Andrew Pyle
April 12, 2024
Another transitory bond market retracement, or is it?
In past commentaries, we have reviewed the corrections in global bond markets since the post-pandemic surge and the how the amplitudes of these pullbacks were diminishing as inflation rates fell and central banks paused or ended their tightening programs. Progress was always going to be uneven, mainly because the effects of the pandemic and geopolitical shocks would take time to work through the system, not to mention that there has been an utter lack of fiscal policy discipline. Over the past few months, the bond market has again suffered declines – more modest again, yet some are wondering if the recovery can get back on track. In other words, are we watching a market dealing with rationalizing things like “when is the Fed going to cut?” or something more problematic?
Let’s begin with some post-pandemic perspective. The chart below shows the generic 1st contract for the U.S. 10-year treasury futures contract. Rather than just focusing on yields, this shows us the movement in price and, as the past few years have shown us, price can eclipse (pardon the pun) what we earn as interest on a bond. As you can see, the contract peaked at the incidence of the pandemic for two main reasons. There was a sudden flight to quality away from risk assets, like stocks and commodities, as we shut large swaths of the global economy down, and there was an expectation that the Federal Reserve and other central banks would have to engage in aggressive monetary easing to rescue the economy.
As we entered the summer of 2020, investors flooded back into risk assets as it appeared that the cataclysm was not going to be as bad as initially anticipated. Official rates were already cut to near zero in the U.S. and Canada (negative in other parts), so bonds had seen their best days. Hence, bond futures began what would become a very painful journey downward. By the end of 2020, it had fallen 10% from its peak. In 2021, it lost another 8%. To its low point in October 2022, the contract had shed another 25%. But then came the reprieve, or so we thought. By April 2023, it rallied 13%, only to shed another 19% by last October. Then, by the end of December, it was up 16% as the Fed excited everyone with its pivot guidance towards lower rates this year. Well, thanks to another stronger-than-expected U.S. CPI print this week, the contract is down 8% from its December high.
For now, however, we are still in a pattern of smaller pullbacks and if we manage to see a floor to this latest retracement in the coming weeks, it could signal the start of a new pattern of higher lows. The dilemma for bond traders is that many thought the exact same way in March of last year, when the contract bounced before returning to its lows from October and November 2022. The bounce ended 12 months ago and by August, the contract broke below its March low. The sell-off continued to last October. Is this just because market participants are disappointed by the prospect of perhaps no rate cuts this year, or is there something else going on?
The window for a shift in Fed policy has certainly narrowed as a result of recent inflation reports. There are four FOMC meetings left before the November Presidential election – May 1st, June 12th, July 31st and September 18th. Given that there is only one last piece of the inflation puzzle before the May meeting (March PCE data on April 26th), this would have to show a miraculous softening in inflation to warrant a cut that meeting. That’s not happening since we already know most of the PCE, now that the consumer price and produce price figures are in.
What is interesting is that the Fed will get two more CPI reports before its June meeting, since the May report lands right on the meeting date. Therefore, it is possible that those two additional reports show inflation heading back down enough to allow for a first cut. Assuming the data remains friendly, the Fed could even go again in July. The September meeting becomes a little trickier as it is right on the doorstep of the election. I wrote about this the other week and it’s not that the Fed has never made a move in front of an election, but without a really solid reason to do so, officials would likely prefer to hold off until the December meeting.
If, on the other hand, the next few CPI reports show an upward trend in either headline or core inflation (or both), then the probability of no cuts before the election will rise. This would probably send fed funds futures lower still and negatively impact bond prices. Even still, simply moving the timing for a first rate cut out another six months should not send bonds to levels we saw back in October, which means a general pattern of improvement could stay intact. Not all areas of the market would be affected the same way, but the consensus today is that the least impacted would be relatively short maturity investment grade corporates. If a period of higher rates for longer was seen as causing the economy to materially weaken, potentially causing a risk-off situation, then longer-dated government bonds would probably fare better. Keep in mind that there could be an increase in market uncertainty and volatility prior to and after the U.S. election, which will also affect relative performances between the different segments of the market.
There is one other thing that we need to consider, and it has nothing to do with what the Fed is doing or where inflation is and that is the current state of fiscal policy. It is clear that the U.S. has missed a golden opportunity to address an excessively large budget deficit, made worse by the pandemic. If the economy is so resilient that the fasted pace in monetary policy tightening in decades has had only a marginal impact, then why is the U.S. deficit is still close to 6% of nominal GDP and has actually deteriorated from 2022 despite the economy. The trend since the start of this century has become unsustainable and made worse by the fact that borrowing costs on the increasing size of the U.S. federal debt are going in the wrong direction. Any delay in getting rates and yields down adds to the problem. Therefore, bond investors are likely to demand higher coupons in order to compensate them for the possibility of further fiscal corrosion.
For these reasons, we have to remain nimble in terms of the fixed income portfolio. This means having a well-diversified mix of securities, from government to investment grade credit and between Canadian, U.S. and global regions. We also need a tactical weighting to cash, as well as alternative instruments that can offer some insulation against rising rates or a resurgence in inflationary pressures.
On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. Andrew and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.
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