BMO ETFs: Bank of Canada Update “We Love Barbells”Dec. 15, 2022
UPDATE – December 15, 2022 Federal Reserve Announcement:
- Last week, as anticipated, the Bank of Canada (BoC) raised its overnight rate for the seventh consecutive time. The overnight rate, which started the year at 0.25%, now sits at 4.25%, marking one of the most aggressive tightening cycles in the history of the central bank.
- Prior to the meeting, the market was expecting either a 25 or 50bps rate hike, with the majority leaning towards the lesser amount, as indicated by the overnight index swaps (OIS). On the ETF desk, we thought the BoC would come in at 50bps, given that recent economic data has been mixed. The labour market continues to show strength, while the October year-over-year CPI number showed no improvement from the prior month.
- As outlined in our last BMO ETF Portfolio Strategy Report (PSR), we’ve been calling for the BoC to pause its rate hikes in early 2023, which now seems to be growing consensus. While the consumer price index (CPI) has proven to be somewhat resilient, it is trending in the right direction. While it’s likely we will experience persistent inflation in some areas, we believe the CPI does exhibit “price stickiness” and may not be reflective of true inflationary conditions. Anecdotally, the housing market is showing real signs of cooling, and a growing number of retailers are reporting a build up of inventory. We believe these are early signs of disinflationary pressure.
- The BoC has also softened its language, which further opens up the door for a pause in its tightening cycle. The OIS market is pricing in a terminal rate for 2023 to be 4.3%, which would mean the market believes this is the last rate hike for now. While inflation, as indicated by CPI, is nowhere near the BoC’s target rate, it should be noted that inflation was largely supply-side-driven, and the move away from COVID-19 lockdowns should mean further healing in supply chains.
- When looking at the yield curve in Canada, the spread between the 10-year and the 2-year has not been this inverted since the early 1990s, which means the BoC must also consider any further rate hikes would not cause significant damage to the economy. While the inversion of the yield curve indicates a recession, it can be argued that risk assets have already been pricing this in all year. A pause in interest rate hikes, would be a positive for risk assets.
Fixed Income Positioning
- The majority of investors have been hugging the short end of the curve and for good reason. The yield curve has been relatively flat for a good part of the year, which means investors have not been compensated for taking on duration risk. Furthermore, investors have typically sought long bonds as a means to help mitigate equity market risk. The correlation between long bonds and equities has also been positive this year, which has limited the ability of long bonds to hedge tail risk.
- The rise in interest rates will likely cause the positive correlation between bonds and equities to eventually break down. Higher funding costs will ultimately reduce leverage in the market, meaning we will experience less deleveraging during equity market sell-offs. We believe this will increase the effectiveness of bonds in portfolio construction, which would provide a rebirth to the 60/40 portfolio, despite its failure to provide stability this year.
The inversion of the yield curve further enforces our view to take a barbell approach to fixed income, which we began advocating for in July. A combination of a short-term bond ETF with a long-term bond ETF would be ideal for today’s environment. Investors can maximize yield on the short end of the curve by overweighting credit through the BMO Short Corporate Bond Index ETF (ticker: ZCS) or the BMO Canadian Bank Income Index ETF (ticker: ZBI). Investors can then complement this position with the BMO Long Federal Bond Index ETF (ticker: ZFL) or the BMO Long-Term US Treasury Bond Index ETF (ticker: ZTL). The exposure to short-term bonds would benefit if inflation persists and/or the economy expands. Meanwhile, the long-term bond exposure would benefit should economic conditions continue to deteriorate.
The yield curve in Canada is now Inverted on the short end
The largest inversion between 10-year and 2-year since 1990
We expect the positive correlation between long bonds and equities to eventually dissipate
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