At long last, central banks in the developed world have finally begun to ease monetary policy in response to progress made on their inflation mandates. The Bank of Canada (BoC) is at the vanguard of this shift, having cut its policy rate by 25 basis points (bps) at each of the June and July meetings. Markets are now expecting the BoC to cut at each of the remaining meetings for the calendar year (September, October, and December).
Meanwhile, south of the border, several U.S. Federal Reserve (Fed) speakers (including Chair Jerome Powell) have stated that the inaugural rate cut for this cycle remains on the table for the September meeting. However, markets are increasingly of the view that by waiting for this long, the Fed is already behind the curve.
Indeed, the real policy rate in the U.S.—which we define as the current Fed funds target midpoint, minus the year-over-year change in inflation—is now at 240 bps. That’s the highest it’s been since late 2007 and a sign that monetary policy conditions are fairly restrictive. Keeping policy this restrictive for an extended period is a risk for the real economy, and we’ve begun to see some signs of strain emerge in the labour market.
In particular, the U.S. unemployment rate is rising as the labour market struggles to accommodate the uptick of new entrants. With the three-month moving average now rising more than 0.5% above the low for the past twelve months, the much discussed ‘Sahm Rule’ has now been triggered—which theoretically portends a looming recession.1
Narratives are powerful. Having the ‘Sahm Rule’ triggered when the yield curve has been inverted for over a year breathes more life into the view that the Fed made a mistake by standing pat a few weeks back.2
As such, Overnight Index Swaps (OIS) pricing for the September, November and December meetings reflects varying degrees of risks for multiple 50 bps cuts. The front-end of the U.S. Treasury curve has also responded, with 2-year yields moving from around 5.00% in late May to around 4.00% now. Further out the curve, 10-year yields have also shifted lower, led by both real yields and breakevens. The former has contributed the most to the decline, which implies markets reassessing long-term growth in the U.S.
Having said this, we do sense that markets have been quick to rush to judgement on U.S. data. The amount of easing priced into Fed OIS dates for this year feels excessive—especially when you consider that most models still have the U.S. economy growing at trend. There’s still two-way risk for incoming data, which implies that U.S. yields are likely in for some consolidation in the near-term.
The theme should be similar in Canada for the same reasons. Markets are pricing some risk of a 50-bps cut in September, which we think is a bit egregious. Instead, we expect that to get re-distributed into the 2025 BoC dates. Additionally, the market is still pricing an orderly easing cycle in Canada with forward OIS implying a resting spot for the BoC at around 2.50% in a few years time (which is within the BoC’s neutral range). We’re a bit circumspect on that theme as we see risks of slower activity looming in Canada which would necessitate more cuts to be priced in over time.
On the issuance front, the latest edition of the U.S. Treasury’s Quarterly Refunding Announcement (QRA) maintained the pace of coupon issuance. Additionally, the U.S. Treasury left guidance unchanged that it doesn’t expect to increase issuance of notes and bonds for several quarters.
Credit:
At the start of this year, credit spreads tightened as the momentum from Q4 2023 carried over. Since then, spreads have largely moved in conjunction with broad risk, and underlying volatility in the rates space.
We remain constructive on U.S. investment grade credit. The diversification benefits should remain appealing for Canadian investors, who tend to have a heavy home bias. Additionally, looming rate cuts and reduced term premiums should be beneficial for issuers when it comes to refinancing or carrying debt loads. U.S. banks, in particular regionals, should perform in this environment given heavy exposure to duration-sensitive investments in their held-to-maturity (HTM) portfolios.
A more normalized yield curve environment should benefit U.S. and Canadian banks as well. This remains a key theme to watch for in the credit space into Q4.
Currency:
The USD/CAD cross rate has spent most of the past few months consolidating in the 1.3600-1.3900 range.3 Realized volatility in the pair has been low, largely because the outperformance of front-end Canadian bonds has been offset by the rally in broad risk (before August, anyway) and still elevated crude oil prices. According to the position proxies that we use, markets are fairly short CAD—which implies that further consolidation in the aforementioned range is likely for now.
Changes to portfolio stats
Curve normalization is expected to be an important theme as we head into Q4. In keeping with prior patterns, we expect the front-end of the U.S. curve to lead the steepening move.
For illustrative purposes only. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Source: Bloomberg, BMO Asset Management Inc., as of July 31, 2024.
Source: BMO Global Asset Management, Bloomberg, as of August 12, 2024.
*As of July 31, 2024. Please note yields will change from month to month based on market conditions.
The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.
Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.
Definitions:
Duration: Duration is a measure of a bond’s sensitivity to changes in interest rates. It is expressed in years and helps investors understand how much the price of a bond is likely to change when interest rates move. Essentially, duration estimates the percentage change in a bond’s price for a 1% change in interest rates.
Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.
Credit rating: An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation.
1 The Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months. It is meant to serve as a theoretical indicator of possible recession.↩
2 A yield curve inverts when long-term interest rates drop below short-term rates. When the yield curve is inverted, yields decrease the farther out the maturity date is.↩
3 The cross rate refers to the exchange rate between two currencies.↩
Disclosures
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.
This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors cannot invest directly in an index.
The viewpoints expressed by the author represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.
Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.
For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.
BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.
BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.
“BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.
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Quarterly Fixed Income strategy – Q3 2024
Quarterly Fixed Income strategy – Q3 2024
Duration:
Credit:
Currency:
Changes to portfolio stats
In advance of such a move, our preference is to switch out of BMO Short-Term US TIPS Index ETF – Hedged Units (Ticker: ZTIP.F) in favour of BMO Short-Term US Treasury Bond Index ETF (Ticker: ZTS). We expect the latter to outperform as markets reassess both growth and inflation expectations in the coming years as the U.S. economy cools.
Portfolio stats*
For illustrative purposes only. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Source: Bloomberg, BMO Asset Management Inc., as of July 31, 2024.
BMO Global Asset Management, as of July 31, 2024.
Credit rating summary*
Term summary*
Source: BMO Global Asset Management, Bloomberg, as of August 12, 2024.
*As of July 31, 2024. Please note yields will change from month to month based on market conditions.
The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.
Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.
Definitions:
Duration: Duration is a measure of a bond’s sensitivity to changes in interest rates. It is expressed in years and helps investors understand how much the price of a bond is likely to change when interest rates move. Essentially, duration estimates the percentage change in a bond’s price for a 1% change in interest rates.
Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.
Credit rating: An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation.
Q3 2024 BMO ETFs guided portfolio strategy report.
Footnotes
1 The Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months. It is meant to serve as a theoretical indicator of possible recession.↩
2 A yield curve inverts when long-term interest rates drop below short-term rates. When the yield curve is inverted, yields decrease the farther out the maturity date is.↩
3 The cross rate refers to the exchange rate between two currencies.↩
Disclosures
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.
This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors cannot invest directly in an index.
The viewpoints expressed by the author represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.
Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.
For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.
BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.
BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.
“BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.
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