Bond markets remain optimistic on inflation — but maybe they shouldn’t be

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When the Bank of Canada (BoC) raised its benchmark interest rate to 4.75 per cent on June 7, media reports widely characterized the hike as a surprise – and some called it a shock. But should investors really have been caught off guard? In January, the BoC had signalled it was taking a pause from hiking, but inflation remained stubbornly persistent.

And yet bond markets were treating the central bank’s pause as if it was a declaration of “mission accomplished.” The 10-year breakeven spread – the yield difference between 10-year benchmark and inflation-adjusted bonds, which indicates the market’s expectations for long-term inflation – sat well below 2 per cent before the June announcement. And it stayed below 2 per cent after the hike, too.

All that suggests investors continue to believe central bankers are done (or nearly done) hiking rates to get inflation down to their 2 per cent target, and the market’s optimism about a return to “normal” inflation is proving almost as stubborn as elevated inflation itself. But is this optimism justified?

Maybe not, says Jeff Carter, Portfolio Manager and Chief Compliance Officer at Canso Investment Counsel Ltd., a leading Canadian institutional investment management firm.

In Carter’s view, “recency bias” – the irrational belief that recent events will occur again soon – might be at work in bond markets now. “Recency bias can cause market participants to believe conditions will return to what they’ve been in the recent past,” he explains. “If you look at the decade after the Great Financial Crisis, Canadian and U.S. inflation had been generally bound within a 1 per cent to 3 per cent annual range. But just because we had benign inflation prior to the pandemic, it does not mean inflation will immediately return to that range.”

Carter also thinks that markets continue to overestimate the inflationary impact of the supply chain disruptions that characterized the COVID-19 period. “As consumers, we all experienced some shortage of goods during the pandemic as production and shipping were brought to a near halt,” Carter explains.

“However, since then, inventories and services have returned.” He points out that even auto manufacturers, which experienced significant difficulties during the pandemic because of an acute semiconductor shortage, have seen production rebound.

“Despite these supply chains being repaired,” Carter adds, “we are still seeing inflation data at elevated levels, which tells us that a frozen supply chain was not the entire cause.”

For Carter and the team at Canso, the more likely driver of inflation today is the drastic increase in money supply resulting from loose monetary policy and heightened fiscal spending during the pandemic. In the U.S., M2 money supply – roughly, all the cash and deposits in the economy – increased by 42 per cent between Q1 2020 and Q1 2022, to US$21.9 trillion from US$15.4 trillion. That huge surge in money available to spend should “inevitably result in increased prices,” Carter says, “and that is precisely what we saw.” Over the three years to March 2023, prices in the U.S. increased by a cumulative 16 per cent.

The good news, at least from the point of view of fighting inflation, is that since the Fed began raising rates in 2021, M2 has declined. The not-so-good news, however, is that it will take time to unwind all that cash in the system. “Getting back to more normal levels of M2 growth will take perhaps another year,” Carter explains, “which means elevated inflation could be with us for a while yet.”

In short, if investors are expecting relief from rate uncertainty anytime soon, the still-vast excess of money in the economy might mean they will be disappointed. Of course, a shock to the system – a “black swan” event that sparks an economic crisis – could prompt central bankers to relent and begin lowering rates.

The rash of U.S. regional bank failures earlier this year sparked some concern that they could spread into a wider financial crisis, but the “bank stress seems to be localized and there has not been any contagion to the much larger money centre banks” such as Bank of America and JP Morgan, notes Carter. “We do not think the recent regional bank failures will be a reason for the Fed to pause tightening.”

Another cause for pause might be a full-fledged recession. While some observers point to the inverted yield curve as a sign of imminent recession and a reversal of central bank policy, Carter notes that unemployment is still low and inflation is still high. Meanwhile, Canso’s preferred approach to monitoring recession risk – looking at corporate credit spreads – is not signalling a downturn.

When they begin to see falling internal cash flows, corporations typically will issue bonds to build liquidity, which will tend to widen yield spreads between corporate bonds and benchmark government bonds. However, so far in 2023, there has not been any material widening of credit spreads. “In fact, we have seen remarkable stability,” Carter says, both in investment-grade and non-investment-grade bonds.

What might all this mean for bond investors? Canso continues to favour shorter-duration bonds, since subdued inflation and lower rates from central banks are anything but a given. Indeed, should inflation persist, more rate hikes are likely, and long bonds – which lost nearly a quarter of their value in 2022 – could be in for another rough ride. “We continue to believe,” says Carter, ‘that the long end of the yield curve does not offer great value with a yield of just over three percent while year-over-year CPI is running at 4.4 per cent.”

In the U.S., the yield on two-year Treasuries is about 75 basis points lower than the Fed funds rate, which implies that the markets expect the central bank to begin cutting rates next year. Clearly, Carter and the Canso team would not bet on that happening. “We believe the Fed will be steadfast in their mission to protect purchasing power by tightening monetary policy until inflation subsides,” he says.

“Last year reminded investors that not just the stock market can go down, but bonds can, too,” Carter adds. If the current market optimism on rates and inflation proves unfounded, 2023 might prove yet another grim reminder of that reality.

The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.