Q4 Outlook 2017: Staying Selective in a Yield-Sensitive World
Steve Locke Head of the Mackenzie Fixed Income Team
The third quarter produced a negative total return for Canadian bond holders as the yield curve continued to rise, albeit more gradually, after the Bank of Canada’s hawkish shift in June. The Bank moved the policy rate higher by 0.25% in two consecutive meetings (July and September), and seemed to keep a tightening bias in its statements. Only near the end of September did we hear Governor Stephen Poloz soften the language slightly. By the end of the quarter, the yield curve adjusted to price-in roughly two more hikes of 0.25% over the next twelve months.
In sympathy with the sudden, sharp change in yields and prospective additional monetary policy tightening, the Canadian dollar adjusted, rapidly appreciating versus the US dollar and other major currencies. Only the slightly softer, late-September language from the Bank, combined with slightly more hawkish comments from Federal Reserve Chair Janet Yellen, caused the CAD to weaken back toward US$0.80.
Looking ahead, both the Canadian and US yield curves have largely priced-in one more policy rate hike of 0.25% from their respective central banks this year. Markets continue to expect only gradual tightening adjustments in major economies, including the beginning of the Fed’s balance sheet reductions in October. It is also expected that the ECB will begin tapering bond purchases early in 2018. The Bank of England has also started to reflect a slightly less dovish tone, notwithstanding the great uncertainty surrounding the Brexit process.
Although the Canadian yield curve provided us with quite an unexpected jolt this summer, and recent slightly less dovish/more hawkish leanings in policy might make one wary of a protracted bond bear market, it serves to keep in mind that we remain mired in a particularly yield-sensitive world. Inflation rates of prices for consumer goods and services remain low and stable in most regions. Wage gains have been tepid for most households despite consistent employment growth, giving central banks no particular reason to be aggressive. Even with a mindset to get ahead of the inflation curve, existing high levels of household and government debts globally will likely restrain central bank policy-rate and yield-curve actions going forward. Our expectation is that government yield curves will remain in their recent low ranges – with some periods of rising and falling yields along the way – for an extended period.
Perhaps because of the “Goldilocks” nature of non-inflationary economic growth and low yields, equity and corporate credit market volatility has drifted lower this year. Credit spreads have narrowed, generally, and default rates have remained low. This has allowed some stretching of valuation in parts of the high yield bond and loan markets, areas that we have been avoiding in favor of better-valued issuers. As the credit cycle moves forward, we will continue to be ever more selective in our holdings of corporate credit, and continue to increase the diversity of our holdings and tighten our downside risk protections as needed. For now, we still see some opportunity to gather additional yield and diversity from actively-managed exposures to corporate credit markets.