Inflation, interest rates take toll on bond markets

As central banks raise interest rates to combat inflation, the bond market feels the pressure. 

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“It’s been pretty tough for the bond market for the past year or so,” said Patrick O’Toole, vice-president of global fixed income with CIBC Asset Management, in a recent interview.

The material rise in yields over that period, resulting from post-pandemic recovery and inflation, resulted in the worst returns the bond market has ever seen, O’Toole said.

As both the Bank of Canada and the U.S. Federal Reserve raise rates — recently, in increments that were larger than typical — the risks are twofold, O’Toole said. 

First, if central banks move too slowly to tame inflation, inflation could stay higher for longer and force the central banks to move more forcefully later, he said. Second, if they tighten too quickly, they could choke off recovery and cause a recession in the next year.

The “jury’s still out” on which way the central banks will swing, O’Toole said. As things stand, the outlook is that both central banks will continue to raise rates through the summer, he said, and then evaluate whether further hikes are needed. The Bank of Canada likely won’t raise rates as much as the Fed because of higher household debt levels and a greater sensitivity to higher interest rates, he added.

The Bank of Canada has moved its key rate to 1.5%, up from 0.25% at the start of the year. Last week, the Fed hiked its benchmark short-term rate to a range of 1.5% to 1.75%.

The bond market has already priced in the majority of the expected rate hikes, with short-term yields higher than long-term yields (two-year yields in Canada have risen above 3.25% this month). That reflects the expectation that “the central banks are going to be pretty aggressive in moving rates higher in the next year,” O’Toole said.

At the same time, the futures market has priced in interest rate cuts within a couple of years, he noted.

“That’s a bit new or a bit different this cycle compared to prior [tightening] cycles,” he said, referring to how quickly the markets have priced in rate expectations. The pricing in the bond and futures markets “tells us that things are moving faster to price in what’s likely to come.” 

While lower long-term bond yields relative to short-term yields reflect the expectation that the central banks will be done raising rates in about a year or so, he said, they also reflect a rising risk of recession in 2023, and thus the pricing in of rate cuts.

Over the next year, O’Toole’s expectation is: “We’ll see some of the expected rate increases moderate somewhat, leaving bond yields a bit lower than where they sit today.”

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Maddie Johnson

Maddie is a freelance writer and editor who has been reporting for Advisor.ca since 2019.