Back in the fourth quarter, when economic prognostications were turning negative and central bankers were chirping about providing some interest rate relief, the bond market had a grand old time. Government and corporate debt took off and it looked like fixed income investors were going to recover some of the capital lost during the 2022 meltdown. In hindsight, the euphoria proved to be premature, much like the previous rally attempt in the first half of 2023; however, developments in recent weeks have given investors reason to be at least cautiously optimistic that a recovery might just stick this time.

 

 

One way to show the journey of the U.S. bond market over this period is by looking at an aggregate index or, in this case, an ETF that tracks it. In the chart above, we are looking at the iShares Core US Aggregate Bond ETF (AGG). It shows the deterioration in the market from 2020 through to the third quarter of 2022, the subsequent and temporary recovery, and then the pullback from late summer to October of last year. It currently trades around $97.80, or about 3% above the April lows. The fact that the dip in April did not take us back to the worst levels of last October is a positive, as we can now set up a pattern of higher lows.

 

For now, the best performance since April has actually been in longer-dated bonds. This might come as a surprise, considering economic data has tended to support Fed easing this year and hence support for shorter maturity bonds. In fact, the 2-yr treasury yield has fallen about 0.25% since end of April, compared to a 0.35% drop in the 10-yr yield. In April and in late May, the 2-yr U.S. treasury yield came close to 5%.  This month, we are seeing it settling in around 4.70-4.75%.  A break below 4.70% would set it up for a return to pre-April levels, but again it is unrealistic for now to predict a full reversal in the yield down to the 4.1% region seen in January. If the forecast of two fed cuts (see our blog from this Wednesday) is reasonable, then we should see the 2-yr yield test down in the 4.5% area, provided fundamentals remain supportive this summer. Here, the news appears to be good – for now.

 

 

On Wednesday, the U.S. CPI report for May came in softer than what the street had expected, with the headline index flat on the month, leading to a one-tenth decline in the year-over-year inflation rate to 3.3%.  The core index (excluding food and energy) rose by just 2-tenths on the month, notching down the year-over-year rate to 3.4%.  Both inflation readings are still far from the Federal Reserve’s 2% objective, but movement in the past two months does paint the March blip in consumer price inflation as just that – a blip.

 

There was also good news with respect to producer prices, or the prices that producers are receiving for their output.  After four straight months where seasonally adjusted prices were rising at an average clip of close to 0.6% per month, the index saw a decline of 0.3% in May.  This took the year-over-year number down to 2.2% from 2.3% in April.

 

If you recall, last week’s decision by the ECB to lower rates was accompanied by a forecast by the central bank that inflation was going to come in higher next year, compared to its previous forecast.  The Federal Reserve did the same thing this week, though it didn’t cut rates.  It’s forecast for the personal consumption expenditure (PCE) deflator inflation rate is now 2.6% for year-end, versus a 2.4% prediction back in March. Core PCE inflation is now put at 2.8% at year-end – two tenths higher than its March call. In fact, the Fed doesn’t see core PCE inflation getting back to 2% until after 2025.

 

Source: Factset Research Systems

 

Most market participants and economists knew that the so-called “last mile” in the battle against inflation was going to be harder than the initial wins and there are good reasons for the Fed to lift its projections, at least for this year.  While the increase of 0.2% in both headline and core CPI in May was the smallest we have seen this year even if we averaged that monthly pace over the remainder of this year, we would see year-over-year inflation increase into year-end. In fact, if you run the numbers the headline inflation rate would rise to 3.8% by December and core inflation would reach 3.6%.

 

The reason is that both indexes declined on a month-over-month base through the fourth quarter of last year, which creates a base effect for this year. Now, the Fed knows this, as do most other economists, but I would argue that these higher readings on inflation are going to come as a bit of a surprise to some and the optics of quickly lowering rates in front of a predicted pop in inflation could reinforce whatever market turbulence we are dealing with in front of the U.S. election.

 

Source: Factset Research Systems

 

It is still possible that consumer price increases could continue to soften and that we see a few months of actual declines, similar to what took place towards the end of last year. As we noted in this week’s conference call, there are definitely signs of cooling in the economy. Last Friday’s payrolls report may have surprised on the upside, but initial jobless claims also rose to a 10-month high of 242,000. The figures tend to lend more credence to the more than 400,000 decline we saw in household employment last Friday and if this weakening trend persists, then consumer demand could slip and with it, prices.

 

For investors, it is important to not get carried away with the month-to-month gyrations in either data or market responses. Getting back to whether this recovery in bonds can stick this time, it’s not of matter of returns between now say the fall, but where we expect to be by the end of next year. In a 2% to 2.5% inflation world by that time, central bank rates should be able to decline by at least a percent in my opinion. If we don’t see a major dislocation to the economy, both investment grade corporate and government bonds should be able achieve high single-digit returns from a combination of coupons and price appreciation. Keep in mind that the Canadian outlook for bonds is probably even better, given that we have already seen the first of an expected several rate cuts.

 

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. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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