Fixed income mid-year review: Mistaking cyclical bounce for a turn in inflation trend

Kamyar Hazaveh's picture

A lot has changed since we positioned our various portfolios for the reflation trade back in the summer and fall of 2016. The initial euphoria around the new administration in the US has faded, continental Europe has rejected the populism that rocked the Anglo-Saxon world, and emerging market assets have seen a noticeable recovery.

Central banks and policymakers are reacting to the aftermath of the reflation trade at various speeds and with different tools. They believe that unwinding years of monetary stimulus may require coordination to prevent market tantrums and economic disruptions. Given the all-time high global debt levels, balancing growth, inflation and financial stability remains a monumental task for central banks.

Economic outlook

Inflation and growth rates in the developed and developing world have improved consistently since the summer of 2016 when global nominal interest rates hit all-time lows. In our assessment, the reflation trade peaked in February this year and has stagnated since. 

Looking ahead to the second half of 2017 and early 2018, global industrial production is slowing, which is putting pressure on realized and expected inflation. This is partially related to the deleveraging that the Chinese authorities are enforcing via their monetary and other policies (Figure 1). In addition, the US growth is projected to slow as lending to non-financial institutions and consumers slows (Figure 2) and the exhausted pent-up demand for autos and multi-family housing lowers the real growth in the US further (Figure 3). 

Figure 1. Chinese government bond curve – monetary tightening has led to near inversion between 1Yr and 10Yr points

Figure 2. Lending to non-financial institutions and consumers

Figure 3. US auto and multi-family growth rates falling

The economic cycle is most advanced in the US, where the lagged effects of central bank tightening along with some other factors are slowing the economy. The UK is ahead of the US in their downswing and is closest to an economic downturn. Japan, Canada and Europe are behind the US in their growth cycles in that order.

Central banks

With the prospect of a fresh slowdown in inflation in front of us, the US Federal Reserve (the Fed) will face difficulty sticking to their best laid plans for further rate hikes and balance sheet reduction (quantitative easing [QE] unwind). 

The most interesting developments in central banking are now outside of the United States with the European Central Bank (ECB), Bank of England (BoE), Reserve Bank of Australia (RBA) and the Bank of Canada (BoC) sounding hawkish in preparing to tighten monetary policy. This came around the time that the Bank for International Settlements (BIS) released their annual report encouraging central banks to take a longer-term view in balancing growth and inflation objectives vs financial stability goals. The tone out of the ECB's annual gathering in Sintra, Portugal, on June 26th was eerily in line with the BIS policy recommendation.

The so-called “Sintra accord,” as it is known in the markets, points to more coordinated monetary policy likely to avoid volatility in markets. This is compared to a similar gathering, the “Shanghai accord” in February 2016, after which central banks paid more attention to the impact of their policies on currency volatility, which at the time was wreaking havoc on financial markets. Neither accord is officially acknowledged by any central bank.

The Sintra accord is ill-designed for many reasons. It is fighting the last war and has learned the wrong lessons from it. Unlike in 2015 and 2016, the US dollar has fallen for most of this year and is not pressuring the global economy. The problem back in 2015–16 was not the lack of FX policy coordination; it was the Fed's policy mistake to raise interest rates in an environment where the US economy was slowing in terms of growth and inflation, and that put undue upward pressure on the US dollar, leading to the Fed having to halt the hiking cycle in March 2016. 

Another problem with the Sintra accord is that tightening is not appropriate for many of the economies outside of the US, most notably the UK, where the economy is slowing. With Brexit on the horizon, the risks to the UK economy are substantially to the downside. In terms of timing, it is unfortunate that these other central banks are turning hawkish at a time when the global growth and inflation are projected to slow. Simply put, central banks are reacting to a cyclical upturn, ignoring the structural forces for the time being, and their timing for turning hawkish is off.

We are not alone in our view regarding the recent hawkishness outside of the US. Observers and investors did not see and still do not see the economic rationale behind the hawkishness in the UK, Canada, Australia, etc. This will likely translate to market volatility and possibly portfolio tactical investing opportunity in the months ahead.

The Bank of Canada – a policy mistake as priced in the bond market

In the middle of the media frenzy of covering the ECB, BoE and BoC hawkish turn, Mr. Poloz is the only central banker who has actually taken action by hiking interest rates by 0.25%.

Given the reaction in the bond market, this looks like a policy mistake to us as the Canadian outlook is fragile; our inflation is low and falling; Canadian real estate market is slowing naturally as the result of macro-prudential policies; and Alberta's economy remains subdued as oil and natural gas prices remain soft. The Bank and other commentators have used a slew of arguments that may sound reasonable to the general public to construct the narrative around the rate hike. The Bank's analysis falls short to us, notably on the following assertions.

