Highlights from the March Canso Market Observer

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Will the recent high-profile bank collapses deter central banks from fighting inflation? Will the U.S. Federal Reserve lower rates sooner than markets expected? Has it tamed inflation enough to do so? Why isn’t inflation going away more quickly – and why are bond markets so stubbornly optimistic that it will? In its Canso Market Observer Newsletter for March 2023, leading Canadian institutional investment management firm, Canso Investment Counsel Ltd., took on those questions and more.

To read the full report, click here.

Cash isn’t trash anymore

The bond market’s inflation rollercoaster ride isn’t over yet. One month, data suggests prices are moderating and yields drop; next month, inflation rears its ugly head and yields soar. “The bond market is moving manically between elation that nagging inflation has finally been vanquished,” the Canso team notes in the March Market Observer, “and fears that it has not. It depends on the day, the hour, or even the minute after an ‘important number’ is released.”

Even as bond yields flap about like a windsock, the Observer notes that markets are still holding on to hope. One sign of that: the 30-year U.S. Treasury bond yield sits lower than the yield on a 1-month Treasury bill, which is considered a “risk-free” security – aka cash. “Investors are giving up more interest with the shorter-term T-bill to lock in their coupon for 30 years and avoid the risk that bond yields will fall,” Canso noted.

That means investors are overlooking the comparatively attractive yield on cash – which only a couple years ago was basically zero, back in the bygone days of ultra-low interest rates – amid “haste to get invested and lock in their coupon to profit from the future riches of falling yields and higher bond prices ahead.”

Bank collapses to the rescue?

Given the relative bullishness for long bonds, markets seem to believe that the U.S. Federal Reserve, which in March hiked by a relatively modest 25 bps, will be successful in subduing inflation to get it back to the 2 per cent target – or at least that the Fed will soon find reason to halt and potentially reverse the hiking cycle it began a year ago. (It no doubt seems much longer to hard-hit investors, along with a few banks.)

The recent collapses of Silicon Valley Bank (SVB) and Credit Suisse (CS), if they spark a wider run on the banking industry, might just provide that reason – or so many investors seem to hope. As Canso noted, the SVB/CS debacles caused yields to plummet, particularly 2-year bonds (where market yields tend to more fully reflect anticipated policy changes), suggesting that “markets have carved back their expectations for future hikes that they were predicating on an aggressive Fed.”

But will that optimism (for bond prices, if not for the banking industry) hold? The Canso team has their doubts. After yields fell in the wake of SVB’s implosion, they rose again with the release of (high) February inflation data.

It took the collapse and eventual fire-sale of Credit Suisse to reverse yields again. “Despite [SVB] being the largest bank failure since the 2008 Credit Crisis and worries over Credit Suisse, we’re still in the middle of enthusiasm for low inflation and desperation that it is not coming down,” the Market Observer noted. Yet “no matter the short-term antics of the bond market, it is clearly anticipating a ‘return to normal’ inflation or even a recession, if the yield curve’s prediction is to be believed.”

Moreover, Canso doubts whether the SVB/Credit Suisse meltdowns will be enough to make the Fed “relent” from further raising rates – a doubt supported by its March rate hike. “Deciding that ‘this time will be different’ is a very dangerous thing for an investor to do,” the team wrote. “On the other hand, we have seen little evidence that there are problems in the credit markets during this tightening cycle so far.” Chair Jerome Powell has reiterated that inflation is still the Fed’s clear priority; in which case it will continue to tighten – “and that never ends well for financial assets.”

So, about inflation…

Whether or not the Fed (along with other central banks) has done enough to conquer inflation is a “very important question,” the Canso team wrote. U.S. core inflation for February remained above 5 per cent annualized. The latest employment data in Canada showed 5 per cent wage growth. Consumers continue to spend. Corporate earnings are steady, and corporate bond default rates remain muted. Those factors suggest that rising prices could be a fact of life for some time. Against the bond market’s on-again, off-again optimism, inflation is proving very sticky so far.

Historical trends might also support an outlook for higher inflation for longer. The Canso team looked at U.S. long bond yields from 1920 to 1960, which they use as a comparator for the 1990 to 2030 period because of the similarities between “the shift of Cold War military production to civilian uses with the fall of the Soviet Union in 1989” and “the shift from WW1 military production to civilian consumer goods in 1919.” During the earlier cycle, yields (and inflation) declined for roughly 30 years before turning upwards.

During the second cycle, yields were tracking the same way, turning slightly upwards after three decades before falling dramatically with the disruptive pandemic of 2020. Now, however, yields are rising and falling back in line with the pattern set in the mid-20^th century. That, wrote Canso, suggests yields may continue to rise – and higher than “normal” inflation is the new normal.

The ladder of chaos

So, what is really going on with inflation and its foil, recession? “Clearly, nobody actually knows,” the Canso team wrote, “especially at the central banks.” Given the recent history of central bank interventionism, and the fact that the current inflationary environment is in large part due to excessively easy money during the pandemic era, the question of whether monetary policymakers will either overshoot or undershoot the mark with rate manoeuvring is not much of a question at all: “If history is our guide, they most certainly will.”

Meanwhile, while financial markets wait for the Fed to turn tack and get things back to whatever “normal” is, they “are like spoiled children in the back seat of the monetary car, constantly asking ‘Are We There Yet?’ and complaining vociferously that we are not.”

As the Canso team points out, this confusing and confused state of affairs is not all bad for investors. Bond yields have risen across the term structure since the days of zero-interest-rate policy, so “at least we’re not being paid virtually nothing to hold shorter-term securities and even long-term yields have risen.” Canso continues to see value in inflation-linked bonds, which “provide inflation protection and upside if real yields decline.” And amid the chaos, the team continues to look for bargains. “Buying things cheaply is in itself a form of protection,” they wrote, “so that’s what we’re now concentrating on.”

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.