Originally published on July 6, 2023.
The second half of the trading year is underway at a time when many central banks are signaling more rate hikes may be needed to tame inflation. Scott Colbourne, Managing Director, Active Fixed Income at TD Asset Management, discusses the implications for the bond market and investors.
Greg Bonnell: We’re past the halfway point of the trading year. Many central banks still signaling there could be more hikes to come to tame inflation. Joining us now to discuss what the current environment looks like for the bond market, Scott Colbourne, Managing Director of Active Fixed Income at TD Asset Management. Scott, always great to have you on the show. Welcome back.
Scott Colbourne: Thanks, Greg. It’s great to be here.
Greg Bonnell: So as we hit the halfway point of the year, perhaps we’re in a situation where the markets only a couple of months ago thought we wouldn’t be. Central banks maybe would have been done by now, maybe would have been signaling cuts– it’s a different landscape now, where they’re still threatening to hike borrowing costs on us. So how do we read it all for the bond market?
Scott Colbourne: Well, I think we can take a little bit of a lesson from the first half of the year. When you think back to the beginning of this year, we were quite concerned about recession, inflation, and, as you pointed out, there was some expectation of a cut at some point. But there was rallies, and selloffs, and rallies, and selloffs in the fixed income market.
At the end of the day, I think we looked back, and it was sort of what we call an income year first half of the year. And maybe that’s instructive for the second half of the year as well. So basically, you didn’t get the big rally. You didn’t get the relief that investors were looking for, or the pivot out of central banks, and so maybe this is– the playbook for the second half of the year is that we’ll just have another income type of year or clipping a coupon for the balance of the year as we sort out these challenges.
Is the recession going to play out? How many more hikes are left? Central banks in Canada and the US have got one to two. Through the balance of the year, hikes still priced into the market. So maybe in that environment, you don’t really get any relief in terms of a big rally in long rates or even short rates, but you get an income year — which is maybe not what we were looking for at the beginning of the year, but it is satisfactory. And it’s still an important part of your portfolio.
Greg Bonnell: And on the equity side, you talk to investors who are dividend investors and they say, I’m getting paid to wait. So if it takes a while for whatever stocks I have in my portfolio to do what I think they’re going to do, I’m still collecting those dividend payments — so sort of the same thing in the bond space. You’re still getting — and you’re getting now coupons that you weren’t getting before all this.
Scott Colbourne: Yeah, and I think that’s when you have to think about income, liquidity, and hedging as tools that fixed income play– and for the first time in a long time, we have income. And it’s a great tool to have. And so yeah, you’re paid to wait. And if you have some long-duration assets in your portfolio, that might hedge the possibility of a recession going forward.
Greg Bonnell: When we talk about the central banks, it’s interesting in the fact that although we thought we may be done by now, we’re getting signals, pretty strong ones, particularly from the Fed, that they have a few more to go. Bank of Canada, after surprising us last month, perhaps has another one for us. At the same time, I’ve seen people say, well, it may not be over, but we’re obviously closer to the end of the cycle than we are to the beginning. How does that set us up, then, going forward?
Scott Colbourne: Yeah, I think it’s a fair way to think about it. I mean, I’ll use governor Tiff Macklem, right? I mean, basically headline inflation has come down. And we’re concerned about the core inflation, the sticky inflation, and how that plays out. And he pointed out over the course of the next year, going from three to two is the tough part, right?
And so that’s going to mean central banks, if that plays out and things are steady and there’s no big shocks, it’s going to be higher for longer in terms of central bank policy. So is it one? Is it two hikes out of the Fed and the Bank of Canada?
But I don’t know. It doesn’t really matter. If you get one more and they’re on hold for six months, that type of expectation sort of has to be creeped in and factored into the market. And that’ll play into mortgage markets. It’ll play into portfolios. And at the end of the day, that leads itself to a sort of a bit of a coupon clipping market.
Greg Bonnell: What would it take to knock them off hold? If they play out the way it seems like it’s going to be now, maybe get two more from the Fed, then they stop. You get maybe one more or not from the Bank of Canada, then they stop– and they’ve clearly communicated saying, we’re going to get there and we are going to hold for a longer period than, perhaps, the market had been predicting. What knocks them off that course, makes them reverse?
Scott Colbourne: You could get a Goldilocks scenario, right? All of a sudden, inflation and core inflation just does a wonderful transition to 2%. And we continue to have growth. And that just gives the central banks, who say they are in restrictive territory, the ability to maybe factor in a cut or two. And that gives some relief. And that is, obviously, a positive scenario for markets.You could also get the darker– recession, things crack, whether it’s in the UK, or Canada with housing-driven challenges, or other markets, right? So you’ve got to handicap those probabilities. But those are examples of taking the Fed and the Bank of Canada off their path.
Greg Bonnell: When we take a look at other central banks– obviously, Britain is in a bit of a different situation, the fact that their headline inflation isn’t coming down. Is that something that is idiosyncratic to the British economy, everything they’ve been through with Brexit and other factors? Or is this something we need to worry about here?
Scott Colbourne: No, I think that’s the right way to look at it. They’ve had a lot of idiosyncratic things. The markets got six more hikes priced into there. So you look around the world, and maybe it’s a one or a two, and then you’ve got the UK, which is taking their policy rate from where they are right now to about 6.25%. So it’s definitely different than elsewhere.And when you look at the early movers, which were emerging markets, a number of those markets are transitioning to definitely on pause, and even raising the possibility of cuts. So the UK looks singularly different than a lot of places around the world, in addition to Japan, which is on the opposite side of that.
Greg Bonnell: When I think about investors who are hunting for yield, obviously, in an environment like this, the math kind of changes. Before all this– the TINA trade, right– there is no alternative. People were into equities because they’re trying to get some gain there for their portfolios. They weren’t getting it off of coupons.In this environment, obviously, you’ve got bonds now paying a coupon they weren’t paying for a while, but you also have GICS, money market funds, other instruments– what’s the competitive landscape for investors’ dollars? Where are they flowing?
Scott Colbourne: It’s been a great year for fixed income. I know that some people look at the returns that are modest or the arguments that you should be in fixed income and it would be the year of fixed income. Besides that, we’ve had about $120 billion of flows into the fixed income market in the US. And a lot of that has gone into government market, a little bit into the credit market as well. So broadly speaking, investors have used this adjustment higher in yields as an opportunity to rebalance their portfolios and add to income, and are patient and willing to take it, even if the sticks at the high level and even if it hasn’t played out to the playbook that people were arguing for at the beginning of this year.
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