  1. Current level of interest rates is emergency-level rates and they can take away the cuts from January and July 2015 to bring the overnight rate to 1% without too much difficulty. – This argument is false, as the current growth and below target inflation in this country when the overnight rate is below 1% will slow even further as higher borrowing costs and higher Canadian dollar weaken the economy through borrowing and export channels.
  2. The Bank’s models project the output gap to close by year-end and inflation to reach 2% thereafter. – Mr. Poloz used this argument and referred to the BoC’s decision as braking before arriving at the "red light" in a recent interview. The problem is that global inflation is in a downswing, and with the strength in the Canadian dollar, Canadian inflation is going to disproportionately weaken. Unless the Bank is afraid of consistently above 3% inflation (the upper band of the BoC target), breaking or tightening now seems ill-timed. The Bank's own inflation measures as well as both survey-based inflation expectations and those expectations priced into the Canadian bond market are depressed out to 10 and 30 years (Figure 4).
  3. Canadian inflation is depressed due to transitory factors. – This is the same mistake that the Fed has made twice in this cycle. In 2015 and again this year, Ms. Yellen claimed that the downswing in inflation was due to healthcare, wireless, autos or other reasons. In 2016, the Fed was forced to halt the tightening cycle (it had planned to hike four times and in the end only hiked once), and it seems the Fed is softening their tone again this year.
  4. Both the Fed and BoC argue that low inflation expectations in the bond market are due to illiquidity of the inflation market. – Admittedly inflation products are not as liquid as nominal Government of Canada bonds or US nominal Treasuries. That being said, when the 10-year breakeven inflation rate is just below 1.4% in Canada, by believing that long-term expected inflation is close to the 2% target, the Bank is essentially stating that the liquidity premium in inflation products is roughly 0.6%, which seems excessive.
  5. Taking action by raising rates will help to slow the explosion in consumer debt. – This is an interesting twist after the Bank has argued for years that macro-prudential policies are better positioned to address these sorts of excesses, rather than the Bank's blunt overnight interest rate instrument.

Figure 4. Canadian inflation metrics – red light?

Unless Mr. Poloz is proven right with strong and consistent inflation in the second half and beyond, the BoC tightening seems ill-timed in the context of global slowdown. The Bank needs positive surprises (or luck) either around fiscal spending or a surge in commodity prices in order not to face the consequences of their tightening. For the time being, the Bank's poor timing risks locking in the new mediocre in Canadian growth and inflation and will likely be reversed in the case any shocks hit the Canadian or global economy.

Market implications 

It seems the Fed is acknowledging that the weakness in inflation is not transitory. That may soften their tone in the months ahead both in terms of rate hikes and balance sheet reduction plans. This would mean that inflation expectations in the United States can partially recover and the yield curve can re-steepen. This development is negative for the US dollar. (see Paul Borean’s “Behind the lines in North American fixed income” and Fernanda Fenton’s “Emerging markets fixed income update”).

The Bank of Canada, on the other hand, is locked into a premature tightening for at least the next 3–6 months or so until they update their analysis of the Canadian economy. This puts upward pressure on the Canadian dollar and downward pressure on Canadian financial assets (stocks and real estate) relative to global assets, with further flattening of the yield curve as expectations surrounding our economic prospects deteriorate (Figure 5).

Figure 5. Canada 5-30 yield curve – Canadian yield curve is near post crisis flats

In Europe, Mr. Draghi is reluctantly acknowledging the improvement in the European economy but realizes that Europe’s problems are structural. This pressures German bunds cyclically and puts a floor under the Euro currency. Longer term, the yield on Italian sovereign bonds is unsustainable, and that is where the ECB will hit the wall in their stimulus reduction rhetoric. Currently 10-year Italian bond yields are about where the US Treasuries are. This situation is unsustainable given the nominal growth levels in Italy vs the US.

In the UK, Mr. Carney's inconsistent flip-flops are reminiscent of his time at the BoC. With the UK economy stuck in low gear and Brexit on the horizon, the BoE cannot hold his end of the Sintra accord. In Japan, monetary policy is effective, and the Japanese know the solution to their deflationary ills is going to take decades to solve. Mr. Kuroda sees no reason to react to a cyclical upturn given Japan's structural deflation. The Japanese yen remains the best gauge of global risk appetite as the result (see “Dr. Yen” from my post “Highlights from February Global Fixed Income Webcast”)

Fixed income investing implications

Pundits and commentators were quick to project a rising rate environment following the Bank of Canada decision. This is not new, and the advice to change the asset mix from bonds to equities or to migrate the fixed income exposure to cash, short duration or floating rate has failed numerous times. Rising overnight rates does not mean bonds would do poorly. It depends. For example, against all forecasts for fixed income returns and even with a surprise hawkish BoC bias, safe Canadian fixed income Universe benchmark is up about 1.5% YTD.

The reality is that this hike is ill-timed and is going to further benefit long duration assets, as the Bank is hiking in the context of subdued and falling inflation. That is counterintuitive to non-fixed income analysts. For the environment that is developing in front of us, a combination of long duration bonds and risky assets (stocks and high yield) has the best chance of outperforming cash. That balanced approach to investing (long duration plus risky spreads) can be expected to generate 3–4% annualized (gross). This is what our Tactical Bond Pool is designed to achieve. A fully flexible and diversified solution that employs government bond duration along with exposure to diversified sources of risky assets remains our best idea in a world of low and diminishing returns.

Tactical Bond Pool – our positioning for the environment ahead

There have been two major tactical moves in recent months. In Q1, we reduced our allocation to inflation-linked products as the reflation trade peaked globally (Figure 6). In Q2, we have increased our exposure to both nominal duration and spread products as a deflationary environment and softer Fed tone will benefit both duration and spread assets (Figure 7).

Figure 6. Tactical Bond Pool exposure to inflation-linked bonds

Figure 7. Tactical Bond Pool shifts in duration, high yield, emerging market debt and preferred shares 

Table 1. Tactical Bond Pool performance attribution 

Signature Fixed Income Product Suite

*First Asset Long Duration Fixed Income ETF is an exchange-traded fund managed by First Asset Investment Management Inc. Signature Global Asset Management, a division of CI Investments Inc., acts as portfolio advisor.

This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein.  This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments.  Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share or 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 securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.




Submitted by Jim Durnin on

Hi Kamyar, Thanks for the detailed, informative, and insightful perspective on where we are headed. Plus attribution analysis is always helpful in understanding the results and why... Jim Durnin

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