Bond Market Gains Momentum as Inflation Stabilizes

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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Adam Ditkofsky, senior fixed income portfolio manager at CIBC Asset Management.

In terms of an update for the bond market, if we look at the overall theme for the year, it’s been how much inflation has normalized, while at the same time, how resilient the economy has been, predominantly in the U.S.

And so far this year, we’ve definitely seen major progress with inflation – in Canada now at 2% while in the U.S., close to 2.5%, 3% depending on which inflation measure we look at and how much weight shelter and rent is in that metric. So, it makes sense that both the Fed and the Bank of Canada have been able to cut rates, especially here in Canada where the economy seems to be on a less-stable footing than in the U.S.

Now in Canada, GDP has remained positive, but this has largely been driven by our strong immigration policies, which, year over year, have seen our population grow by 3%. And we’ve already seen the Bank of Canada cut rates by 1.25% to 3.75%.

Now in the U.S., where economic growth has been strong and inflation has been more elevated, the Fed has only cut by 0.75% — or 75 basis points — which, with the Fed funds rate sitting at 4.75%, and the outlook for how much and how far they will go being a lot more murky.

From a return standpoint, the Canadian bond market has returned 3.2% year to date, ending as of the end of October, while in the last six months, has actually returned 6.6%. Now keep in mind, this has been — really the bulk of these returns this year — have been mainly in the periods where we’ve actually seen the central banks cutting.

Now, one area that has been also very strong has been the corporate bond market, with the investment grade corporate bond universe outperforming the broad market, returning 5.4% year to date as of the end of October, and this is with credit spreads, which reflect the extra yield investors required to buy corporate bonds over government bonds, materially tightening. This means investors are demanding less yield to hold corporate bonds, which as of the end of October, was close to 100 basis points, or 1% above government bonds.

And it’s a similar theme in the U.S. dollar investment grade credit and high-yield market, as investor demand for risk assets has been exceptionally strong, despite supply being elevated. Now, a big factor here has been strong corporate earnings and easing cycles tend to be favourable for risk assets.

There’s clearly a lot of money in the system with significant assets also sitting in cash or money market products, generating high yields by historical standards.

Now in terms of how further cuts will continue to impact the market, the short answer is, it really depends.

Currently, futures markets are pricing in four 0.25% rate cuts by the Bank of Canada over the next 12 months, which would bring the overnight rate to 2.75%. While in the U.S., markets are currently pricing in two to three cuts, which would bring the Fed funds rate closer to 3%.

What investors need to keep in mind, though, these expectations have been very volatile throughout the year, and they’ve been continuously changing as market / economic data continues to be produced and become public. The impact of economic data and these changes — or these changes in assumptions — tend to have more of an impact on shorter-dated bond yields as opposed to longer-dated bond yields. Longer date yields are more impacted by terminal rate expectations, which means, ‘Where is the central bank’s targeting? What’s their end game?’ And of course, supply and demand expectations and longer-term secular views.

For example, it’s now mid-November, and markets are pricing in a 40% chance that the Fed cuts rates by 0.25% in mid-December, and a 30% probability that the Bank of Canada cuts rates at their next meeting in December by 50 basis points, as opposed to 25 basis points.

So 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, especially if expectations become more bullish or more aggressive for rate cuts.

Longer-dated bonds have priced these expectations in so far, and so it’s more relevant for how these expectations change over the longer term.

In terms of our expectations, going forward [it] is that central banks will continue to cut rates, provided inflation remains on a path to normalization. But then in the near term, we believe it’s likely inflation in the U.S. will likely stay sticky and close to 2.4%. So we believe that central banks don’t need to be on a very aggressive trajectory. Which means it’s likely we’ll see periods of pausing by the Fed and less-aggressive moves, as opposed to the 50 basis points cuts we’ve already seen by both the Fed and the Bank of Canada in recent months.

