Fixed Income:
Are we there yet?

How high will rates get, how long will they stay there and when will they begin to come back down?

By Al Rizk

August 10, 2023

Since central bankers around the world began raising rates in 2021, markets have been trying to discount the end game. How high will rates get, how long will they stay there and when do they begin to come back down?

Of course, the path of interest rates is highly dependent on factors that nobody can accurately predict. How quickly will inflation come down and will the economy enter a recession are likely the two most important issues.

There has been a tug-of-war between financial markets and central bankers. Markets have been pricing in a lower peak and an earlier pivot than officials. We have seen many examples over the last six months where speeches made by central bankers have led to market drops and trend reversals to the downside. It has become a familiar pattern: market participants begin to assume the tightening cycle is set to end at a certain rate (terminal rate), only to get pushback from officials that rates will be “higher for longer”.

There has been a tug of war between financial markets and central bankers. Markets have been pricing in a lower peak and an earlier pivot than officials.

Notwithstanding the tough talk, recent developments in the banking sector clearly indicate that the financial system is already struggling to withstand the current monetary conditions. Problems at several small American banks triggered a panic in financial markets a few weeks ago. While these issues were self-inflicted to a large extent, they uncovered the damage being done and the limit that can be tolerated by the system to the relentless rise in rates.

Furthermore, rates have already fallen for longer-dated fixed-income maturities. In fact, in a recent issue of TFI, I wrote about the opportunity to purchase 5 year guaranteed investments at rates in the 4.5 to 5% range. Since that time rates have steadily fallen. Those rates are no longer available. Shorter term maturities (1-2yrs) at 4.5 to 5% are still accessible, this inversion (higher rates for shorter maturities) is due to market expectations of rate cuts.

Recent comments from Fed officials are centered around whether or not a 25-basis point hike in May is on the table. Some market participants believe that the recent turmoil in the banking sector is acting as a drag on economic activity and perhaps rate hikes are finished.

What we are talking about is relatively minor compared to where we came from. The rapid rise of borrowing costs and the damage done to bond portfolios is now water under the bridge. The economic fall out however is not.

This is precisely the case for rate cuts. The argument is pretty simple, the economy can’t handle these rates, and the effect of higher rates was instantaneous on marketable securities, but will take time to show up in the real economy. When it does, an economic slowdown or recession will force a pivot. Meaning that economic weakness will force central bankers to cut interest rates to stimulate economic growth. Since markets are forward-looking, they are telling you what’s going to happen, and hence rates have already moved lower.

‘How quickly will inflation come down and will the economy enter a recession are likely the two most important issues.’

Here in Canada, it would appear we have already reached the terminal rate. Despite recent comments by Bank of Canada Governor Tiff Macklem suggesting that while rates are on pause, the bias remains to the upside, however, market participants are not convinced. The most recent inflation data is dovish and supports the market’s position.

After being massively underweighted bonds going into the tightening cycle, we have been slowly and steadily adding to the fixed-income component of accounts. We still believe that equities will most likely outperform a 4-5% guaranteed investment over the next 5 years, nonetheless, we believe the reduced volatility and an asset that will perform well in a recessionary environment is a good idea.

How good an investment fixed income is at this point depends on the future path of inflation. If as central bankers insist, inflation comes down to 2%, then a 5% nominal return is not bad. If however, inflation stays higher. then clearly it will be less profitable. You may want to hedge your bet by keeping an important component of dividend growers who can keep pace with rising prices.

Are we there yet?…..probably…..Al.

Al Rizk

Feature image courtesy of BMO Nesbitt Burns

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