Macro versus the bond markets
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Franklin Templeton on the attractiveness of fixed-income fundamentals
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“SO, WHEN do you think central banks will start cutting rates?” has been a popular question from clients – so popular, in fact, one could argue that the fight against inflation and the future of policy rates has been the singular, overriding driver of market returns so far this year.
Central banks have made considerable progress toward getting back to their inflation targets, although progress has slowed lately, suggesting a “last mile” problem. Still, lingering inflation did not prevent the Bank of Canada (BoC) from initiating its rate-cutting cycle with the first 0.25 percent cut on June 5, bringing the bank’s overnight rate down to 4.75 percent, the same level as one year ago.
Mortgage interest costs and rents are by far the biggest subcomponents keeping inflation above central-bank targets. Canada headline inflation is 2.9 percent, but if you strip out mortgage interest costs you find inflation running at about 2.1 percent. The US headline number is 3.3 percent, with core at over 3.4 percent. The strength of the US economy means the US Federal Reserve (the Fed) can stay on pause longer than the BoC. That said, the challenge of finding monetary equilibrium remains complex.
Franklin Resources, Inc. [NYSE:BEN] is a global investment management organization with subsidiaries operating as Franklin Templeton and serving clients in over 150 countries. In Canada, the company’s subsidiary is Franklin Templeton Investments Corp., which operates as Franklin Templeton Canada. Franklin Templeton’s mission is to help clients achieve better outcomes through investment management expertise, wealth management, and technology solutions. Through its specialist investment managers, the company offers specialization on a global scale, bringing extensive capabilities in fixed income, equity, alternatives, and multi-asset solutions. With more than 1,300 investment professionals and offices in major financial markets around the world, the California-based company has over 75 years of investment experience and over US$1.6 trillion (approximately CAN$2.2 trillion) in assets under management as of April 30, 2024.
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“Currently, the credit market is pricing in a soft/no landing scenario, so we prefer to maintain our liquidity by investing in short-duration, high-quality paper that ... offers a relatively attractive level of yield”
Tom O’ Gorman,
FRANKLIN FIXED INCOME
Canada’s economy is in considerably worse shape than its US counterpart. Growth has slowed to a crawl, with homeowners struggling to renew mortgages at higher rates at a time when unemployment has risen and consumers are cutting back on spending. In contrast, the US economy continues to benefit from size, diversification, and the fact that, to a large extent, homeowners and corporate borrowers have been able to lock in comparatively low, long-term lending rates.
Although the BoC is expected to cut rates further than the Fed, the pace is likely to be gradual. The BoC is strongly affected by US central bank policy, and there is a limit to how far it can diverge from the Fed without hurting the Canadian dollar.
As recently as March, markets were pricing in three to four rate cuts through the second half of the year, but the Fed’s latest “dot plot” now indicates only one policy rate cut toward year-end. Should the troika of US growth, inflation, and employment data all remain stronger than expected, it is plausible the Fed may not need to cut rates at all this year.
we expect a normalizing of the shape to start this year as the markets price-in rate cuts.
“[Y]ield curves remain deeply inverted. In the near term, we expect curves to remain inverted as central banks will likely be more patient with policy rate cuts while inflation metrics remain elevated”
Tom O’ Gorman,
FRANKLIN FIXED INCOME
The setup for fixed income remains bright, with fixed-income yields at attractive levels. Credit spreads have been remarkably resilient. Currently, the credit market is pricing in a soft/no landing scenario, so we prefer to maintain our liquidity by investing in short-duration, high-quality paper that, for the first time since 2007, offers a relatively attractive level of yield.
Currency will be another factor. We really like the US dollar. It is a volatility absorber, and it plays an important role not only as a hedge, but also as a way to make money when mispriced.
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Where do we go from here?
Rate volatility reflected in the markets…
Published July 16, 2024
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US and Canada inflation trend
10%
Why Canada cut first
In both Canada and the US, yield curves remain deeply inverted. In the near term, we expect curves to remain inverted, as central banks will likely be more patient with policy rate cuts while inflation metrics remain elevated. But as growth and inflation fall and unemployment rises due to tighter credit conditions, we expect a normalizing of the shape as the markets price-in rate cuts.