Overall, our base case scenario calls for the economic growth to average about 1.8% in Canada, and for inflation to remain sticky. We continue to see rate cuts over the next 12 months, but at less-aggressive levels, with longer-dated yields hovering close to current levels.

So, five-year rates, we’re expecting to be closer to the 3% and 10-year rates close to that 3.25%. Very close to where they are now.

Now in terms of corporate bonds, they’ve had very strong performance this year, with spreads looking what we would say is rich or expensive. Overall, though, we continue to maintain our overweight in corporate bonds, but we don’t believe there’s significant room for further tightening in spreads.

For context, high-yield spreads are below 300 basis points, and investment-grade credits are close to recent historical tights. Still, we do think that spreads could stay tight for some time, especially if corporate earnings remain resilient, but at this juncture, we’re taking a more defensive stance, looking for opportunities in higher-quality sectors, one being in particular U.S. agency MBS.

In terms of how the outcome of the U.S. election will impact the fixed-income market next year, we have to look at, well, of course, Donald Trump won the election and the Republicans took control both the Senate and the House of Representatives. That basically increases the expectations that Donald Trump will have significant flexibility in executing his policies.

So, the question surrounds, what are the implications for the bond market? So, in terms of his pre-election policies, most emphasize four key categories: trade tariffs, tighter immigration, tax cuts and deregulation.

Overall, the emphasis of these policies is to boost GDP over the mean term, but implications would also be inflationary, with estimates ranging from 0.4% to close to 2% in additional inflationary pressures. This, of course, would not be favourable for the bond market, but at this stage, given these policies are still very murky, it’s difficult to really assess the full implications.

Now, some headlines have highlighted worst-case assumptions, including a 10% tariff on all non-Chinese imports, but these seem excessive. And mass deportations would also reduce the availability of labour, especially amongst lower-wage service jobs, which could also reagitate the labour shortages in the U.S. and cause further inflation in service prices.

From what I’ve seen overall, core PCE estimates — or inflation estimates — for next year, I could say, if we see the original expectation was closer to 2%, I’ve seen it move up to potentially a 2.4 to 3.5%.

Now, in terms of estimates for debt issuance, [they] are also set to increase significantly under his policies. But of course, depending on what the actual policies are. However, unlike 2016 during Trump’s first presidency, markets are far more sensitive to inflationary pressures and rising deficits. Gone are the days where bonds were purchased at any price, with central banks and governments holding less bonds overall. So, the bond market could become one of the controls that keeps the new administration in check.

Overall, these policies are risks to the bond market. However, the severity of these policies are still very much unknown and will take time to implement.

Also, the administration will not ignore what happens to the bond market, so it’s likely the rollout will be somewhat gradual and more balanced. Still, we could expect increased volatility in the rates market.

So, in terms of other key trends that investors should be watching for in 2025 and what opportunities exist, I think the main focus really is inflation and the central bank’s plans for further rate cuts, with the pace and magnitude of cuts being somewhat uncertain.

Still, there’s a lot of opportunities — and risks, of course — to look at.

First, there’s, of course, the ongoing conflicts around the world that can escalate and cause volatility for the market. Should the conflict in the Ukraine or in the Middle East escalate, this would likely push rates lower and would be unfavourable for risk assets, including stocks and corporate bonds.

Other key trends also include traditional risks surrounding re-escalation of inflation and recession risks, and increased concerns around volatility. But one major interesting observation has been really this correlation between government bond yields and corporate bond yields, which I would argue, have essentially normalized, meaning that it has returned to being negative. So, this is unlike the relationship we saw last year.

So, this should provide more stability for corporate bonds as they benefit from lower yields and risk-off periods, and tighter spreads in risk-on periods, both partially offsetting each other.

So, this means more stability and less volatility, both favourable characteristics for fixed income or fixed-income investment.

Now, we also have to keep in mind that at this juncture, at mid-November, following the U.S. election, a lot of excessive optimism for the bonds was priced out early in October, with rates moving higher. So again, bond yields are looking a lot more attractive than what they did earlier in the year.