WBND - Considering The Chances Of More Rate Hikes Amid Sticky Inflation

2023-05-18 14:13:00 ET

Summary

• Choppy inflation environment may leave bonds range bound.
• Rate hikes in Canada & U.S. a possibility in June.
• Fixed income a potential option for riding out recession.

With inflation remaining sticky and the potential for more central bank rate hikes ahead, MoneyTalk’s Greg Bonnell discusses the outlook for the bond market with Scott Colbourne, Managing Director, Active Fixed Income, TD Asset Management.

Transcript

Greg Bonnell: Latest Canadian inflation report shows that it may be a choppy ride to bring higher consumer prices to heel. Joining us now to discuss what that means for central banks and the fixed income market, Scott Colbourne, managing director of active fixed income at TD Asset Management. Scott, great to have you back on the show.

Scott Colbourne: Good to be here, Greg.

Greg Bonnell: Well, this has been an interesting year. And it's interesting in the fact that as it grinds on, we're not too far away from the halfway point. We went into this year with an assumption that at some point, the central banks would be finished their work and not only pause, but maybe even cut. And then that could mean things for fixed income. Well, this Canadian inflation report had some people stepping back for a second and saying, whoa, what's going on? Inflation came in higher than we thought.

Scott Colbourne: We're at the difficult point in that transition of inflation. So a lot of the easy gains are behind us. And I think even Governor Macklem laid it out very nicely that we'll likely get closer to 3% by the end of this year. We're at just over 4%, the headline. We've got median -- the meat of inflation year-over-year at around 4.2%. Likely, we're going to get closer down to 3% by the end of the year.

The tough part is going to get it back down to 2%, where everybody's -- from a policy point of view is the ultimate target. And that will take the bulk of next year. So it's not an easy -- the easy part is over. And now we're transitioning to the data dependency. It's really data-dependent.

We've had some positive surprises out of the US on the growth side this week. We've had some of the Fed governors talking hawkish. So net-net, we are in that difficult, choppy environment. And it leaves us, if you will, in a bit of a range-trading bond market environment with this -- that is consistent with this transition of inflation.

Greg Bonnell: Canadian report, even though it was only for one month, one report did get some tongues wagging the fact that, well, maybe the Bank of Canada, which is pretty clear conditional pause, depending on what happens, might be hiking again in the next little while. Is that an overreaction to one report or is it possible?

Scott Colbourne: No. I think it's a fair handicap. Look, I mean, the markets are saying, they haven't fully priced in a rate hike this year -- pretty close. So there's a likely handicapping based on your comments and the observations of the central bank here in Canada that they're conditional and they're data-dependent, but they're leaning hawkish. And so I think that we might get one more.

I think the bar for June is still pretty high to get a rate hike then. But certainly, they will be talking hawkish. And I think they would like a little bit more data beyond just this one inflation -- they just paused. They've had one inflation print that's a little stronger than expected. So I think the broad parameters suggest a little bit more pause and wait and let the data fill in and see how we transition. But the backdrop is still we are closer to the end.

Greg Bonnell: You talked about the fixed income market being a little range-bound as we wait. Entering this year, there was an idea that as they get close to the end and then perhaps go on pause and then perhaps even cut, depending on who in the market thinks, before the end of the year, that there is your opportunity in fixed income -- what do we need to see now for that opportunity to come true in the second half of the year?

Scott Colbourne: We rallied about 50 to 70 basis points from the fall, the end of October until now. So there's been a bit of a rally in rates and a bit of, as I say, a range pause at the moment. What we haven't had in a long time in fixed income is income. So if I told you you're only clipping 1.5% circa 2020, you're not being paid a lot to wait. Now you're being paid 3.5%, 4%. Throw in some credit spreads. It becomes a lot more attractive. And that income, as we wait for this transition to lower yields, lower inflation -- there is a substantial risk that we have a recession in the US. We keep pushing that out a bit. But I definitely think the broad strokes suggest that we are going to have a recession. I think it's more important to debate what type rather than if.

So that backdrop, given the fact that you have income, you can wait. You can wait this out. So you're looking at maybe 3.5% for the moment, the lower end of where 10-year yields are. Maybe we get back closer to 4% in US 10-years. But that 50 basis point is something that you can manage through given the level of income at the moment.

Greg Bonnell: Let's talk about recession fears, obviously. Is this part of the thinking as to why the market keeps pricing in cuts? And the market pricing has changed in recent days and weeks based on what's happening with all the data on both sides of water, maybe pushing the possibility of a cut later into the year. But they still think that the central banks are going to be cutting when the central banks are saying, no, no, no, no, no. Once we even pause, we're going to stay there for a long time. They keep hammering the desk on that idea. And it seems that the market keeps going, yeah, but not really. How do we read that?

Scott Colbourne: If you look back in history, the Fed would be on pause for maybe six to nine months historically, between their last hike and when they cut. We came out of a pandemic. We have these extraordinary policies. We have these tailwinds that we're still talking about. The San Francisco Fed did a nice study that said, look at the peak. We had $2.1 trillion in excess savings. And now we're down to only a half a trillion, still a ton.

That tailwind is still with us. We talk a lot right now about the resilience of the consumer. That will peter out over time. These rates will impact. The central banks will be patient. Maybe it's not the historic six to nine months. Maybe it's a little longer. But ultimately, this is going to bite. It's going to bite the consumers, the credit conditions, the tightening of lending standards.

We've seen manufacturing traject lower, services being held up by strong consumer. So sometimes, it's tough to be patient. The markets are always wanting a trend. They were wanting to move to inflect. But I think the trend is obvious. It's just being patient and waiting for it to play out. And maybe the central banks will be on hold this year. But ultimately, they're going to have to cut.

Greg Bonnell: Ultimately, when that cut comes, really, is with the central banks realizing there's too much pain in the economy. They're too restrictive. They've tamped down growth too much. The argument has been made, because of everything we've been through through the pandemic, that perhaps they're going to allow us to feel a little more pain than usual before they rush to the rescue yet again. Does that make sense?

Scott Colbourne: It's a little far out to see if they're going to really hammer us. But I think the ultimate -- the way they phrase it is, we have to restore the balance between supply and demand. If that means we're on hold a little bit longer -- at the end of the day, though, we also -- going into all this, the Fed talked about having a slightly higher average inflation target over a cycle. So maybe while we talk about getting to 2%, ultimately they don't get as close to 2% as we think they will be. So on the positive side, maybe they stop with the tightening, with pushing back on the demand side earlier than we think.

Original Post

For further details see: