Fixed Income Monthly Monitor – August 2022

Market Update

After six consecutive months of negative returns, the FTSE Canada Universe Bond Index turned the corner to deliver a 3.9% return on the month. This still leaves the YTD returns in the red at -8.8% to the end of July. Yields have moved well below their peaks reached in mid-June, rallying to lower levels during the month. The Government of Canada 10-year yield reached a low on the final day of the month at 2.61% or about 100 bps below the current cycle’s peak. 

Central banks were in the mood for shock-and-awe, but decades high inflation will solicit such a response. It began with a surprise 100 bps hike by the Bank of Canada, followed by a 75bps hike by the US Fed two weeks later. Governor Macklem sounded decidedly hawkish, keeping open the door to more hikes over the near term, while the market interpreted the comments from Chair Powell as having a dovish lean. Both central banks have expressed the desire to get rates to and then above neutral expeditiously, and are well on the path to achieving this objective. All in, both the BoC and US Fed have each raised rates a cumulative 150bps over their last two meetings. Counter intuitively, the result has been falling yields across long rates as growth concerns take root. 

The market pricing across the yield curve is intriguing. First, the market now believes that policy rates, in both Canada and US, are likely to peak by year end between 75-100 bps from current rates. But more importantly, the market is pricing in rate cuts for the second half of 2023, as they believe the slowing growth backdrop will require action. These expectations may be premature. Second, the yield curve is inverting to levels not seen since the early 1990’s in Canada. The differential between the 10-year and 2-year Government of Canada yield ended the month at negative 36 bps. Deeply inverted yield curves are typically a harbinger of economic weakness to come. 

Credit in Focus

Canadian credit spreads tightened 2-3 bps, on average, but underperformed compared to provincials. The mantra for the month was a demand for high-quality credit, as Corporate A performed inline or outperformed Corporate BBB’s across maturity segments. Spreads are likely to remain volatile, given the weakening macro backdrop, elevated inflation and tightening financial conditions, however, corporate yields have jumped to 4.44% compared to 2.10% one-year ago. 

Provincial bonds were strong performers as longer term yields fell and improving risk-sentiment helped to narrow spreads. Provincial bonds outperformed corporates in short-, mid and long-term maturity segments. Spread tightening was most pronounced in longer tenors as a means for investors to pick-up incremental yield in high quality government backed issuers. All provinces benefited from the shift in tone. 

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