Ongoing fears of inflation and the prospect of higher interest rates have created an unfriendly environment for bondholders.
“What we’re seeing is elevated inflation,” said Patrick O’Toole, vice-president of global fixed income with CIBC Asset Management, in a Nov. 25 interview.
“There’s been this tug of war between those who think it’s transitory, as the central banks have been talking about, and those who think it’s more persistent.”
Central banks shifting gears have “spooked the market” to some extent, he said. While last year the U.S. Federal Reserve said interest rates would remain near zero until 2024, the central bank last week said it would end its bond purchases earlier than forecast and likely raise rates three times next year. The Bank of England went one step further, becoming the first central bank in a major economy to hike.
The Bank of Canada, meanwhile, held its overnight rate on Dec. 8 and maintained its guidance that it would likely keep the overnight rate at 0.25% until sometime between April and September next year.
However, depending on how the omicron variant affects the economy, some analysts said the BoC could move earlier.
RBC senior economist Josh Nye said the economy could reach full capacity sooner than the central bank expects, which could lead to a more hawkish tone in January.
“Markets are now pricing roughly 50/50 odds of a rate hike at that meeting though we think it’s more likely the BoC will signal upcoming rate hikes rather than actually raising rates in January,” he wrote in a Dec. 8 research note.
O’Toole said a hike as early as April is “sooner than the market had expected,” forcing futures markets to adjust. Before omicron led to fear of more shutdowns, O’Toole said the futures market was expecting four to five hikes in the next 12 months and two to three in the U.S.
He added that futures markets have “notoriously been wrong and too aggressive in expecting rate hikes.”
O’Toole said he believes central banks will move slower in raising rates, given that “both the Bank of Canada and the Federal Reserve have put a greater focus on achieving full employment before hiking rates.” By full employment, O’Toole clarifies that they mean for all parts of the workforce, including the less advantageous.
However, O’Toole said that while the central banks seem to have set a target, the bond market could derail policy-makers’ plans with what he calls a “Mike Tyson moment.”
Mike Tyson is famous for saying, “Everyone has a plan until they get punched in the mouth,” and O’Toole said that blow could come from longer-term bond yields spiking higher.
So far, bond investors aren’t concerned enough about inflation that they’re demanding a higher, longer-term bond yield to compensate for that risk, he said. “We haven’t seen those yields moving materially higher.”
Canada’s 10-year yields were at a one-year high around 1.8% near the end of November, when O’Toole spoke, but they’ve since fallen below 1.5%. U.S. 10-year yields are also below 1.5% after approaching 1.7% a month ago.
“To a certain extent, you could argue it’s a stamp of approval from the bond market that agrees with the Federal Reserve and the Bank of Canada, that inflation is actually going to be falling next year and will get closer to that 2% target both central banks have sometime by late 2022,” said O’Toole.
On the flip side, O’Toole said it could also reflect concerns that the central banks will be too aggressive in raising rates next year, “thereby resulting in the economy slowing faster than some think.” In other words, tightening monetary policies too soon and too fast.
Having said that, bond yields or longer term interest rates should move up a bit next year, while GDP and inflation slow to around 3% in Canada and the U.S., O’Toole said.
“That should justify the bond yield moving up a little bit,” he said. “Maybe just perhaps not as soon as the market’s currently expecting.”
So what does that mean for investors?
O’Toole said investors should look to funds that offer diversification away from typical Government of Canada bonds and typical investment-grade corporate bonds, and look instead to products that include high-yield bonds and emerging market bonds, private debt, and “other things to enhance returns.”
“We think some of those alternatives will provide better returns than domestic bonds,” he said.
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