Inflation, Interest Rates Take Toll on Bond Markets

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Patrick O’Toole

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Patrick O’Toole vice president, fixed income, CIBC Asset Management.

Well, it’s been pretty tough for the bond market for the past year or so. We’ve seen a pretty material rise in yield that’s resulted in the worst returns the bond market has ever seen. That resulted really from the speed of recovery in the pandemic, once economies reopened, and more so from the rise in inflation that was initially thought to be transitory, but it’s proved to be more persistent. So the result has been the start of a rate hike tightening cycle by both the Bank of Canada and the Federal Reserve in the US. And both are now moving higher in half a percent increments, as opposed to the traditional quarter percent increments they usually do when raising rates. And they’re doing that because they’re trying to move quicker to move inflation lower and reestablish their inflation fighting credentials, but there are risks and the risks are really twofold.

The first risk is that the central banks move too slowly to try and bring inflation back down. That could result in inflation staying higher for longer than they’d like, meaning they’d have to move more forcefully later. And the second risk is that the central banks move too quickly, of course, and tighten policy too much, thereby choking off the recovery and leading to recession in the next year. Now the jury’s still out on which way they’re going to go. No one knows. But regardless we believe the Bank of Canada won’t be raising rates as much as The Fed. And that’s due to the higher household debt levels in Canada and the greater sensitivity to higher interest rates we have on this side of the border, partly due to our housing market.

So the outlook is for central banks to continue to raise rates through the summer. And then we’ll see from there if they need to do more. We could see a pause should we see the economy wobble due the rate hikes that we’ve seen thus far and a couple more hits. But regardless the bond market has built in the vast bulk, if not all, of the rate hikes that are expected. And we know that by looking at the rise in short and long term bond yields.

Two year yields in Canada, as an example. They’re already above three and a quarter percent at mid-June and they priced in the Bank of Canada raising its rate to about three and a half percent by year end. And longer term yields, 30 year bond yields, are actually lower than two year yields. And that really reflects the belief in the market that inflation’s going to move back closer to target within the next couple of years. So we think that over the next year, we’ll see some of the expected rate increases moderate somewhat leaving bond yields a bit lower than where they sit today.

So when we look at what’s going on in the bond market and what’s being priced in already, we look and see that short term yields are higher than long term yields as I mentioned. And that reflects the expectation that the central banks are going to be pretty aggressive in moving rates higher in the next year. But if you look at the futures market and what it’s priced in, it actually has interest rate cuts priced in within a couple of years. That’s a bit new or a bit different this cycle compared to prior cycles when you see the central banks looking to start to raise interest rates, which they’re well under way in the start of that rate hike cycle already.

The Bank of Canada has already moved its rate from a quarter percent at the start of the year up to one point a half percent. And the Federal Reserve is going to be hiking its rate here in mid-June as well. So it’s different in that when a rate hike cycle starts, you generally see the market pricing a few hikes, and then as the central bank starts raising rates, they price in more and more. This cycle’s a little different that we’ve priced in three percent plus of rate hikes in the next year or so. And then within a couple of years, actually starting to see central banks cutting interest rates a little bit, and that’s a bit unique this time.

It just tells us that things are moving faster to price in what’s likely to come. And really when you look at the longer term bond yields in Canada, the fact that they’re lower than short term yields I think reflects that expectation that the central banks are going to be done raising rates in about a year or so. And it also reflects a rising risk of recession in 2023. And as a result of that, they’re already pricing in the central banks cutting rates at some point in the next two years.