Traders work on the New York Stock Exchange floor on May 20.Ted Shaffrey/The Associated Press
There’s a sobering reality hidden in the bond market’s recent rebound.
After spending most of the year plunging alongside stocks over the global inflation predicament, North American bonds have turned the corner over the past few weeks.
The yield on 10-year Government of Canada bonds has dipped to 2.89 per cent after hitting a 12-year high of 3.13 per cent. (Bond prices and yields move inversely.)
The good news for investors is that the bond rally likely represents an easing of inflation fears. The bad news is that the antidote for runaway prices detected by the bond market may just be a recession.
Confronted by an overheating economy driving consumer prices skyward, central banks have a big challenge on their hands – how to slow things down just enough to tame inflation without sacrificing growth entirely.
“That’s what a ‘soft landing’ is, in theory. It’s much harder to achieve in practice,” said Ian Pollick, head of fixed income, currency and commodities strategy at CIBC Capital Markets.
With inflation running at a more than three-decade high, Canadian and U.S. central banks are at the outset of an aggressive tightening campaign to unwind vast amounts of pandemic stimulus.
On Wednesday, the Bank of Canada is almost certain to announce a second consecutive oversized rate hike of 50 basis points, with another likely to come in July. The U.S. Federal Reserve is raising rates at the same pace, while also starting to unload its US$9-trillion worth of securities sitting on its balance sheet.
The odds that policy-makers will ultimately imperil the economy in trying to get a handle on inflation are on the rise. The recent decline of long-term Canadian and U.S. bond yields – shrinking the gap against short-term rates – points to a growing expectation for rate cuts as early as next year to combat an economic downturn, Mr. Pollick said.
After all, the history of major inflationary episodes isn’t encouraging.
“Every time inflation has risen this sharply, a recession has resulted,” Eric Lascelles, chief economist at RBC Global Asset Management, wrote in a recent note, while noting that the sample size is limited to inflationary leaps between the late 1960s and the early 1980s.
“The inflation itself is no doubt partially responsible for the subsequent recessions. However, it should be noted that central bank tightening was also involved in the great majority of episodes,” Mr. Lascelles said.
As investors this year have learned the hard way, excessive inflation is like kryptonite for both bonds and stocks, for slightly different reasons.
In the stock market, it’s the fight against inflation that causes most of the pain. Rising rates and the withdrawal of liquidity by central banks reduces the appetite for riskier assets.
With fixed income assets such as bonds, inflation reduces the value of future interest payments the holder of the security is entitled to.
This is why 2022 has been among the worst years on record for bonds. Up until a few weeks ago, the Bloomberg U.S. Aggregate Bond Index, which includes U.S. Treasuries and high-quality corporate bonds, was down by roughly 10 per cent on the year.
The bond rout combined with the stock sell-off made for a double-whammy for investors. Under normal circumstances the two different asset classes tend to move in opposite directions, with bonds providing some ballast when the stock market sinks.
In fact, pretty much every asset outside of commodity markets went into freefall as the year started.
“We were experiencing a price resetting of almost everything,” said Craig Basinger, chief market strategist at Purpose Investments. “Everything did so well in 2019, 2020, and 2021, prices simply got well ahead of themselves. Everybody knew it, it’s just that nobody wanted the party to end.”
So it came as some relief when bonds started behaving like bonds again, despite the growth fears at root of the reversal.
“The market really started to shift toward recession fears. And you can’t really have inflation in a recession,” Mr. Basinger said. While the combination of stagnant growth and inflation known as “stagflation” is a possibility, that’s often the temporary outcome of a lag between the overall economy and consumer prices, he added.
So long as it may alleviate the scourge of inflation, the bond market is happy to entertain some amount of recessionary concern, Mr. Basinger said.
“For now, bad news is good news, until we get too much of it.”
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