There was no shortage of predictions, proclamations and warnings about the economy last year, with experts of all stripes – as well as bond markets – now appearing convinced that rate hikes are behind us, and that, at most, we’ll be in for a “Recession Light” in 2024.
But, as the portfolio managers at Canso Investment Counsel Ltd. point out in their latest Canso Market Observer, this isn’t the first time “wants, prejudices, and biases” led to a premature victory cry in a fight against inflation – and “the question for bonds yields is very much whether inflation has indeed been defeated.”
“The Break Even Spread (BES) on long RRBs (Real Return Bonds) represents the yield difference between nominal (normal) Canada bonds and RRBs of the same term and represents the bond market’s predicted maximum inflation over that term,” Canso says in its January 2024 Market Observer, noting that it’s currently 1.6%, “just shy of where it was prior to the pandemic in 2018 and 2019.”
While that suggests the current bond market consensus belief is that inflation is under control, it’s important to keep in mind that “no Wall Street economist or strategist is likely to predict a coming inflationary Armageddon and recommend selling all the bonds from one’s portfolio. At the moment, there are few calling for caution in the bond market after the powerful rally we’ve just seen.”
Inflation history, however, shows that the last time we saw similar levels of inflation, central bankers were also too quick to pull back on rate increases. Inflation soared in the 70s on the 1973 Arab oil embargo, climbing to 12% from 3%, before dropping 7% to 5%, by 1977.
“Central bankers eased too early, convinced they had defeated inflation. Considering their job done, the Fed then eased monetary policy and inflation soared to over 14% in 1980 before the Volcker Fed slammed on the monetary brakes and took interest rates to exceedingly high levels, caused a severe recession, and finally defeated inflation.”
Given all the ups and downs it’s taken to get us here, whether the end of rate hikes is real and sustainable, or simply wishful thinking, remains to be seen, and for Canso, that means proceeding with caution.
Read more about the monetary policy decisions and investor choices that brought us here, and what this may mean for bonds, in the January 2024 Canso Market Observer.
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