Andrii Yalanskyi
The bond market has started 2023 on a much stronger footing than it was on for much of last year. Greg Bonnell speaks with Scott Colbourne, Managing Director for Active Fixed Income at TD Asset Management, about the outlook for rates and the case for bonds in the year ahead.
Transcript
Greg Bonnell: With markets weighing whether central banks are close to the end of their rate hiking cycle, there’s been a growing focus on the potential opportunity in fixed income. For more on that, we’re joined now by Scott Colbourne, managing director for active fixed income at TD Asset Management. Scott, welcome back to the program.
Scott Colbourne: Thanks, Greg.
Greg Bonnell: So this is this is supposed to be the year, right, we’ve been talking about this for several months now, but the opportunity in fixed income if certain things happen in the market this year. So how are we set up?
Scott Colbourne: Well, we anticipated it’d be a reasonably good year for fixed income. I mean, if I could only annualize the last three months, though, we’d be even better. So over the last three months, the markets, broad bond markets are up about 5 to 7%. So I wouldn’t expect that sort of annualized performance going forward. But, you know, you’re still talking about very good yields both in the government bond market and the corporate bond market. And, you know, as a firm, we’ve generally liked, you know, fixed income for a while here. So, you know, we are coming towards the end of the rate cycle, at least in North America and in emerging markets, Europe and Japan, maybe elsewhere. But at the moment, we’re coming in towards the end of that sort of rate hiking cycle, whether we got one or two more going forward. And then we’ll see from there.
Greg Bonnell: Is that really the base condition right now that indeed we do sort of get that scenario play out where we’re expecting, you know, more hikes from our central banks, including our own. But then when they get to that certain point and they’re very– I guess the market betting they’re very close to that, then we just stay there for a while. Is that the base condition for fixed income to work in our favor this year?
Scott Colbourne: I mean, I think if the governor Powell is, you know, we talked about pace and the pace is becoming, you know, a dead issue, we’re at the end of it. So now it’s the destination at the Fed. The markets are sort of debating between, is it one or two more hikes this year? And then Bank of Canada’s one hike. And then the question is, as you suppose it is, how long are we going to stay there? Really, the markets are saying six months. That’s it. And within a year, we’ve got two to three cuts priced in in both Canada and the US and two years out we’ve got about seven or eight cuts priced in. So there’s a lot of forward looking, you know, the inflation issue by and large for the markets, at least the bond market, is a debt issue. Like it’s come and gone, whether it’s, you know, the TIPS market, the real return bond market or the TIPS fixing markets or the swaps market, really inflation is not an issue. So it’s a question of growth. Are we going to sort of land in this Goldilocks soft landing where, you know, inflation’s come down a lot, the central banks step back, start cutting, the labor market softens up, but wages sort of settle in nicely and off we go. And we have a great, you know, risk-on market in the equity market, in the credit market.
So that’s the debate we’re having right now, is that transition, how long will we keep at, you know, that steady rate hike and before we pivot to any cuts and what it means for the economic outlook. And there’s definitely a lot of uncertainty as for that frame of reference.
Greg Bonnell: I want to ask you what the bond market is telling us about that, because, of course, you have the central banks working and doing, you know, what they’re doing pretty aggressively all through the last year. And so the front of the curve perhaps feels a little bit more as we get further out the yield curve. What is the market telling us about the economy, where they think we’re headed in this economy?
Scott Colbourne: When you look at financial indicators, so the yield curve is the obvious one that we’ve talked about for a long time is flashing red. It’s a leading indicator of a potential for recession. You’ve got leading economic indicators that came out this morning and that also reinforced this. But then you step away and you look at some of the harder data and it’s a little less clear in terms of whether we’re flashing red in terms of recession. And this is sort of where I think people are sort of landing in terms of the outlook at least right now, is, look, it looks like a soft landing, maybe a recession lite, but nothing to worry ourselves too much about. And, you know, let’s put aside for a variety of reasons the big, you know, yield curve inversion and we’ll move on from that and central banks will pivot quickly to cutting.
Greg Bonnell: I want to talk about that, right, because some people are saying, the naysayers who don’t believe in that narrative will say, hey, if you get central banks cutting within six months or before the end of this year, it’s because something has gone horribly wrong in the economy. But as you lay out the pricing that we’re seeing in the market actually, it seems to suggest that we’re going to get those cuts at the end of the year according to the market. And it’s not going to be because we’re in a deep recessionary hole. So because everyone just simply just mellowed out. I mean, is that is that a bit of a– I think you might have to use the term Goldilocks earlier.
Scott Colbourne: And that’s a tough landing to nail, right? It doesn’t happen very much in economic history. And so, you know, is this a transitory Goldilocks, you know, is a way of looking at it, that the degree of uncertainty is very high. We’ve had a lot of uncertainty as we’re coming out of the pandemic, incredible monetary policy and fiscal policy. And we’ve sort of ripped the bandage off of financial repression where interest rates were kept low and inflation was high, and that we had negative real yields. Now, in the bond market, there are positive real yields on where inflation is going. And with that, it creates a lot of uncertainty in terms of the outlook for economic growth, inflation. You know, the economic growth path around the world, the US dollar.
So you sort of ask, where are we going? Are we going to land on that Goldilocks? I doubt it is my personal opinion. So, you know, I’m keeping our investment sort of very flexible and mindful of the fact that a lot is priced in for, you know, the good news story of a lot of cuts. I don’t think it’s going to play out the way that the market thinks. But, you know, within financial repression and coming out of this now, positive real rates and lots of uncertainty, it’s going to be a very challenging market to navigate.
Greg Bonnell: Is the market paying enough attention or perhaps individual retail investors paying enough attention to the other parts of what the central banks have been doing? The headline is always the next rate announcement going to be 25, is it going to be 50? What are they going to do when they’re going to hold it? But what about some of the quantitative tightening outside of just the, you know, the overnight rate? So, you know, the pulling back of the bond buying, all that kind of stuff, letting the balance sheet roll off. Is that being factored in enough?
Scott Colbourne: That is continuing, right, the broad drain of liquidity and that is a headwind for the broad, you know, risk-on markets. I would add to that quantitative tightening and the ECB is going to step into that as well, is that, you know, you’ve got other central banks out there stepping into the, you know, the withdrawal of liquidity in the markets. So ECB will be going and they’ve got about another 5 to 6 hikes priced into the market. You know, what’s been topical over the last couple of weeks is the Bank of Japan. And I think most observers think that the Bank of Japan will step away from its yield curve control in some fashion. And in fact, the bond markets have priced in over the next year or two hikes. And so, you know, you’ve got that broad setback of liquidity, whether it’s the Fed or ECB or the Bank of Japan. And that’s going to be a headwind against, you know, the broad risk-on market. So from an asset allocation point of view, it’s going to be choppy and uncertain. And I think that that’s what investors should take away.
I mean, we’ve had a tremendous rally in the bond market. I don’t think this rally continues with the same pace, but I still think it’s very attractive. Look, worst case scenario, rates go back up given where yields are right now and given where you lose in terms of prices, probably your worst case scenario this year is zero. But on the other side, you’re either clipping a coupon of between 3 and 5%, which is a great thing, or you’ve got a little bit of a recession hedge, particularly on longer dated bonds. You know, the economy slows down. We do get the Fed and the Bank of Canada cutting and you’ve got that insurance by being in long duration government bonds. So I think it’s a reasonable place to buy bonds, maybe not the same returns that we’ve had over the last three months, but it’s not bad. And I think given the withdrawal of liquidity, whether it’s the Fed, ECB or the BOJ, that is a supporter for the fixed income market.
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