Last fall, I was in New York for an investment conference hosted by the Center for Financial Stability. Speakers included world-leading asset managers, academics and policy makers – an exciting line-up for an investment nerd like me! A recurrent theme during the conference was the uncertainty around Donald Trump’s policies and their potential impact to create a wider range of risks for capital markets and the economy.
So, just ahead of today’s inauguration, I wasn’t surprised when the Bank of Canada announced it was keeping its overnight rate unchanged at 0.5 per cent.
The bond market reacted as I expected. Our bond holdings showed little change as the market had already anticipated no movement in Canadian interest rates in 2017, and had priced this in. In fact, even after global bond yields rose in the fourth quarter of 2016, we had positioned our fixed-income funds with the same expectation.
I also wasn’t surprised – although maybe the markets were caught off guard – by Bank of Canada Governor Stephen Poloz’s comment that a rate cut remains on the table.
Like many others, I’m partially blaming President Trump who still represents a wildcard when it comes to U.S. policy. The Bank of Canada (BoC), along with other global policymakers, are unable to predict what the coming months will bring, and this uncertainty was reflected in the Bank’s recent rate decision and subsequent comments.
Why is the BoC considering a future rate cut? The Bank aims to keep inflation around 2% for the total consumer price index (CPI) – the goods you and I buy on a daily basis. If they were to lower rates, it would most likely be because expected inflation isn’t high enough –for example, falling food prices
As a consumer of goods, I should be cheering that my Shreddies don’t cost as much as they used to (I’m 6’5” and eat a lot of Shreddies!). As a bond manager, I also appreciate the higher rate of return, but know that lower rates are really just a sacrifice of future performance.
So what does this mean for the bond market? First of all, it’s important to note that the BoC rate influences short-term Canadian bonds, while global policy decisions (like the Federal Reserve’s December rate hike) has more of an impact on mid- and long-term Canadian bonds. That’s why Canadians are now seeing higher mortgage rates.
The possibility that the BoC could lower rates suggests the Canadian economy is weaker than previously thought. Injecting further policy support – in the form of a future rate cut – could help the economy and will likely cause short-term Canadian bonds to appreciate even more.
Changes by the BoC have less of an impact on the price of longer-term bonds and I expect a very slight drop in long-term Canadian bond prices.
Although short-term Canadian bonds are likely well anchored, I believe long-term Canadian bond yields will continue to follow their global counterparts to modestly higher levels.
As rates do rise, we’ll see short-term losses, but I also expect that those losses will be recovered quickly through higher yields – good news for your MD bond portfolio.