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Patrick O’Toole, vice president, global fixed income, CIBC asset management.
There’s been a flood of debt in the bond market due to Covid as central banks essentially print the money that governments want, to cushion the blow. And normally economists would warn us that that money printing would lead to higher bond yields and higher inflation. You get higher yields because more supply usually needs higher yields to attract buyers, and you get higher inflation generally resulting from all the money circulating through the economy that chases prices higher. It’s like the old economic story, more demand than supply. But it’s not happening. Yields have fallen and inflation expectations were maintained.
Low yields mean savers need to tuck away more money to generate the income they need in retirement. And we’ve seen that happen in those countries where yields have turned negative. And with central banks buying the bonds issued by governments, there’s less supply for private investors, so yields have actually fallen.
You also have the demand for goods and services has fallen, too, so there hasn’t been that excess demand that would normally drive inflation higher.
So despite a record amount of supply in the first half of 2020, there’s been no trouble digesting the bonds.
Now, what are the implications of this going forward? Well, we don’t see much of a change in the dynamics. The data we’ve seen from the U.S. shows more money going into fixed income and coming out of stocks. Inflation expectations are a little bit higher than at the worst point that we had the economic shutdown, but they’re not materially higher.
We think that investors are rationally adjusting to the guidance we’ve seen from the Fed and the Bank of Canada. And the Fed gives us guidance through something called the dot plots. And they survey the Fed governors every second meeting, and those governors collectively think that there’s no change in the current 0% to 0.25% target for the Fed funds rate until 2023. Now, the Fed may also do yield curve control, meaning they would put a ceiling on how high government bond yields of a certain maturity would be allowed to go. And that may be coming as soon as September. The Bank of Canada could easily follow the Fed’s lead in that regard.
That leaves investors with the choice of extremely low yields on the safest government bonds. Or you can look to alternatives with higher yields like investment-grade and high-yield corporate bonds and global bonds. Now, those sectors generally outperform government bonds in the long run, but there’s no doubt they can run into trouble over shorter term periods like we saw in the latter half of the first quarter of this year. But you manage that risk by buying broadly diversified products where managers manage the credit risk for you. And you make sure you’re buying something cost effective, however — you don’t want to be paying elevated fees for this. But look for an experienced fixed income team with the resources that have an in-house credit analyst team that understand the risks of investment-grade and high-yield companies.
But know, still, when you’re buying these sectors, there remain risks at all times when investing. No one knows—we could have a strong second wave of infections, not just a bit of a resurgence like we’ve seen recently, that results in a more broad shutdown in the economy again than we expect. That would hurt corporate bonds while government bonds would benefit like we saw in the first quarter of 2020. Inflation could come back stronger than expected to. After all, the money printing in this episode far outpaces anything we’ve seen since the end of World War II. And that would see government bond yields rise as investors look to be compensated for the loss of purchasing power from higher inflation. And we could see stocks have a collapse again. That would hurt corporate bonds as well given riskier assets tend to get hit at the same time, and corporate bonds are riskier than government bonds.
We always really recommend: don’t be fearful. We’ve seen the economy and markets where there are a lot of, quote unquote, once-in-a-lifetime shocks in this century that have caused upheaval like Y2K, 9/11, or the Greek crisis in 2011, China had a crisis in 2015, early 2016. Of course, you had the great financial crisis and now we have the pandemic. But each time, we weathered the storm.
Markets are resilient, the world isn’t ending, capital needs to be deployed, societies continue to advance. So be cautious in trying to time markets. Always remember it’s time in the market that matters.