Traders work on the floor at the New York Stock Exchange in New York City, on Jan. 29.BRENDAN MCDERMID/Reuters
The bond market had a volatile ride in 2023 as traders and investors attempted to discern the outlook for inflation and whether the economy was headed for a devastating recession, a soft landing or no recession at all.
Those in the recession camp pointed to the inverted yield curve as a telltale sign that economic contraction lies ahead. Yet, at least in the United States, that recession hasn’t arrived, and the yield curve is now not nearly as inverted as it was.
How should the fixed income investor proceed? Very carefully, for starters. The yield curve being less inverted is not a sign that a recession has been averted. One key is to pick the duration of your bonds carefully.
Although it felt like another tough year for the bond market, the overall returns for 2023 were good, thanks to a rally in the fourth quarter. The FTSE Canada Universe Index returned 6.69 per cent in 2023. Corporate bonds returned 8.37 per cent as yield spreads relative to government bonds remained tight, suggesting investors didn’t have much concern about economic weakness hitting companies’ balance sheets. The long bond index for Canada, which includes federal, provincial, municipal and corporate issues, returned 9.51 per cent, while short bonds and mid-term issues returned 5.12 per cent and 6.13 per cent, respectively.
The inverted yield curve is when short-term bonds offer higher yields than long-term ones. The U.S. Treasury two-year to 10-year spread is currently inverted by only about 19 basis points – two-year and 10-year yields are 4.35 per cent and 4.16 per cent, respectively. The inversion had been as high as 109 basis points in early July, 2023.
While the inversion became much less acute by year end, the yield curve saw a volatile 2023 as traders focused on economic data that ultimately fell well short of indicating a recession in the U.S.
Accompanying this normalization of the yield curve was a drop in long-term yields in the fourth quarter of last year of about one percentage point. Since bond yields and prices move inversely, that meant a sharp rise in long-term bond prices.
The bond market was clearly oversold before that fourth-quarter rally. Long-term bonds are most likely now only mildly overpriced.
The market is discounting significant interest rate cuts in 2024 by the central banks, but I believe that could be a mistake. Inflation seems to be stuck at just over 3 per cent in the U.S. and Canada.
If the U.S. money supply is any indicator, however, inflation may surprise and drop to under 2 per cent or lower, which would help open the door to aggressive rate cuts. The U.S. money supply, as defined by M2, is now falling. It was down 2.3 per cent in 2023. That’s a sign that inflationary pressures will decline.
The business cycle has not been repealed. It takes time for a recession to hit after leading indicators turn. That’s why they are called leading indicators. The Conference Board’s U.S. Leading Indicator is at levels that historically have preceded recessions.
Importantly, recessions usually begin after yield curves normalize. The yield curve being less inverted is a sign that a recession is actually getting closer. Rising interest rates have taken longer to slow the economy than expected because borrowers simply locked in historically low rates for longer periods of time. In 2024 and 2025, considerable amounts of debt will mature and be rolled over at higher rates, which will be a drag on economic growth.
The yield curve will return to a more normal shape in 2024. Long yields will fall by less in basis points than shorter bonds – if long bonds fall much at all. That will depend on the severity of the economic downturn many analysts expect in 2024. Bonds should do moderately well in 2024, but because of the return of the yield curve to a more typical shape, mid-term issues will keep up with long bonds.
Investors should be cognizant that the ratio of the U.S. deficit to gross domestic product has not been under 2.5 per cent since 2008. It is concerning how low economic growth is given huge government deficits. Perhaps government cannot just spend its way to prosperity and malinvestment is a problem, as some economists have warned.
The U.S. is incurring deficits usually seen near the latter stages of a recession. This has resulted in a massive debt-to-GDP ratio. If we do enter a sharp economic decline, the debt situation could start getting very ugly, very fast. This would result in central banks cutting short-term rates, with long-bond holders demanding higher yields, since government and corporate creditworthiness would deteriorate.
This year may prove to be a wild ride for financial markets. An increasingly volatile global political situation adds to the appeal of North American bonds, and mid-term government bonds may be a relatively headache free place to be. A good way to gain exposure is the BMO Mid Provincial Bond Index ETF. It covers a promising area of the yield curve with some extra yield and no corporate credit risk.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.