Don’t Overlook Bonds Ahead of a Recession

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Adam Ditkofsky, CFA

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Adam Ditkofsky, senior fixed income portfolio manager at CIBC Asset Management.

With central bankers in North America on pause, basically the question is how are bond markets responding?

So on May 3rd, the Fed executed what could be their last rate hike and they’ve moved their Fed funds rate up a quarter of a percent. It’s now at five to five and a quarter. This is similar to what the Bank of Canada did in early January or in January when they highlighted further actions, when they hiked rates to four and a half percent. Any further actions would be data dependent. They put themselves on what we see as a conditional pause. So essentially, as long as inflation continues to come down or move in the right direction, we can expect no more rate hikes from either the Federal Reserve or the Bank of Canada. Again, they have to be confident that inflation is moving back to that 2% target.

So in terms of reaction, the bond market has actually been fairly stable since the Fed’s May 3rd rate decision, which is surprising as short dated bonds have seen close to record volatility this year with the market trying to anticipate what the Fed and the Bank of Canada’s next actions are going to be. In fact, what may seem surprising to some investors, we’ve actually seen bond rates move modestly higher in the days past that May 3rd meeting. Now, a big part of that is really because of the strong reaction on the day of the announcement where we actually saw bond yields rally, but essentially what we could say since the effective pause, the boat the Fed is on now or is expected to be on now, really bond yields have been fairly stable. And then I think the main reason for this is the fact that the bond market has been pricing in a pause by the Fed ahead of this meeting, especially after the collapse of the Silicon Valley Bank and the Signature Bank and Credit Suisse.

At that time, the futures market started pricing in rate cuts within six months. The market essentially was already pricing in that the Fed had potentially one more hike in ahead of that meeting and that they would have to go on pause because they were already starting to see cracks in the market.

Corporate bonds have also been fairly stable since the Fed’s announcement at their current levels. With the current spreads, meaning the difference in yield between government bonds and corporate bonds, which in Canada right now is approximately 160 basis points, I’d say they’re already at stress levels. The question to pose is can credit spreads improve or worsen from here? And that really depends on the outlook for the economy and what happens with inflation.

So many investors are pricing and rate cuts later this year, and what’s our outlook? As I mentioned earlier, the future’s markets now pricing in that the Fed and the Bank of Canada will start cutting rates in the next six months. If you look at history and every rate hiking cycle, going back to the early 70s, on average the Fed has started cutting rates six months after the last hike. We aren’t surprised to see this market reaction, but unfortunately we think the market is likely getting a little ahead of itself this time. Let’s not forget that the Fed remains committed to bringing inflation back to its 2% target. And while it’s definitely been coming down from the highs we saw last summer of eight to 9%, we’re still well above target right now between roughly four and 5%.

With the Fed and the Bank of Canada wanting to regain their credibility, we expect they want to see strong data and have confidence that inflation will continue to come down. So unfortunately we don’t see any rate cuts this year unless something in the market breaks, such as a material situation where liquidity in the market materially deteriorates.

Now, in terms of our outlook for the next 12 months is that we are calling for a recession both for Canada and the U.S. over the next 12 months, and we’re already starting to see signs of consumer spending pulling back and the business outlook has been deteriorating. Now we’ve also had issues in the regional banking system, particularly in the U.S. and we’ve been seeing the exodus of deposits to higher yielding money market funds. This could also have a negative impact on future lending by regional banks, which are a big part of the banking system in the U.S.

Now, labour data has been strong. We’ve definitely seen very strong labour numbers, it continues to be resilient. But that’s a lagging indicator and we are actually seeing early signs of cracks. So the first one being, there’s two examples. The first being we have been seeing an increase in weekly jobless claims. Those have been arising all year and then tends to be more of a leading indicator and average weekly hours worked, which is the number of hours an employee works per week. That number has been coming down. Those tend to be more leading indicators and you think about that, it makes sense as the company will try to hold onto their workers as long as possible to just cut their hours before they have to start engaging in layoffs.

So from our perspective, the prospects for the economy over the next 12 months aren’t great. Now in terms of inflation, we do see it continuing to come down, but it’s slowly and likely going to remain above that 2% for the balance of this year. Now we are seeing some very good signs of supporting further cooling. For example, specifically supply chain pressures have been normalizing and both food and shelter prices are showing signs of cooling as well. Even in the service sector, we’re seeing pressures are actually starting to improve as well. And this has predominantly been reflective of staffing issues, which you’re seeing those challenges that the service sector has been highlighting through the past 12 months. Those have definitely been coming down. You’re seeing less service companies highlighting the fact that they’re having challenges hiring people. So we do see inflation normalizing overall, just not fast enough to warrant a rate cut this year.

Given the uncertainty around inflation, which types of fixed income do we like in this environment? With the move in rates we saw last year, the backdrop we’re facing now with the potential recession, cooling inflation, and central banks being at the end of their rate hiking cycle, bonds look like a very compelling investment offering to investors today with some of the most attractive return opportunities we’ve seen in a long time. In Canada, five-year government Canada bonds today are yielding approximately 3%, which is already at their highest level since the great financial crisis. So carry alone is already decent. Then you add on potential corporate spreads and yields are more than 4.5%. Now we are somewhat cautious on corporate credit, given our outlook for recession, those credit spreads can move wider, but a lot of that has already been priced into the investment grade market.

So bottom up analysis is extremely important right now for looking at specific companies and making sure that the credits or the companies that we’re investing on maintain strong credit metrics and maintain sound profitability. Now, in terms of sectors that we like, we like energy right now, we like pipelines, we like infrastructure, and even in some cases, some commercial real estate. But the devil’s in the details there, specifically well anchored retail properties that have strong grocery tenants as an anchored tenant in many cases and properties related to senior living, which have seen a very strong recovery from the pandemic and again, continue to benefit from aging demographics.

A lot of those challenges that we saw in the pandemic, specifically as people were afraid to enter the living situations because of the spread of COVID, a lot of those concerns have dissipated.

Now, we also believe government bonds, which also look attractive, we think they’ve regained their traditional properties as a strong portfolio diversifier, especially in risk off periods. And we definitely just saw this play out in March when Silicon Valley Bank was taken over. Investors, we saw their sold stocks in a rush to government bonds.

So overall, yes, we are cautious and we remain defensive in our portfolios, but again, we do think that bonds today make sense and again, offer that diversification factor in risk-off periods and are offering attractive yields as well.