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The bond market is looking better than a few months ago after taking a beating this year, but investors should still be wary of both inflation and slowing growth, a CIBC analyst says.

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“There’s a lot that is now priced in for rates and there is a risk that the market may have become too optimistic in regard to what the Fed will be ultimately able to deliver over the medium term,” said Éric Morin, senior analyst at CIBC Asset Management, in a recent interview.

In the U.S., markets are expecting a hike of about 200 basis points over the next 12 months, which would bring the policy rate close to 3% in the second half of 2023. Morin said the rapid increase of the policy rate should slow economic activity — particularly in the first half of 2023.

As a result, small businesses have lowered their sales outlook, he said, and the end of fiscal stimulus and unaffordable housing should also impact growth.

“So the growth outlook is not compatible with rate expectations moving further up,” Morin said.

Another reason interest rates may not go much higher is that inflation — while “sticky” and likely to remain elevated for some time — is starting to slow, Morin said.

“Unwinding of transitory factors boosting inflation currently and the lag effect of slowing growth should bring inflation lower,” he said.

In this environment, bonds are more appealing than they were at the beginning of the year, Morin said, as yields are more likely to go down than up in the near term.

The FTSE Canada Universe Bond index was down more than 10% for the year at the end of May.

The long-term expected return for developed market government bonds is around 3% on average, he said, a full percentage point higher than at the beginning of the year.

“Government bonds are more attractive than they were at the beginning of the year, so this is pointing towards higher weight for these asset classes,” he said.

However, Morin laid out two key risks for his outlook.

The first is “lackluster” growth as rates move higher and the Chinese economy weakens.

In this scenario, government bonds still look attractive, he said, and “an allocation to defensive, low-volume names and sectors can help to smooth portfolio returns.”

Persistently high inflation is the other risk, which would be negative for government bonds as it could result in more rate hikes than markets have priced in, he said.

However, one factor unique to this cycle is the effect the supply shock has had on energy. Morin said an increased allocation to commodities could provide a “cushion” for government bonds in the event of high inflation.

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