Anyone who held onto the idea that bond markets are safe and boring got that notion shaken out of them fairly violently this past year.
Market participants had plenty to keep them on edge, from rate hikes and persistent inflation to fluctuating yields and geopolitical events.
Despite all those distractions and endless hope that each time central banks raised rates would be the time that made things better and quelled spiraling inflation, investors would be wise to keep their eye on the supply of money above all else, say the portfolio managers at Canso Investment Counsel Ltd. in their December 2022 Market Observer.
“It’s all about monetary policy and central banking. If the central banks are truly serious about crushing inflation, they can do it, as the Fed did in 1981,” Canso says in its newsletter.
“On the other hand, as we know from the lateness of the central banks’ response to pandemic cost pressures and the non-temporary inflation we are now experiencing, central bankers might want to appear omnipotent, but they are only human.”
According to the break even spread (BES) between the Canadian Real Return Bond (RRB) Index and the Long Canada Index, or the market’s maximum inflation expectations (which is the difference between nominal bonds and inflation-linked bonds – or Real Return Bonds – in an efficient market), the current predicted inflation is an annual rate of 1.9% over 30 years.
That’s a maximum CPI inflation of 1.9 to 2.0%.
“The problem for the markets is that they have gotten far ahead of themselves in terms of long Canada yields … (bondholders) obviously believe inflation is headed back to the 2% BoC target, if the market and the BES are to be believed,” Canso says.
“Hopefully inflation will fall, but it is not reasonable to think the BoC will reach its 2% target any time soon, looking at current core inflation and wage growth running near 5%. The BES shows that Canadian bond investors have already declared victory and impound 2% as inflation for the next 30 years. To us, that seems a tad premature.”
Will all this show that central bank intervention in the bond markets and quantitative easing went too far?
“That’s what we are about to find out.”
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