Major central banks were quick in their policy responses at the onset of the pandemic, launching almost every quantitative easing (QE) tool they had to instill market confidence and stave off deflationary forces. Fast forward to today and we are seeing a 180° change in mentality as the focus shifts to unwinding these accommodative monetary policy programs.
Along with the release of its April Monetary Policy Report, the Bank of Canada (BoC) announced its intention this week to taper its purchases of Government of Canada bonds from $4B/week to $3B/week. This is the second taper announcement since last October (also a $1B/week reduction), signalling that the economic recovery remains intact and does not require the same degree of monetary support that it did last year. The BoC’s foray into QE was significant when compared to the size of other central banks. The chart below shows that the BoC currently owns 42% of Government of Canada bonds outstanding, amongst the most globally. Further, the Bank purchased the largest share of its own government bonds (35%) than any central bank since March 2020. Considering that Canada is a smaller sized economy than most of these other regions, the Bank has delivered an aggressive amount of stimulus thus far. Now with vaccination programs well underway and economic indicators showing signs of recovery, the BoC took a big step this week in reducing emergency levels of stimulus.
Source: Bank of Canada Monetary Policy Report (April 2021)
With regards to its overnight policy rate, the BoC is aware of the unintentional consequences that near zero interest rate policies may have on different sectors of the economy. Governor Macklem admitted his concern that the housing market is showing signs of speculative behaviour during the press conference. With echoes of the 2009 housing crisis still etched in their minds, it is obvious that the BoC would like to raise interest rates to cool the rapid rise in house prices. But policy rates are a blunt tool in addressing potential housing risks. There are other more surgical instruments at the government’s disposal, so it was good to see recent proposals come through, such as a higher qualifying mortgage rate (OSFI) and a vacancy tax to non-resident owners (Federal budget). Both may help temper excessive behaviour but are simply not as effective as raising interest rates. So it was not fully surprising to hear the BoC accelerate its timetable for a rate hike from the first half of 2023 to sometime in the second half of 2022.
This is of course dependent on many variables such as the absorption of excess capacity in the economy, as well as a successful vaccine rollout across Canada. If the BoC does hike interest rates late next year, it could be a repeat of what we saw in 2010, when the Bank raised interest rates ahead of the US Federal Reserve (Fed) for very similar reasons. But the BoC will need to pay attention to the Fed’s actions, as a wide departure in policy rates could lead to undesirable Canadian dollar strength that could potentially restrict exports.
We believe the US Fed’s bar to hike remains high as it has communicated its intention to maintain accommodative policies until the economy reaches full employment. As well, the inflation rate will need to be sustainably at, and on pace to exceed, its 2% target. Chairman Powell committed to these two targets and will not raise the policy rate until these conditions are met. As well, the Fed will also need to taper its QE programs before announcing the timing of its initial rate hike – all suggesting the likelihood of a multi year timetable.
Taking into account all of these considerations, our base case assumption is for short maturity bond yields to remain grounded by low policy rates. But long maturity rates could continue to face upward pressure if economic growth accelerates and inflationary pressures rise. Furthermore, added bond supply from government deficit funding could also lead to higher bond yields further out the curve. Also worth mentioning is that the Fed appears to be more tolerant of rising interest rates than in prior cycles – it did not push back nor seem concerned when bond yields gapped higher last quarter. We remain cautious towards long maturity bonds as their higher price sensitivity to rising interest rates could lead to disappointing returns.
Based on the assumptions we have laid out and the low level of starting yields today, we estimate a low return profile for fixed income until yields return to more normalized levels. However, bonds continue to serve that important role in a balanced strategy to hedge equity risk during stock market selloffs and be a source of liquidity for portfolio rebalances and asset mix adjustments. We may purchase longer maturity bonds as yields normalize from current levels. But for now, the prudent positioning is to maintain our defensive bias towards interest rate risk. Timing will depend on market conditions and relative valuations, and we stress it is not an exact science. Patience is vital and may just be the strongest quality a long-term investor can exhibit at this juncture as we wait for bond yields to reflect the unwinding of these emergency policies.