Expectation vs. reality: Are bond investors in for a rude awakening?

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Hope springs eternal for bond markets – or so it seems, given that bond yields remain well-anchored even though high inflation is persisting. But the markets’ expectation is one thing; reality is another. In their April 2023 Canso Market Observer Newsletter, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. looks under the hood at the factors driving inflation – and at whether it might stay higher for longer than many investors seem to hope or expect.

For the full April 2023 Canso Market Observer Newsletter, click here.

Do you believe in miracles?

The bond market certainly seems to, at least when it comes to inflation and where interest rates are headed. But the latest Canso Market Observer suggests that investors might be in for a rude awakening. “It takes considerable faith and prayer in the central bank gods to believe in inflation miracles, and that seems to be the case with the bond market,” the Canso team wrote.

Even though the Canadian consumer price index rose by 4.3 per cent annualized in March – down from the 8.1 per cent peak last June, but still well above the Bank of Canada’s 2 per cent target – investors have pushed yields on 10-year Government of Canada bonds to under 3 per cent. That suggests they believe that the Bank of Canada, like other central banks, is well on the way to taming the rampant inflation that started in 2020. And as the latest Canso Market Observer points out, the so-called Break-Even Spread between inflation-protected real return bond yields and nominal government bond yields is hovering around 2 per cent.

Basically, bond investors seem to be betting that inflation has already returned to target (or soon will), and that the post-pandemic era of higher interest rates will turn out to be flash in the pan.

The Canso team is skeptical.

One reason: “The bond market is an absolutely terrible forecaster of inflation.” The Break-Even Spread was very wrong in the ‘90s, when it indicated much higher inflation than what actually occurred, and it has been wrong more recently, since 2021, when it has consistently predicted lower inflation. As well, the current period of abnormal inflation has lasted two years – already longer than the inflation spike of 2002-03 and the deflation trough following the Credit Crisis of 2008-09.

“It took seven years in the 1990s for forecasted inflation to approach actual inflation,” the Market Observer noted. “Will it take another five years for today’s bond investors to eventually come to their senses?”

Follow the money (supply)

In declaring “mission accomplished” on inflation, markets might be underestimating the extent of pandemic-era easy money and its lingering impact. According to the Canso team, the historical growth of M2, the Fed’s estimate of total money supply, has long been around 6 per cent. Between February 2020 and March 2022, however, M2 grew by a whopping 42 per cent. The law of supply and demand dictates that such an increase had to be inflationary, in Canso’s view – and turns out it was.

Now that monetary policymakers are tightening – effectively, reducing money supply – the “real questions are, when will inflation fall, and what will it take to make that happen?” noted the team. They calculate that since the Fed started hiking last June, U.S. money supply has been declining at a rate of 3.7 per cent annually. That suggests it will not get back to prior trend (increasing “only” by 6 per cent a year) until the summer of 2024 – more than a year away. “At that point,” they wrote, “if the Fed resumes its prior rate of money supply growth, and that is a big IF, with all other things being equal, things should get back to ‘normal inflation.’” In Canada, meanwhile, money supply is still growing even after the BOC’s hikes, and the fact that the BOC has paused its rate hikes suggests that it might take even longer for inflation to get back to “normal” than it will in the U.S.

Add in the fact that expectations for higher inflation may be becoming entrenched – as reflected in higher wage settlements for unionized workers recently – and the Canso team concluded that “things on the inflation front [may] be a lot more difficult than the fashionable market crowd suspects.”

When will the hurting stop?

One way to infer whether central banks have done enough to restrict money supply and address inflation, the Canso Market Observer noted, is to look for signs of recession, and one of those is widening credit spreads. “We’ve had yield spreads trend up without recession, but we’ve never had a recession without yield spreads trending up, usually well before the recession,” the Canso team wrote.

So far, however, credit spreads are not signalling that a recession is imminent, according to the newsletter. While overall corporate yield spreads have been widening, the “quality spread between BBB and A-rated bonds is not showing signs of stress,” suggesting that “investors have not yet started to worry about lower quality bonds.” Even in the high yield market, credit concerns seem muted, with spreads sitting around the long-term average. Meanwhile, stock markets seem resilient, as does the leveraged loan market.

The Canso team also looked at yield curve inversion as a potential recessionary signal. The yield on two-year Canada bonds currently sits below the Bank of Canada’s policy rate – a classic inversion. Yet, while the newsletter noted that the inversion of -0.95 per cent is “nearing the danger zone,” it is still well off the -3 per cent or -4 per cent inversions that occurred in previous inflationary periods and helped convince the BOC to relent on rate hikes.

With mixed but weak recession signals, “it seems to us … that we’re still a long way from scarce money,” the Canso team wrote. “[We] think it is highly unlikely that [central bankers] will relent until well after inflation hits their target band around 2 per cent, so interest rates could stay higher much longer than the bond market consensus believes.”

Batten down the hatches

With money supply still high and inflation perhaps far from tamed, the base case according to Canso is that “things will get worse before they get better.” The bond market is banking on a return to 2 per cent inflation, but if that doesn’t happen – and the newsletter points out several reasons to think it won’t anytime soon – then bond investors should prepare for higher yields rather than lower.

Given market expectations, long bonds are offering very little in the way of upside, so the Canso team favours shorter-duration exposures. Meanwhile, they wrote, “inflation-linked bonds … are looking very cheap” – especially in light of the potential for inflation staying higher for longer. And Canso remains cautious in its credit portfolio.

After all, the team noted, the outlook right now for inflation, interest rates and bond markets is “as clear as mud, so we’ve got our boots and rain gear ready to go, still prepared for heavy weather ahead!”

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.