Bond market gains momentum as inflation stabilizes

The bond market in 2024 has been driven by cooling inflation and resilient economic growth, says Adam Ditkofsky, vice-president and portfolio manager, Core and Core Plus at CIBC Asset Management.

“If we look at the overall theme for the year, it’s been how much inflation has normalized. And at the same time, how resilient the economy has been,” Ditkofsky said in a recent interview. 

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In Canada, inflation has returned to the Bank of Canada’s target of 2%, while in the U.S., it remains slightly higher, between 2.5% and 3%, depending on the measure, Ditkofsky said. 

“It makes sense that both the Fed and the Bank of Canada have been able to cut rates,” Ditkofsky said. “Especially here in Canada, where the economy seems to be on a less stable footing than in the U.S.”

This progress has allowed both central banks to reduce interest rates, though Ditkofsky said their approaches differ.

Canada’s central bank has cut rates by 1.25 percentage points to 3.75% this year, as the economy shows signs of slowing. 

“In Canada, GDP has remained positive, but it has largely been driven by our strong immigration policies,” Ditkofsky said.

The U.S. Federal Reserve has been more cautious, cutting rates by 0.75 percentage points to 4.75%. Economic growth remains strong in the U.S., Ditkofsky noted, but inflationary pressures persist, leaving the future of rate cuts uncertain.

“The outlook for how much and how far they will go is a lot more murky,” Ditkofsky said. 

From a return standpoint, Ditkofsky said the bond market has performed well this year, with Canadian bonds returning 3.2% as of October and an even stronger 6.6% in the past six months. 

He noted that corporate bonds have done especially well.

“The investment-grade corporate bond universe [in Canada] has outperformed the broad market, returning 5.4% year-to-date as of the end of October,” Ditkofsky said. 

He added that credit spreads — the extra yield investors demand for corporate bonds over government bonds — have tightened, signaling strong demand for corporate bonds.

Looking ahead, Ditkofsky said the markets expect more rate cuts over the next year. The Bank of Canada is projected to lower rates by another percentage point to 2.75%, while the U.S. Federal Reserve is expected to cut by 0.5% to 0.75%, bringing its rate closer to 3%.

However, Ditkofsky said these expectations could change quickly. 

“Near-term economic data can cause shifts in these near-term expectations, which could cause short-term rates to be volatile over the coming weeks,” he said. 

Ditkofsky noted that while short-term bond yields react to rate changes, longer-term yields are influenced by broader factors.

In this environment, Ditkofsky expects five-year bond yields to remain around 3% and 10-year yields near 3.25%, similar to where they are now.

Despite their strong performance this year, corporate bonds may be nearing their peak. 

“We continue to maintain our overweight in corporate bonds, but we don’t believe there’s significant room for further tightening in spreads,” Ditkofsky said.

Instead, he’s focusing on higher-quality investments, such as U.S. agency mortgage-backed securities, which offer a more defensive approach in today’s market.

The return of Donald Trump to the U.S. presidency could also affect the bond market, Ditkofsky said. He noted that Trump’s policies on trade, immigration, and tax cuts could drive up inflation, with estimates of additional inflationary pressures ranging from 0.4% to 2%.

“Markets are far more sensitive to inflationary pressures and rising deficits today than during Trump’s first presidency,” Ditkofsky said. While some policies could create volatility, their full impact will depend on how they are rolled out.

Geopolitical risks, such as conflicts in Ukraine and the Middle East, also pose potential challenges. Ditkofsky said escalation in these regions could push bond yields lower and hurt riskier assets like stocks and corporate bonds.

Despite these risks, he sees opportunities for fixed-income investors. 

Ditkofsky noted that the relationship between government bond and corporate bond yields has normalized this year, making corporate bonds more stable and less volatile.

“This means more stability and less volatility—both favourable characteristics for fixed-income investment,” he said.

Looking forward, Ditkofsky expects central banks to keep cutting rates as inflation continues to ease. While some short-term ups and downs are likely, bond yields today “are looking a lot more attractive than what they did earlier in the year,” he said.

This article is part of the Advisor To Go program, powered by CIBC Asset Management. It was written without input from the sponsor.