Generating alpha in the face of a more hawkish Bank of Canada

Paul Marcogliese's picture

The Bank of Canada's hawkish shift

In an interview with CNBC at the end of June, Governor Poloz communicated a surprisingly hawkish tilt at the Bank of Canada (BoC). The markets, unready for this degree of hawkishness, sent yields screaming higher. By the time the BoC raised its overnight rate 25 bps only a couple weeks later, thereby unwinding half of the stimulus injected into the Canadian economy during the oil downturn, the Canadian government ten-year bond yield was up over 40 bps to 1.88%.

We were also surprised by this level of hawkishness and believed the BoC would not start raising interest rates in 2017 even if the U.S. Federal Reserve continued their hiking path. There were good reasons to keep rates on hold:

  • Inflation had softened to 1.3% in May from 1.9% in the first quarter of the year.
  • Western Canada was still recovering from the oil downturn.
  • We felt that the lack of clarity on trade agreements and import tariffs related to the Trump agenda warranted a “wait and see” policy approach.
  • While the Canadian economy was doing well, Canadian households faced a heavy debt burden that amounted to over 165% of disposable income. In the U.S., households maxed out around this level just prior to the Financial Crisis. By raising rates, the BoC would risk pressuring household balance sheets and having a dramatic impact on personal spending. Time will tell.
  • The markets were in agreement with our view pricing in little or no hikes into the Canadian government yield curve at the start of the year. Thus, we saw the yield curve as fairly valued and focused less on the direction of rates (or duration) to add value. Instead we looked for alpha in other areas like foreign holdings and credit.

Finding alpha in foreign holdings and credit

The Cambridge Bond Fund generated a total return of 3.2% and outperformed the FTSE TMX Canada Universe Bond Index by 82 basis points in the first half of the year. The Cambridge Bond Fund is not available to the public but is enjoyed by investors in the Cambridge Asset Allocation Corporate Class and the Cambridge Global High Income Fund.

We drove a large part of this outperformance by overweighting foreign bonds. Our foreign holdings made up greater than 20% of the total portfolio for most the year with U.S. dollars bonds constituting the vast majority. We hedged out our U.S. dollar exposure for these investments. We took an overweight position in U.S. dollar bonds because we believed they were an attractive investment compared to Canadian dollar bonds. The U.S. Treasury yield curve was pricing in more Federal Reserve rate hikes than what we thought were likely. This meant we could purchase bonds with a higher yield and generate stronger capital appreciation should yields fall in anticipation of fewer rate hikes.

We also generated alpha through an overweight in corporate bonds and by focusing on bonds with higher relative spread. Spreads were at a reasonable level and the large demand for corporate bonds suggested spreads could compress further, which ultimately happened. Our corporate weight was as high as 50% of the portfolio and helped drive capital appreciation. We were able to selectively generate alpha in corporate bonds through our credit research and relying on Cambridge’s equity analysts who look for core companies with a sustainable competitive advantage and a strong history of capital allocation.

Scanning the market for new alpha-generating opportunities

Today, the hawkish tilt of the BoC has changed market dynamics and the opportunities to generate alpha. The U.S. Treasury yield curve is becoming less attractive than the Canadian government yield curve. As a result, we started to lower our foreign bond holdings. We have also been lowering our corporate weight and high grading the credit quality of the corporate portfolio. Spreads have compressed to fairly tight levels, making the risk/reward less compelling, especially if global central bank tightening drives credit spreads wider. Finally, we believe the market is pricing in too many rate hikes and an overly aggressive pace of tightening from the BoC. Thus, in contrast to the first half of the year, opportunities to add alpha in duration or the shape of the yield curve could potentially present themselves. In the second half of the year we hope to continue our performance by continually monitoring the market to find the best opportunities for reward while minimizing risk.

 
 

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Comments

Submitted by Dan Sexsmith on

In 2015 the Bank of Canada lowered rates twice by 0.25%. Each time the banks refused to pass along the full rate decrease and only lowered prime by 0.30% instead of 0.50%. Last month the Bank of Canada raised rates by 0.25% and the banks raised prime by the full 0.25% (which the financial media and bloggers happily accepted). From my view there was 0.30% stimulus in 2015 and there was 0.25% tightening in 2017. The remaining difference is 0.05%. How is this half? No one actually borrows at the overnight lending rate so it’s a meaningless figure compared to prime (which the banks apparently can control independently). My larger question is why would the Bank of Canada raise rates again in the fall when they have already reversed 0.25% of the 0.30% emergency stimulus from 2015?

Paul Marcogliese's picture
Submitted by Paul Marcogliese on

Thank you for your question, Dan.  You are correct: Canadian bank prime rates are only 5 basis points lower than before the Canadian bank cuts in 2015.  Therefore, as a whole the floating rate mortgage level has not changed a great deal.  Most floating rate corporate borrowing is not done off of the prime rate; rather it is done off either a CDOR rate or the 3-month treasury bill rate, both of which are approximately halfway to their 2015 levels.  You raise a good point about whether the Bank of Canada is going to increase the bank rate again this year. We feel that whether the Bank of Canada will raise rates or not depends on what effect it expects a rate increase to have on the economy.  

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