Some investors looked at the 2022 carnage in the bond market and concluded that bonds were not worth investing in, forgetting that over the long-term, bonds have been an important element in a well-diversified and volatility-minimizing portfolio strategy. Likewise, some have crowded into the short-term GIC / money market strategy in search of the best rates in years, forgetting that as rates move lower this short-term strategy leaves them vulnerable to another important element – reinvestment risk.

 

Transitions in monetary policy typically don’t go as smooth as investors predict and the one that we are entering probably won’t be either. This is partly intuitive since policy is supposed to be implemented on a look-forward basis, yet using past-tense information. If future information runs counter to what was anticipated when policy changes are enacted, then we get bumps in the road. You may have felt a few of them in the past few weeks. The important thing is to not lose sight of what the fundamentals are telling us in terms of the direction that interest rates will take, not in the coming days but the coming months.

 

This week, central bank officials in Canada and the U.S. have reiterated their comments from recent policy meetings that there is no rush to cut rates while, at the same time, acknowledging that further increases in rates aren’t necessarily needed either. And they have had the data to back these comments up. The U.S. ISM Services PMI rebounded in January to 53.4 from the near break of 50 in December (anything below 50 suggests a contraction in services activity). More concerning for the Federal Reserve though was the jump in the prices paid index to 64 – a move of about 10 points from the levels we saw last summer.

 

 

 

Now, as the chart shows, the prices paid index is well below the peak witnessed in 2022 (when headline CPI inflation reached 9%) and not quite back to the level reached before the Fed tightening in 2018. The problem is that we are seeing an increase in perceived inflation among service-sector CEOs after the most aggressive monetary policy tightening in a generation. Last week, we saw a rise in the manufacturing ISM price index, but not to the same extent and this is what central bankers have been worried about. What if service price inflation is sticky?

 

Sure enough, the minutes from the January Bank of Canada policy meeting revealed concerns among officials over the breadth of inflation increases and that over half of the Canadian CPI basket components were growing at more than 3%. With an official inflation target rate of 2%, this is not the observation that entices a central bank to cut rates, or at least not for a few months. Markets may have been slow to accept this reality, but it is now showing up in both pricing for future policy rates and the bond market.

 

 

 

The December futures contract for the 3-month Canadian banker’s acceptance (BA) has pulled back to 95.52, which is the lowest since late November. The way we interpret this is by subtracting the contract value from 100, which gives us a yield of just under 4.5%. The current 3-month BA rate (the underlying rate is referred to as CDOR, or Canadian Dollar Offer Rate) is currently around 5.35%, so this implies a decline of around three-quarters of a percent by expiry of the contract in December. Translating that back to the Bank of Canada’s overnight rate target would suggest a decline to 4.25% from the current rate of 5%. Back in December, the market was pricing in an implicit decline of a percent. Note, this is simply the implied rate from a market instrument and not a forecast.

 

The adjustment in views towards what central banks will do with rates this year has also been reflected in bond yields. Sticking with the Canadian market, the 5-year government yield has moved above 3.60% this week, after trading below 3.2% in late-December. The 10-year yield has risen to above 3.5%, which represents a pullback of half a percent from the December lows. As yields rise, the price of a bond declines so investors will have seen the value of most of their bond investments slip since the start of the year (whether individual bonds, mutual funds or ETFs).

 

 

 

 

For some investors, this might remind them of what happened during the May-October period of last year or even the larger correction in bonds in 2021 and 2022. The above chart shows the Bloomberg Canadian Aggregate Bond total return index going back to early 2021. The decline to the low point in October 2022 was around 17%, which was a major decline for bonds. Last year, we saw a pullback of roughly 7% and, so far, the index is down close to 3% from its December high.

 

The analogy I use to explain the development of the bond market since the post-pandemic inflation run-up is that it’s like throwing a rock into a pond. The initial wave kicked up is large, but dissipates the further away from the incidence you get. The extreme bullishness that enveloped the bond market back in the fourth quarter, on speculation that central banks would cut rates rapidly in 2024, was clearly overdone, but as I stated at the outset, the fundamentals really haven’t changed. Nor have the intentions of central banks. Rates are going to be lowered, but at a pace that is consistent with the medium-term evolution of the economy and inflation.

Unfortunately, some investors may respond to recent moves in the bond market in a similar fashion to what we saw at the start of last year. If they had (correctly) moved money back into the bond market after the 2021-2022 sell-off, they might get nervous and start selling, for fear of losing capital. If they had cashed out and never returned, leaning more towards investments like GICs or money market funds, they might simply stick with that strategy. Both decisions, in our opinion, carry risk.

 

Not moving money into bonds with longer terms to maturity presents an opportunity cost of missing out on potential capital gains once policy rates start to move lower. As I have discussed before, we aren’t talking about the types of gains one would expect from stocks, but in a relatively low risk asset class, even single-digit gains in bond prices can push total returns up close to 10% or more in the space of a year. For example, the Canadian 10-year bond future rose close to 9% in the fourth quarter alone and even if 10-year yields only returned to where they were in the summer of 2022 (around 2.6%), this could give us another 9% lift.

 

 

 

 

The other problem is what we call “reinvestment risk”. This is where investors buy short-term vehicles (like a 1-year GIC or money market), only to find that rates are lower at maturity. Of course, this depends on where we think policy rates will go and where short-term GICs and money market rates will be. Let’s assume that the Bank of Canada ends up lowering rates by two percentage points between now and the last rate cut. That would take us to 3%. Money market rates would be close to, or below that level, while 1-year GICs might be in the 3-3.5% area.

 

Does the investor roll into another 1-year GIC or stay in money market, in hope for rates to move higher down the road? What if the economy weakens and rates head lower instead? This is reinvestment risk and the biggest problem is that once the individual decides to finally extend term, either in a GIC or bond, then this might be actually at the peak of the bond market cycle. In other words, they risk getting caught in a similar trap to back at the start of 2021.

We do not believe that 2022 represented the end of the 60/40 portfolio, nor did it change the basic rules of dynamic portfolio rebalancing. When bond yields get to unsustainable levels, you trim back on duration and when the opposite happens, you should be extending term. This will get you out of the vicious circle of becoming underweight bonds and overweight stocks at the wrong time in the cycle.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

 

Andrew Pyle

 

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Ally Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Ally Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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