Rate volatility reflected in the markets…
…but fixed-income fundamentals remain attractive
We find the short corporate part of the market especially attractive. It’s at the highest point in the yield curve because overnight rates are higher than anything else. Add on 100 to 150 basis points of spread, and a one-year corporate can yield 6.5 percent or seven percent. High-quality corporate bonds with short maturities are relatively well-insulated, should rate volatility pick up. Once the market finally begins to price in a recession, we would expect to increase our credit exposure.
A stronger foundation
It’s worth remembering that just a couple of years prior to the COVID-19 shakeup of the global economy and markets, interest rates were really low, and so were bond portfolio yields. To generate returns, yield and spread compression were squeezed to the last drop. When rates started to rise, the market buckled. Fast forward to today. When you're starting with a yield of five to seven percent, it takes many more rate moves to wipe that out versus when you’re starting at one or two percent.
So, yes – we're optimistic about the asset class.
Source: 1 Macrobond; As of May 31, 2024
2 Federal Open Market Committee, as of June 12, 2024
Important Legal Information
Disclaimer: This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell, or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager, and the comments, opinions, and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region, or market.
Commissions, trailing commissions, management fees, brokerage fees, and expenses may be associated with investments in mutual funds and ETFs. Please read the prospectus and fund fact/ETF facts document before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated.
Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.
as of May 31, 2024
8%
6%
4%
2%
0%
-2%
2019
2020
2021
2022
2023
Canada Headline CPI
Canada Headline CPI excluding Mortgage Interest Cost
Canada Core CPI
US Headline CPI
US Core CPI
Furthermore, we continue to maintain a neutral duration to our benchmarks and intend to lengthen duration on clear signs of economic weakness and position for a bull steepening of the yield curve over time.
1
Macrobond, as of May 31, 2024
2024
Source: Bloomberg
2
As of July 9, 2024
Canada yield curve
7%
6%
5%
4%
3%
2%
4.66%
4.59%
4.50%
4.30%
3.87%
3.62%
3.43%
3.43%
3.50%
3.51%
5.33%
5.37%
5.29%
5.00%
4.63%
4.40%
4.24%
4.25%
4.29%
4.58%
1
mo
3 mos
6 mos
1 year
2 years
3
years
5
years
7
years
10
years
20
years
Canada
US
Source: 1 Macrobond; As of May 31, 2024
2 Federal Open Market Committee, as of June 12, 2024
Important Legal Information
Disclaimer: This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell, or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager, and the comments, opinions, and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region, or market.
Commissions, trailing commissions, management fees, brokerage fees, and expenses may be associated with investments in mutual funds and ETFs. Please read the prospectus and fund fact/ETF facts document before investing. Mutual funds and ETFs are not guaranteed. Their values change frequently. Past performance may not be repeated.
Franklin Templeton Canada is a business name used by Franklin Templeton Investments Corp.
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It’s worth remembering that just a couple of years prior to the COVID-19 shakeup of the global economy and markets, interest rates were really low, and so were bond portfolio yields. To generate returns, yield and spread compression were squeezed to the last drop. When rates started to rise, the market buckled. Fast forward to today. When you're starting with a yield of five to seven percent, it takes many more rate moves to wipe that out versus when you’re starting at one or two percent.
So, yes – we're optimistic about the asset class.
Where do we go from here?
Why Canada cut first
Rate volatility reflected in the markets…
A stronger foundation
About
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Resources
Investments
Pensions
Benefits
News
RSS
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Contact us
About us
External contributors
Authors
Terms & Conditions
Terms of Use
Subscribe
People
Companies
Copyright © 1996-2024 KM Business Information Canada Ltd.
Where do we go from here?
…but fixed-income fundamentals remain attractive
The setup for fixed income remains bright, with fixed-income yields at attractive levels. Credit spreads have been remarkably resilient. Currently, the credit market is pricing in a soft/no landing scenario, so we prefer to maintain our liquidity by investing in short-duration, high-quality paper that, for the first time since 2007, offers a relatively attractive level of yield.
A stronger foundation
It’s worth remembering that just a couple of years prior to the COVID-19 shakeup of the global economy and markets, interest rates were really low, and so were bond portfolio yields. To generate returns, yield and spread compression were squeezed to the last drop. When rates started to rise, the market buckled. Fast forward to today. When you're starting with a yield of five to seven percent, it takes many more rate moves to wipe that out versus when you’re starting at one or two percent.
So, yes – we're optimistic about the asset class.
1
2
2
1