and persistently high inflation delivered a reality check to the herd. Spilling over into this week, European inflation figures for February actually showed a re-acceleration. To cap it off, there are signs that the Chinese reopening has led to a spike in economic activity.

 

Regardless of the reason for inflation stickiness, whether it be underlying strength in domestic demand or continued tight labour markets, the upshot is that central banks have been given a green light to maintain pressure on the brake pedal. Certainly, the Federal Reserve is prepping for another couple of hikes starting with its March 22^nd gathering and, considering inflation in Germany and France, the European Central Bank (ECB) is likely to stick to its guidance of another half-point hike at its next meeting. As for the Bank of Canada, which meets next Wednesday, it will be interesting to see if officials adhere to their previous comments of pausing.

 

 

 

The shift in expectations with respect to central bank policy isn’t really that dramatic and, in the case of the Fed, investors are simply back to believing what officials have been telling them all along. What has been dramatic is the effect on the fixed income market and, to a lesser extent, stocks. The 2-year US treasury yield has broken above November’s highs around 4.7% and rose to 4.9% on Wednesday. The 6-month T-Bill has climbed to almost 5.15%, which represents more than a half-percent increase since November.

 

This shouldn’t be a surprise considering that the Fed funds futures contract for December has fallen from just north of 95.50 at the start of February to only 94.62 this week. The way we interpret the futures contract is by subtracting the value from 100, which implies where the market sees the Fed’s overnight target rate by the time of the contract expiry. So, at the end of January, the implied rate of 4.5% in the contract suggested that even if the Fed raised rates one or two more times (to 5%), rate cuts towards the end of the year would bring the target rate back to 4.5%. Today, the contract suggests that fed funds will be in the 5.5% neighbourhood by December, which implies another 0.75% in tightening and no cuts.

 

 

 

The question often arises as to why this new Fed expectation doesn’t factor into the 2-year bond, which is still trading more than half a percent below implied fed funds? The reason is that looking out beyond this year, there is still anticipation of rate cuts in response to lower inflation and/or an economic recession. For example, the December 2024 fed funds contract, while it has sunk in recent weeks, is still trading at close to 96 and this implies a fed funds rate of around 4%. Back in January, the contract implied a 3% rate. The more pertinent question is whether the bond market today is closer to the truth in terms of pricing in where the Fed’s terminal rate will be and whether this pricing represents value?  Ally and I would say yes to both, even though there remains a significant inflation risk.

 

 

 

The last time the 2-year yield and inflation were equal was in May 2020, with both roughly at 0.2%. We remember those days, right? From there, the gap between the 2-year and inflation widened and reached a trough of minus 6.5% this time last year. The gap has since narrowed steadily and is currently about minus 1.5%. Now, let’s assume that the market is (finally) correct about where it sees Fed policy and, while we are at it, let’s also assume that the economy does enter a recessionary phase at some point this year. That will indeed bring inflation down closer to the Fed’s 2% target, but we think it might get stuck around 3% initially. Meanwhile, even if the 2-year treasury yield were to come in a bit from current levels, this would cause the gap between the yield and inflation to go positive. The last time the gap was at or close to plus 1% was in early 2019 and then again back in 2015.

 

Looking out over a one-year time horizon, I would suggest that this would create the condition for a significant rally in this part of the curve. In fact, we believe that we are approaching an inflection point where the risk-reward ratio for bonds is going to be even better than what we saw in the fourth quarter of 2022. Now, not all bonds may be lifted at the same pace. High-yield debt could become distressed if the economy does snap, though short-term investment grade corporate credit should still deliver positive total returns. For investors that may be listening to rhetoric suggesting it’s time (again) to dump bonds, they should stop and consider where else they might be able to increase income and get capital growth at the same time. The past few weeks have seen a resetting of policy pricing in the bond market, but this would not be a good time for retreat.

 

On behalf of the Pyle Group, have a wonderful weekend.   

 

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.