2024 policy rates may go up again before they come down, how does this affect fixed income?
Long duration eventually proved the investor’s friend in 2023, after falling inflation and hints of a federal pivot sharply reversed the direction of G7 yields, says FTSE Russell in its Global Investment Research – Market Maps on Fixed Income Insights. Yields ended December back at first quarter 2023 levels. Canadian long government bonds, municipal and provincial bonds took centre stage, with returns of up 16 per cent in the fourth quarter.
The Canadian economy slowed sharply, after real GDP contracted by 1.1 per cent in the third quarter – its first contraction since the second quarter of 2021 – contrasting significantly with market expectations of a slight expansion, following growth of 1.4 per cent in the second quarter of 2023, says the FTSE Russell report. Even so, the economy is expected to have grown by 1.1 per cent in 2023, according to consensus forecasts.
Canadian policy rates have remained at five per cent since September 2023. The growth slowdown and disinflation may give the BoC the opportunity to at least match the US Fed’s easing moves in 2024, given lower core inflation, but the BoC did not match the Fed pivot in the fourth quarter.
Bonds gained 16 percent
Long government, municipal, and provincial bonds gained up to 16 percent in the fourth quarter Canadian bond rally, however, as the Canadian curve continued to disinvert in December, as 20-year bond yields fell sharply on expectations of aggressive rate cuts, despite the Bank of Canada caution on its rate policy
Yield curves remained deeply inverted, after G7 curves bull flattened. The fourth quarter, notably December, saw a brisk decline in bond yields, across the curve, which erased 12 months of yield rises, as median federal dot plots show 75bp in cuts for 2024 (see Chart1).
The FTSE Russell report also says that the Climate World Government Bond Index (WGBI) and adjusted-Climate WGBI outperformed, helped by duration.
German and UK government bonds performed best in the fourth quarter after the US dollar and European yields fell following the federal pivot, boosting returns in non-US markets.
Canada also outperformed the US market, with Canadian government bonds outperforming US bonds, says Robin Marshall, director, global investment research, FTSE Russell. “For a Canadian based investor there was also actually a bit of a currency effect, so it paid to stay at home. Given that, in a way, the US pivot came from the Feds on policy, one would have thought that treasuries might have outperformed because the Bank of Canada actually struck a much more cautious note in its policy statement in December. That, to me, was a bit of a surprise.”
A roller coaster year
Marshall says it has been a roller coaster year, with the long-short up 16 per cent in the fourth quarter. “Basically all the gains in the year were in the fourth quarter and the market was lower in the balance of the year. Looking at 10-year yields, I noticed that they were almost at exactly the same level as they were 12 months ago. We started the year at about 3.20 percent and went to above four percent. It reached almost 4.25 percent briefly and now we’re back to about 3.20 percent. It was all fourth quarter gains.”
For both Canada and the US, and to some extent Europe, the risks in this have skewed towards the central banks not doing as much as expected, adds Marshall. “Before the December meetings, particularly before the Fed signal, the markets were still slightly on the ‘higher for longer' narrative.
“That all changed dramatically in December, when the US priced in about 150 basis points off policy rates in 2024. Canada showed only 75 basis points of cuts. We had this exact same phenomenon in 2023, when markets got very rattled about rate caps. They never came through at the beginning of the year.”
As for policy rates going forward, Marshall says the central banks will manage the process of easing rates quite carefully. “The Bank of Canada says it is prepared to raise rates if it has to, because it actually forecasts inflation to come back up a bit. The rate is down at just over three percent at the moment, and BoC forecasts it will come back up a bit before it finally gets down to target in 2025.
“Labour markets are still quite tight, so that could make 2024 more difficult. That may be partly why the BoC is forecasting inflation go up a bit before it comes down. It's often the case that that last bit of getting from three to two percent is the most difficult and most costly.”
