Hitting snooze on the bond trade

Market recap

• Equity markets struggled this week, with firm U.S. inflation data further pushing out Fed easing expectations, and even the Bank of Japan is set to end an era of negative interest rate policy.

• The S&P 500 dipped 0.1%, with Consumer Discretionary and Health Care lagging.

• The TSX added 0.5%, as Energy and Materials posted solid gains.

Inflation

With the U.S. Federal Reserve’s (Fed) “dot plot”—a projection of the expected interest rate trajectory—set to be released this week, attention has turned to recent inflation numbers. Data released last week showed that prices picked up slightly in February, prompting questions about whether rate cuts in 2024 could be in jeopardy. Let’s address the biggest concern first: no, we don’t expect the Fed to move away from their rate cut trajectory. However, we’re not likely to see 50 bps cuts on the way down like we saw 50 bps hikes on the way up, and the schedule for rate cuts is not likely to be aggressive, either. Some investors and analysts have been expecting more than three rate decreases before the end of 2024. In our view, this is aggressive and may not happen, but we continue to believe that between two and three cuts is the most likely scenario. Given the continuing resilience of the U.S. economy, we wouldn’t necessarily be surprised if there are no rate cuts at all in 2024. That is not our base case, however.

Bottom Line: With inflation persisting, we wouldn’t be shocked if the Fed doesn’t lower interest rates in 2024; the most likely scenario, however, is two-to-three rate cuts before the end of the year.

Bonds

The U.S. Treasury’s monthly auctions for bonds showed relatively weak demand in March. Should this worry fixed income investors, and does it mean that interest rate spreads are likely to blow out? In our view, there is some risk—it’s not disastrous that the auctions drew little interest, but it’s certainly not a great sign. Low demand for bonds means that yields will have to go up in order for them to be attractive, and that’s not necessarily positive for bond returns; bond yields tend to be inversely correlated with bond prices. However, if rate cuts do seem imminent later in the year, then that would be a tailwind for bonds because yields would likely head lower and investors would start to believe that bond prices will pick up. With the current pace of equity returns, we could see demand pick up for bonds as equity valuations start to become excessive, but we are not there yet.

Bottom Line: Weak demand for bonds isn’t great news, but potential interest rate cuts and a rotation from equities could cause demand to pick up later in the year.

Earnings

With persistent inflation, speculation about interest rates, and political (and geopolitical) news all creating noise in markets, what should investors expect from corporate earnings for the rest of the year? Overall, we’re still optimistic. As long as the consumer is spending and the employment picture looks relatively good, which is the case at present, we wouldn’t anticipate any major misses. However, keep in mind that expectations do remain high and the bar to beat may not be easy. As the year progresses, there may be an adjustment in spending patterns—we’ve already seen some of that earlier in the year with luxury items, though that trade down seems to have stalled in the last quarter. For now, though, money continues to flow into Consumer Discretionary, and consumers don’t seem to be adjusting as sharply as some had expected.

Bottom Line: We’re still optimistic on corporate earnings, though they may be affected by adjustments in consumer spending in the second half of the year.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled The Bulls Keep Running: Why Markets Remain Upbeat.