As the BoC fights inflation, where should fixed income investors focus?

On July 13, the Bank of Canada (BoC) raised its overnight lending rate by 1% to 2.50%.¹ Bank of Canada Governor, Tiff Macklem, front-loaded the expected rate hike path that was already priced into bond markets. A larger hike now likely means fewer hikes will be required later to quell inflation, as the economy continues to run too fast. A more moderate pace of rate hikes for the rest of the year will raise rates into restrictive territory by year-end.² At that level, we believe the Canadian economy would meaningfully slow down and possibly contract. We expect the overnight rate to peak at 3.5%.³

The BoC had to front-load interest rate hikes to repair its damaged credibility; the Bank’s sole focus is now inflation. The risk of a hard landing for the Canadian economy is rising but shouldn’t be overstated given the strength of domestic demand. The unemployment rate dropped to 4.1% in June, reaching a new record low for the fourth consecutive month.⁴ The risk is that the current aggressive tightening of monetary policy is actually slamming on the brakes of the economy.

The yield curve is likely to flatten from current levels, which will be supportive of 5–10 year maturity bonds. Our view is the market is currently expecting too much BoC tightening this year, therefore we’re bullish on owning duration. We think current bond yields will decline (as prices rise), so more duration in the portfolio would potentially lead to higher total returns.

Missed opportunity

Back in January 2022, the BoC had the opportunity to begin raising interest rates, as the market was expecting by the usual 0.25% increments. Clearly, the BoC made its decision to hold rates at that time based on economic forecasts that were completely wrong. Inflation has been allowed to broaden, as real yields (the difference between prices and nominal yields) remain excessively negative, supporting credit growth.

Consumption should be under pressure from a combination of the very sharp rise in interest rates and the decline in many asset prices recently. So far, we’re only seeing small signs of slowing demand. Therefore, the BoC could now be forced to be more aggressive at each of its remaining policy meetings this year. It’s extremely hard to reverse an anchoring of high inflation expectations.

The challenge of inflation

Inflation stayed more subdued due to longer social lockdowns during the pandemic. Now that restrictions have been lifted, we are witnessing a broadening of inflation throughout the economy. The Consumer Price Index (CPI) rose 8.1% on a year-over-year basis in June, up from a 7.7% gain in May⁵ — less than the market was expecting. As consumption of goods slows, there are price increases across service sectors to attract labour and cover rising energy prices.

Ultimately, with the current pace of price pressures, demand is to set to slow. Supply-side inflation, led by energy, is likely to mean rising prices won’t retreat as quickly as we have witnessed historically. That said, the structural forces of disinflation have only continued to be enhanced through technology and automation. Demographics will continue to play a role in capping how high real interest rates can go over the longer term.

The household sector is stretched

Canadian household debt continued to rise over the pandemic period, as residential real estate investment contributed strongly to the economy. Much of this new mortgage credit was created at very low nominal levels of interest rates. That said, interest rates have now risen very quickly in a short period of time. We are starting to see signs that consumer confidence is being affected, as the reality of rising interest expenses will impact the stability of household spending.

Relative to the U.S. economy, we believe Canada is more sensitive to rising interest rates and the longer-term level of interest rates could be lower as a result.

Corporate bond market is flashing ‘Buy’

Canadian corporate bond yields are at their highest level since 2009 (figure 2). Large companies were able to capitalize on the exceptionally low level of interest rates available for longer-term financing needs over the past couple of years. As a result, these companies are now in a position where pressure to refinance and pay the current higher interest rates will be limited. Less issuance of investment grade corporate bonds provides a positive technical to the corporate bond market relative to the government bond market.

Longer-term financing means default rates are expected to remain historically low. The pricing power for many companies is continuing to improve, and credit fundaments are improving for those ‘best-in-class’ companies. The first half of 2022 placed pressure on all credit asset classes, but the second half of the year will likely see the ones with the strongest balance sheets rise to the top.