September Outlook
September 18, 2023  |  By Hank Cunningham

Inflation remains at the forefront of factors influencing bond yields and there is little doubt that it has crested globally. After three relatively mild CPI prints in the U.S., the market believes the Fed will pause in September but will likely hike again in November. Fed Chair Powell is on record as saying he would like to see several encouraging inflation reports before reconsidering the Fed’s monetary stance. However, signs are pointing to a near-term setback in inflation. Not only is the spike in energy prices contributing to this view, but wage inflation appears to be meaningfully taking hold. Thus, the “higher-for-longer” view remains.

As for Canada, the Bank of Canada faces a deteriorating economy and a fragile housing industry, as borrowers are struggling with soaring mortgage rates. At the same time, inflation remains elevated and could rise further, the employment market remains firm, and wage inflation is on the rise. The Bank of Canada is likely to stand pat, no matter what the Federal Reserve does. Other central banks have not yet signaled a pause.

However, the factors that contributed to the recent increase in yields are likely to prevent market yields from retracing lower. Such factors include the resilient economy, the $2.3 trillion annual borrowing requirement by the U.S. Government, the Bank of Japan’s move to tighten, and ongoing firmness in the important employment and housing sectors. Notably, the employment market has cooled steadily but remains healthy overall. Moreover, the Bank of Japan’s decision to allow their 10-year bonds to move another 50 basis points higher, towards 1%, may cause Japanese investors to repatriate some of their foreign holdings, thereby putting upward pressure on bond yields. They own more than $1 trillion worth of U.S. Treasuries.

The strength in corporate bond markets and the accompanying tightening of yield spreads with government bonds argues against a recession this year. Thus, bond yields have challenged and exceeded 4.25% again with the U.S. 10-year maturity reaching 4.34%. Interestingly, the latest rise in the 10-year note was not matched by the movement in two-year yields. The yield curve is now less inverted by 25 basis points and this trend should continue.

Also of importance, the recent decline in the inflation rate, combined with the rise in interest rates and bond yields, has produced something not seen in years – positive real yields! The Fed Funds Rate at 5.5%, is now decidedly punitive. Investors can earn a pre-tax real yield and borrowers are incurring a real cost of funds.

Fixed income investors have earned meager returns this year. As measured by the FTSE Bond Universe Index, year-to-date returns have been close to zero. Corporate bonds have returned close to 2%. For the remainder of the year, fixed income investors will likely realize positive, but modest returns.

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