Canso Market Observer: Are market expectations getting ahead of reality?
“Once it seemed that the harsh medicine of tighter monetary policy and higher interest rates might be working to slow the economy and inflation, bond yield hopes sprung eternal.”
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If the rally in long-term bonds in late 2022 is any indication, bond investors are looking forward to a 2023 in which inflation gets whipped and central banks turn the monetary taps back on. But in their latest Market Observer newsletter, published in December 2022, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. suggested that market expectations might be getting ahead of reality, as above-target inflation is showing few signs of going away anytime soon – even as investors bet on prices and interest rates getting back to ‘normal’.
To read the full report, please click here.
The more things change…
Long bond yields made an abrupt about-face in the last two months of 2022. After peaking in the third week of October, yields on long Canada bonds and long U.S. Treasuries ended Q4 lower than at the start of the quarter – and in the case of some Canada bonds, prices increased by more than 20 per cent from their October low, the newsletter observed. As inflation moderated slightly and the tea leaves suggested that central banks were at least about to pause on further rate hikes, markets breathed a sigh of relief that the end of inflation and monetary tightening was coming into view. “Once it seemed that the harsh medicine of tighter monetary policy and higher interest rates might be working to slow the economy and inflation, bond yield hopes sprung eternal,” the Canso team wrote.
Beyond such rosy expectations, the newsletter also suggested that the rally in long bonds might have had something to do with the dynamics of market bottoms. In short, it noted, “nobody was selling bonds and only buyers dominated the market,” in much the same way that during market panics, there are only sellers and no buyers. The result in both cases: “gapping” (sizeable rapid movements) up or down in prices, as traders seek to capitalize on the imbalance between supply and demand. “On the way up in price, a trader asked to offer a security without an underlying inventory position will build in a substantial premium to protect their exposure,” the Canso team noted. “That gaps prices upwards.” With overall trading volume very low, investors looking for a market turn might be skeptical that the late-2022 rally will have legs.
Priced for perfection
As it stood, however, yields on long bonds at the end of 2022 suggested that markets expected rates were going to come down and long-term inflation would revert to the U.S. and Canadian central banks’ 2 per cent target. That seems overly optimistic, the Canso newsletter argued.
To gauge market expectations of inflation, the Canso team looked at the break-even spread, or BES, which is the difference between conventional (nominal) bond yields and yields on inflation-linked (real return) bonds. During the height of the inflation scare last year, the BES on long bonds soared to nearly 3 per cent, but by late 2022 it had reverted to its level for most of the past 20 years – around 1.9 per cent to 2.0 per cent. That might seem heartening, but the picture is less rosy when you compare the BES to yields on long bonds. With the Canada 30-year paying 2.8 per cent at year’s end, the real yield (yield above expected inflation) was only 0.9 per cent. “While 0.9 per cent above inflation might seem ample, it is very low from a historical point of view,” the Canso team wrote. “In fact, … the ‘real yield’ above inflation of the Canadian long bond has seldom been below 1 per cent, except in period of higher inflation like the 1970s.”
The newsletter further observed that the average historical real yield on a long Canada bond is 3 per cent. “To get there, CPI inflation would have to drop to almost zero, at 0.2 per cent, which doesn’t seem likely, short of a severe recession,” the team explained. They also pointed out the current real yield on long bonds (yield minus current CPI) is -5 per cent, the most negative since 1955.
Inflation’s long goodbye?
In short, investors seem to be waving goodbye to inflation (and higher interest rates), expecting CPI to return to target and are willing to accept lower-than-historical-average yields while they’re at it. But the newsletter suggests that markets’ anticipation of inflation’s demise might be premature. In other words, elevated inflation could well stick around a lot longer than investors expect.
Why? Consider history. The newsletter points to what happened with inflation after the recession of 1975. Recessions are highly effective at reducing inflation, and even though the 1975 downturn was relatively shallow, it did cut inflation, from 12 per cent to 6 per cent. Policymakers were quick to take their collective foot off the monetary brakes. And then, quite promptly, inflation came back with a vengeance as central banks relinquished control. “Inflation subsequently jumped from 6 per cent to the peak of over 12 per cent before the even more severe recession of 1980 lowered it to 4 per cent,” the Canso team wrote. “That sounds a trifle ominous to us and central bankers, it seems.”
Not dead yet!
The question is whether the economy is set for an upward wage-and-price spiral like in the 1970s. The newsletter noted that the consumer price index (CPI) seems to have settled into a range above 5 per cent, while wage increase expectations are hovering around 5 per cent as well, owing to continuing strong labour demand amid mass retirements among older workers. “Ample money supply and continued strong demand meeting reduced labour supply is a recipe for strong wage increases,” Canso wrote.
Of course, a recession would (probably) be an effective inflation-killer. But looking at the data, the Canso team found little indication such a sharp slowdown was imminent. Corporate credit spreads – a reliable indicator of recession – have expanded to levels seen during some, but not all, recessions; in fact, “there have been 5 or 6 periods with corporate spreads at these levels without recession,” the newsletter observed. Declining corporate profits are another good recession bellwether, and they have indeed fallen (by about 12 per cent). On the other hand, they have not fallen by nearly as much as during the Great Financial Crisis in 2008 or the European debt crisis of 2015, when Canadian companies’ operating profits plummeted by 30-40 per cent.
What bond investors should do now
It’s not necessarily what they are doing. Inflation is still looking sticky, while there are few signs that an inflation-reducing severe recession is imminent. “It is not reasonable to think the [Bank of Canada] will reach its 2 per cent [inflation] target any time soon, looking at current core inflation and wage growth running near 5 per cent,” the Canso team wrote. But the “BES shows that Canadian bond investors have already declared victory and impound 2 per cent as inflation for the next 30 years!”
In reality, inflation could hang around and stay higher for longer than markets expect. So could rates, with core inflation running above 5 per cent and wage pressures still elevated. Secular trends, like deglobalization and onshoring, are inflationary tailwinds and could mean that “domestic labour has more bargaining power,” the team observed. “That means wages could be sticky on the upside.”
In Canso’s view, the one bright spot is that short-term interest rates and yields have risen enough to provide a reasonable return to investors. A 1-year Canada bond held to maturity, the team noted, would pay out a “handsome” 4.3 per cent – about six and 27 times more than in December 2021 or December 2020, respectively.
Attractive yields suggest that short-term bonds still look like the place for investors to be. But as the newsletter noted, “when a market wants to rally, there’s no stopping it.” Despite worrisome signs on the horizon, investors have been placing their bets on long bonds, counting on the yield curve normalizing and on central banks declaring “mission accomplished” in the war on inflation.
“If the central banks are truly serious about crushing inflation, they can do it, as the Fed did in 1981,” the Canso team concluded. “On the other hand, as we know from the lateness of the central banks’ response to pandemic cost pressures and the non-temporary inflation we are now experiencing, central bankers might want to appear omnipotent, but they are only human.”
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.
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