Mackenzie Fixed Income Team
Outlook & Positioning
The rapid yield increase in the fourth quarter of 2016 gave way to a much more sedate first quarter 2017 trading range for both the Canadian and US 10-year government bonds. Both bonds traded in an approximate range of 0.25%-0.30%, and finished March slightly lower than where they began the year. Bond investor sentiment, which was particularly bearish for US Treasuries at the start of the year, became more neutral through the first quarter as traders grew accustomed to the higher trading range, but were provided with no additional catalyst for a continued sell-off of bonds. In fact, uncertainties related to the handover of the US administration to President Trump, combined with hawkish Fed language in February that preceded a Fed Funds rate hike on March 15th and with looming possible event risks in Europe, to keep the market in check around the higher end of the last six months’ yield range.
The Fed’s rate increase was accompanied by statement language and a “dot-plot” that signaled no change to the expected moderate pace of policy tightening. At the end of March, the bond market is pricing in expectations of two more hikes this year, with the next increase not expected until June.
The Bank of Canada remained on hold and signaled no inclinations to change the overnight rate at upcoming meetings. Governor Poloz seemed interested in keeping the Canadian Dollar on the weaker side as he positioned inter-meeting comments that capped and reversed a rally against the US Dollar early in the quarter. Some Canadian economic data turned stronger over the last three months, culminating in the surprisingly strong end-of-March release of January real GDP growth at 0.6% for the month. On balance, we believe that the Bank of Canada will remain on the dovish side notwithstanding this data, but it will be very interesting to see what revised growth forecast appears in their Monetary Policy Report scheduled for April 12th.
A distinct wildcard for both markets and for central bankers this quarter was the handover of the US Administration to President Trump. His agenda, as stated, contained a number of potentially major changes to existing policies and laws enacted by his predecessor, including changes that could have a positive impact on growth and potentially a major impact on the budget. Markets discounted much optimism based on Trump’s pro-growth policies, while ignoring some of the uncertainties and potential volatility that could come from some of his ideas. Near the end of the quarter, one key piece of his early agenda – the repeal or refurbishment of “Obama-care” – seemingly failed to garner enough support in Congress and was pulled before the vote. For the short term, this setback may delay or diminish some of the pro-growth fiscal agenda planned by the Administration.
Outside of North America, some positive signs for growth appeared in Europe, and the UK continued to outperform expectations of an impending slowdown ever since the Brexit vote last June. Still, the ECB and the Bank of England appear to be on hold, seeing headline inflation risks as temporary. The upcoming French elections pose a low-odds macro risk to region and to markets, as does the two-year-long Brexit process which commenced on March 29th.
Without the destabilizing impacts of these macro risks from Europe, or a derailed growth agenda in the US, it is possible for yields to drift modestly higher in the second quarter. The US 10-year yield may push towards the high-2% area on continued optimism and policies supporting growth and employment. With the Bank of Canada continuing to hold steady, this could put some downward pressure on CAD versus USD. Investment grade corporate and high yield bond and loan markets have all performed very well year-to-date, and are poised in this scenario to outperform government bonds. The risk for the higher yield markets lies in their valuations which have richened during the first quarter. Should there be an unwinding of growth expectations, some overpriced bonds could experience some modest revaluations lower. We generally expect higher yield markets to earn investors approximately their carrying yields over the coming months.
Our portfolios ended the quarter with slightly short durations and remain overweight in investment grade bonds. Loans outweigh high yield bonds in our non-investment grade positions within core-plus mandates. Given the movement to richer valuations experienced last quarter, we have engaged some downside protection against a sell-off in high yield bonds should any growth risks or macro scares arise during Q2.