January Outlook
January 22, 2024  |  By Hank Cunningham

The bond market rallied further after the recent dovish comments from the U.S. Federal Reserve, pushing yields lower at all maturities. Several Fed officials have been quick to douse the market enthusiasm for near-term reductions in the Federal Funds rate, conditioning investors to be patient. Too early a reduction could be counterproductive to its inflation fight. What is more probable is a gradual move to lower rates with the Fed Funds rate likely to settle in the 3%-4% level.

Importantly, while inflation has steadily improved, it is becoming sticky around 3% and expectations have inched higher. Also, the labour market remains healthy with the unemployment rate low and as wage growth has moved to 4%. Belying recession forecasts, corporate bond spreads remain tight to government bonds.

Besides this, the bond market must deal with not only the tsunami of U.S. Treasury bond issuances to fund the deficit but also ongoing quantitative tightening.

This argues against further declines in bond yields, especially long-term bonds. At 4.1%, the U.S. 10-year offers investors no premium over inflation and may not fall in yield from here. It could possibly move higher.

The net effect will be an eventual return to a positive yield curve with 3% as its base and the two- to six-year maturities falling below the 10-year and longer.

The Bank of Canada faces a weaker economy than the Fed, and it would like to begin to reduce its bank rate but is being restrained by stubborn inflation and strong wage increases. Our mid-term rates should follow those of the U.S., thus permitting some badly needed relief in mortgage costs.

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