Q3 Outlook 2017: Fixed Income
Steve Locke Mackenzie Fixed Income Team Lead
What was a generally positive quarter for bonds, with 10-year yields drifting modestly lower in developed markets, turned on a dime during the last two weeks of June. A second 0.25% increase by the Fed, which was expected, combined with slightly more hawkish statements by several central banks to catch the market off-guard and produce the sharp sell-off.
Most notably, the Bank of Canada seemed to abruptly change its tune on the near-term outlook for the policy rate. The market was forced to price-in some expectations of a rate hike from the Bank, based on media comments from Governor Poloz and his Deputy Governors. Their statements seemed to indicate a greater expectation of inflation rising as the output gap closes in coming quarters, leading them to conclude that the two rate cuts implemented in 2015 as “insurance” against a slowing economy may no longer be needed. As a result, the Canada 2-year yield ended June about 0.41% higher than where it began the month. Because of the reaction, the Canadian yield curve is now approximately priced for two 0.25% rate hikes through the rest of 2017, and pretty much for a third hike by mid-2018.
In sympathy with Canadian yields rising more sharply than those in the US, the Canadian dollar rallied against the greenback at the end of the quarter.
The Fed, for its part, raised the Fed Funds rate in June by 0.25% and also pre-announced some details, but not the timing, of its plan for balance sheet reduction. Should all else be equal, the current market expectation is for the very gradual reductions of the Fed’s holdings of Treasuries and MBS to begin in Q4 of this year.
It seems that the Bank of Canada, the European Central Bank, the Bank of England, and to a lesser extent the Federal Reserve, have almost coordinated the timing of their hawkish turns. While the bond and currency market reactions have been swift, yield levels are still well within the low ranges established in the post-crisis years. Even in the wake of potentially tighter monetary policy, both inflation break-evens and yield curve slope are not signaling a breakout of inflation ahead. Current inflation levels and inflation expectations remain muted. It seems likely that longer term trends of economic yield sensitivity, global excess savings and excess capacity, past globalization trends, and continuing technological innovations will all conspire to keep inflation and yields relatively low.
Looking more specifically at Q3 and Q4, there are some potential risks that could emerge to ultimately delay or remove the potential for policy tightening. Growth trends have not proved robust and uncertainties such as continuing Brexit negotiations, credit tightening in China, lack of wage growth in the US, and contentious fiscal debates which may cause the US to hit the debt ceiling, remain near-term obstacles.
Credit markets have performed well so far this year – so well, in fact, that valuations in parts of the high yield bond and emerging market debt markets look expensive in absolute and relative measures. A change in risk appetites due to one of the aforementioned risks could re-introduce some volatility to these markets – something that has been largely missing year-to-date.
Our portfolios have generally increased their diversity of holdings to more careful alignment to markets and selection of corporate issuers where we believe good value still remains. We continue to hold overweight positions in corporate bonds, but those positions have become more defensive. While a significant default cycle is unlikely to emerge through the rest of this year, we will continue to use our flexibility and discipline to reposition portfolios toward lower-beta credit holdings when the valuation-for-risk no longer makes sense.