Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.
The bond market has seen one of its worst years in recorded history, as inflation has gone from close to non-existent to levels not experienced in four decades. Even with a rally that started in early November, the U.S. 30-year U.S. Treasury index is down 26 per cent in 2022, which should teach us that bonds are not a safe haven against bear markets in stocks when inflation is skyrocketing.
Yield curves all over the globe have inverted – an unusual state whereby yields are higher in shorter term bonds than longer term ones. This historically has been a predictor of significant economic weakness.
The current consensus among market players for the year ahead lines up with this, with many expecting a recession and a major bond rally (bond prices rise as yields fall, which they usually do when central banks return to the easing of monetary policy). For stocks, many are debating whether we are at the start of a new bull market or if the recent move higher in equities is simply a short-term rally in an overall bear market. Only time will tell.
More often than not, consensus views end up being wrong. If this were not true, investors would be much wealthier than they are and market forecasting would be the world’s easiest profession.
There are three reasons for this. One, is that as humans we are fallible; attempting to predict the future in a dynamic adaptive system where billions of people make trillions of minor and major decisions is beyond Herculean. Two, a consensus tends to be self-destroying. If everyone, for example, believes prices are going to fall – and many players are taking short positions – there will be few securities to sell, alleviating the expected downward pressure on market pricing.
The third reason is that the behaviour of traders and portfolio managers is governed by psychology – something that is overly influenced by the recent past. We go from cycles of complacency to manic exuberance to despair and back again.
The market always surprises us. In hindsight, selling bonds in 2020 when yields were at rock bottom near the start of the pandemic was an “obvious” call, yet the vast majority of bond investment funds lost significant amounts of value.
It may seem overwhelmingly likely that Canadian bond investors will have a good year in 2023 if one believes the pundits.
But there’s a catch: Canadian-dollar denominated bonds have lower yields than their U.S. counterparts. As such, they do not have as much room to rally if inflation starts to come down, as most expect.
At the beginning of 2022, the 10-year government of Canada bond yield was trading at about the same level as its U.S. counterpart. Now it is about 70 basis points below the U.S. 10-year Treasury, far lower than has been the case historically. If that spread starts to narrow, it may mean underperformance for Canadian issues. (A basis point is one-hundredth of a percentage point.)
And the trajectory of inflation may hinder the performance of both U.S. and Canadian bonds. The U.S. dollar appears to have peaked and has entered a downtrend. All things being equal, this will add to U.S. inflationary pressures. Consequently, bonds may not rally as much as the consensus believes.
We also need to be reminded that from a historical point of view, interest rates are exceptionally low compared with current inflation. The human mind can get accustomed to anything. The interest rate lows of 2020 were a historical aberration. Over the past three centuries, the average long-term bond yield of the country with the world’s reserve currency – currently the United States, and previously Britain and the Netherlands – is 4 per cent. It mostly ranged from 2 per cent to 6 per cent until the great inflationary period that began in the 1960s and ended in 1982.
Today, both the Canada and U.S. 10 year bond yields are trading well below 4 per cent.
Even if the economy is as weak in 2023 as pessimists are forecasting, interest rates may decline less than some bond market bulls are expecting, limiting any price gains.
Meanwhile, when examining the outlook for fixed income securities, we must not forget the concept of creditworthiness. There is a good reason that a major Canadian bank borrows at a lower rate of interest than someone taking out a payday loan – and that is creditworthiness. Although one may argue governments create currency and therefore have unassailable creditworthiness, the reality is more nuanced. Governments run into crises all the time and even more developed countries such as Greece, Turkey and others have experienced this. Weaker credit results in higher interest rates spreads. I do not expect a serious crisis in either the U.S. and Canada in 2023, but debt levels relative to GDP have exploded, and that’s negatively affecting the creditworthiness of governments. The more debt a government, institution and even individual has relative to their cash flow, the more they will have to pay to borrow. This should result in relatively higher yields as investors demand a risk premium for a deteriorating fiscal situation.
To some extent, the outlook for bonds in 2023 will depend on the equity markets. If stock markets surprise on the upside, bond prices will be held down and rates will remain relatively high by recent standards.
Bonds are still a good idea since rates provide an acceptable return given the risk in the world economy and markets. If stock markets get ugly, bonds will benefit from the flight to quality trade. Bond bulls may not get quite the returns from bonds they’re expecting in 2023, but they will be able to sleep a bit better.