How Rising Rates Are Impacting the Bond Market

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Éric Morin, M.sc

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My name is Eric Morin. I’m a Senior Analyst at CIBC Asset Management.

There’s a lot that is now priced 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.

So in the US right now markets are expecting about 200 basis point hikes in the next 12 months, which would bring the policy rate close to 3% in the second half of 2023. While this is not materially above the Fed’s long-term neutral stance of about 2.5%, the sharp or the rapid increase of the policy rate itself, should slow material economic activity, particularly in the first half of 2023.

We’re reflecting this. Small businesses have already lowered materially their sales outlook. And the outlook has also been by the effect that quantitative tightening will have and also by a negative fiscal impulse and by unaffordable housing. So the growth outlook is not compatible with rate expectations moving further up.

The other reason supporting our view of limited upside on rates is inflation, which should start to slow. Unwinding of transitory factors boosting inflation currently and the lag effect of slowing growth should bring inflation lower looking ahead. However, we have to keep in mind that inflation should nonetheless remain elevated for an extended period of time. So if we were to expect some downside prospect for rates, it could be limited given the… How sticky inflation is.

Regarding our outlook for government bonds. We consider that they are more appealing than they were at the beginning of the year. At first, yields are… Have moved up. They are higher than bonds by… Because of that are more attractive. The other reason is that we believe that the pronounced increase of rate hike price has planted the seeds for future positive performance of bonds and developed markets as yields face limited upside in the near term and most likely some downside over the medium term.

Looking at our fair value matrix, we now estimate that the long-term expected return for government bonds is about… In developed market is about 3% on average. This is about one percentage point higher than at the beginning of the year.

Regarding asset allocation. What kind of adjustments should investors consider for their asset allocation? Well, bonds. Government bonds are more attractive than they were at the beginning of the year, so this is pointing towards higher weight of these asset classes.

But also investors should be mindful of the most important risks surrounding our outlook. We see two important risks. The first one is a negative one. It’s that global banks aren’t lending. While central banks are hiking rapidly to curb inflation, we also have the Chinese economy that is weak and we don’t expect a large-scale stimulus in China. And this is pointing towards a global growth and development that will be lackluster with some downside risk. So in this environment, government bonds look appealing. They look attractive in this environment. And more generally an allocation to defensive, low volume names and sectors can help to smooth portfolio returns.

The other risk that investors should keep in mind is the risk of persistently high inflation. And this risk could materialize looking ahead due to several factors, such as the ongoing and lingering impact of the Ukraine war on food and energy prices. Due potentially to also insufficient supply of new housing units in Canada and the US, which would bring more upward pressure and inflation. Another factor also that could bring… That could make inflation more sticky and keep it elevated is the fact that we may be underestimating the strain of underlying demand in the US and Canada, which would result ultimately in higher inflation.

So this environment of higher inflation would be, of course, negative for government bonds, as it would mean potentially more rates and more rate hikes than what’s priced. And also another factor that investors should consider for that risk of high inflation is that government bonds or first government bonds are… Would be vulnerable in this situation. But we have also to keep in mind that one thing that is unique in this cycle is the nature of supply shock on energy. And this could be compatible with an increased allocation to commodities, which would provide a cushion to the risk of high inflation scenario and would also provide some cushion to government bonds.