At the end of 2022, investors felt betrayed by their long-trusted friend – the bond market. Through no fault of its own, it succumbed to the post-pandemic rise in inflation and late-to-the-rescue monetary policy tightening. That feeling of duplicity returned in October of last year, but as we approach the one-year anniversary of the highs in government yields, there has been a rekindling of the friendship. Lower inflation and expectations of central bank easing have sent yields lower and the valuations of bond portfolios higher. In addition to simply focusing on absolute movements in bond prices and yields, investors need to also pay attention to what is happening to the shape of the yield curve and whether there any clues as to where the economy and markets are heading.

Since May, the 2yr yields for Canada and the U.S. have come in by close to 1.5% and we are at the lowest levels since July 2022 for Canada and May 2023 for the U.S. This is a rapid move to be sure and on a near-term basis, one could argue that the market is a little overbought. Next week, the U.S. Federal Reserve is expected to deliver its first rate cut. After this week’s firmer than expected CPI and PPI reports, the market has had a reality check on recent anticipations of a half-point decline in the Fed’s target rate to come back home to the originally forecast quarter-point cut.

CPI and PPI data notwithstanding, it is clear that the general move in inflation is to the downside and that is reinforced by a mild deterioration in labour market activity which all things being equal should provide for weaker overall levels of consumption and a weaker trajectory for real GDP growth. That would support a decision by the Federal Reserve to not only lower rates next week by quarter point but to follow that up with further such moves over the remaining meetings this year.

The rally in bonds may also reflect a move away from cash and cash equivalents, similar to what we are seeing with respect to dividend stocks. I believe it also suggests that investors are becoming more confident that the positive correlation between bonds and stocks, that caused the damage to balanced portfolios in 2022 and parts of 2023, has diminished. There have been episodes this summer where a risk-off shift in sentiment did cause a sharp pullback in stocks and a rally in bonds, but we are far from calling the positive correlation dead. That said, anything that restores investor confidence in bonds as a defensive tool in the portfolio will reinforce the rally we have seen.

The key development from this summer’s bond market rally has been in the so-called “de-inverting” of both yield curves. When central banks began to hike interest rates aggressively, this caused short-term bond yields to rise above longer dated bonds, thus causing the curve to invert. Historically, an inverted yield curve has been seen as a precursor to a significant slowdown in the economy or outright recession. Conversely, a positive or upward sloping yield curve is generally viewed as an indicator of stronger economic activity ahead. Emphasis on the word “general” here.

In the above chart, we are looking at the spread between the U.S. 2yr treasury yield and the 10yr yield, expressed in percentage terms, back to 1990. The purple shaded areas correspond to periods where the U.S. economy was in recession. As you can see, we have just come out of an environment where the yield curve was quite inverted, with the 2s-10s spread getting close to 0.9%. As in previous cycles, this inversion prompted calls that a recession could be at hand. The jury on that call is still deliberating, and while we have not seen any direct evidence that we are in a recession, some point to the fact that the time lag between peak inversion and the occurrence of an economic contraction could simply be longer this cycle.

Today, the curve has dis-inverted to the extent that both 2yr and 10yr yields are basically in line with each other. As you know, our call is for continued rate cuts into 2025, culminating with a Fed funds rate of around 3% by the end of 2025. All things being equal, this should lead to a positively sloped yield curve, with 2yr yields possibly half a percent below the 10yr. If so, some would argue that this would be a leading indicator of stronger growth to come, although history has shown that it typically takes at least a positive spread of a percent, before growth begins to pick-up. Again, this time might be different.

But rate cuts are only one factor behind creating a positively sloped and steeper yield curve, through their influence on the short end of the curve. What of longer-term bonds? The upcoming U.S. election results will be critical on several fronts, but one thing that credit rating agencies and bond investors will be watching is the direction that U.S. fiscal policy takes post-election. Given the magnitude of the budget deficit today, anything that suggests a widening in that deficit could cause investors to price a higher probability of a credit downgrade. In other words, investors will demand a higher premium to hold longer-dated paper, resulting in a potential rise in yields and a steeper curve. Rather than viewing this shift in the curve as a positive, however, we would be cautious. Higher long-term yields would translate into a lift in borrowing costs for businesses and households, which could choke of economic growth. Such a development could also uncover fragilities in the financial system, in the same way that aggressive monetary tightening put stress on regional banks in 2023.

For now, we see the return to a more normal yield curve as a positive but will be on alert for any signs that recent inversion is playing out in a harsher form than what current indicators suggest. And, it goes without saying, that we will need to be diversified and nimble in terms of the bond portfolio heading into November.

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

Andrew Pyle