“At one point, markets were pricing over six rate cuts in 2024, but it was rather exuberant on that front,” recalls Earl Davis, head of fixed income and money markets at BMO Global Asset Management.
More astute observers were not expecting anything to happen with rates before the second half of 2024. “In December, we still didn’t expect the Fed and the Bank of Canada to ease until mid-2024,” says Michael Heydt, Senior vice-president, sector lead, global sovereign ratings, at Morningstar DBRS. “That still holds, because the bar to ease is still high.”
The Economy is Softening, But Inflation Remains Rough
Granted, many factors that contributed to holding rates high are softening, Heydt observes. For one, consumer spending is relenting, especially in Canada, where “they have already started to pull back, perhaps reflecting consumers’ greater sensitivity to rising interest rates, he continues. Over the last two quarters, household consumption was flat despite a surge in the country’s population.” And households facing mortgage resets at higher rates certainly won’t stimulate spending in 2024.
Heydt also identifies two other weakening areas that argue for rate cuts: a less supportive fiscal policy environment in 2024 and dampened private investment. Both will help ease inflation.
Supply Chain Challenges Continue
However, pressure exerted on supply chains could contribute to making inflation sticky, Davis warns. “There is the trouble happening in the Red Sea, but there are also low water levels in the Panama Canal, where spots are being auctioned out. All this affects the supply chain,” he claims, though the effect on inflation might take more time to materialize.
The key ingredients that still propel inflation - and solidify the unrelenting stance of central banks – are jobs and wage growth. But Heydt sees things improving. While the U.S. labour force added 3.7 million workers last year, a 2.3% increase rarely seen since the 1970s, demand for labour has been moderating at roughly half the pace of the previous year. However, wage growth still remains fairly strong, “but we expect market conditions will continue to loosen next year and help ease labour cost pressure,” Heydt expects.
The Unemployment Threshold
If inflation remains high and the economy slows, as everyone expects, the key factor determining whether central banks ease or not will be unemployment, Davis believes. Presently, the unemployment rate in the U.S. stands below 6%, but “if it hits 6.5%, the bank will ease for sure,” he asserts.
Bond Investing for Canadian Interest Rate Cuts
Davis attributes a 70% probability that rates will come down in the third quarter. In the meantime, what is happening to his bond portfolio? At the end of 2023, he had what he considers “a very bullish stance” with an average duration of 7.85 years. He has since dialled back that exposure: “We are slightly overweight the FTSE Canada Bond Universe Index,” he notes, “The index stands at 7.1 years, and we’re at 7.35. The difference is not huge, but the direction is reflective of our views, and it’s still a bullish stance.”
He is invested only in government and investment-grade corporate bonds, steering away completely from high-yield bonds. “Spreads have narrowed and become very tight, he notes, so we prefer to move to safer bonds. The spread doesn’t justify the increased risk of high-yield notes.”
His position seems to be paying off, his Core Bond Plus fund having gained year-to-date 40 basis points ahead of his index, after being 90 basis points above last year.
Credit Opportunities Other Than Bonds
But bonds are not necessarily the most profitable area at this moment in credit markets. “We like leveraged loans as high-yielding, floating-rate instruments that have a number of key advantages if rates are to stay higher for longer than we expect,” asserts Andrew Sheets, Global head of corporate credit research at Morgan Stanley.
That’s an area in which Justin Jacobsen, portfolio manager of Penderfund Capital Management’s Alternative Absolute Return Fund is concentrated. His fund invests long and short in bonds and leveraged loans, but his preference goes to the latter. “In many cases, you can earn a much better spread in a loan with floating rates,” Jacobsen asserts, indicating that a Hilton (HLT) investment-grade loan comes in at 210 basis points above the SOFR rate, while the corresponding Marriott (MAR) bond has a fixed coupon that trades at 100 basis points above the Treasury curve. He shorts the second against the first, pocketing a profit from the spread difference. His long/short strategy allows him to have little exposure to interest rate movements.
In credit markets where he finds “that it is challenging to find value right now”, Jacobsen has been stocking up on leveraged loans. “We’re up to 25% in loans, a proportion that has doubled in the last few months, he says. It’s where we’ve been putting capital to work lately. Even if rates drop, which could happen by the end of the year, you have a margin of safety here that is better than in the bond market.”
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