Quarterly Fixed Income Strategy – Q1 2022
In this report, we highlight our fixed income positioning strategies for the first quarter ended January 31, 2022 (calendar year).Jan. 24, 2022
In this report, we highlight our fixed income positioning strategies for the first quarter ended January 31, 2022 (calendar year).
- Rising rates will be a central theme dictating asset returns in the new year. The Bank of Canada (BoC) is just one of many G7 central banks set to raise its overnight rate. The U.S. Federal Reserve (Fed) has already initiated the tapering of its asset purchase program, while the Bank of England (BoE) raised its benchmark rate in a surprising move to end 2021.
- While we expect higher rates on the horizon, the pace of tightening in monetary policy will likely be more gradual than the market anticipates. Currently, the Overnight Interest-Rate Swaps (OIS) are expecting six rate hikes by Canada’s central bank. Readers should note that there are only eight scheduled BoC meetings throughout the calendar year, with the market currently anticipating the first move to be at the March meeting. That would mean that the BoC would have to raise rates six out of the seven remaining meetings. It is likely that multiple quarter-point hikes, would only be considered if inflation cannot be contained.
- Given the ongoing pandemic and the uncertainty it imposes on government response – and thus the economy– the central banks will likely err on the side of caution, and not overshoot on raising rates in risk of choking out economic growth. In the event that they stall the economy, without being able to stop inflation, it would create “stagflation,” a far more serious problems.
- As a result, we believe the rise in interest rates will be more gradual. Rates have likely over-reacted on the short-end of the curve, while perhaps under-reacted in the belly. We expect the curve to eventually reflect this, as higher rates get pushed out the curve as the year progresses, with the market pricing in a more gradual path towards higher rates.
- In addition, as we have stated over the last year, inflation will not be “transitory” in nature and the Fed has finally acknowledged this. However, we anticipate higher inflation to persist, as the Fed won’t run the risk of stalling the economy, as mentioned. Also, as indicated in our Q1 2022 Portfolio Strategy Report, supply chain issues will continue if we see more lockdowns. On the other hand, if we see governments start to treat COVID-19 as a pandemic, the reopening would lead short-term demand to outstrip already strained supplies. Inflation is with us… at least for the near term.
- With upward pressure on interest rates, an overweight to credit is warranted to partially mitigate the duration risk in a fixed income portfolio. The recent widening of spreads, particularly in the U.S. corporate bond market, was largely technical, as many companies looked to raise capital ahead of higher rates. Strong demand in the space will likely drive spreads tighter in recent weeks, not to mention the likely continuation of encouraging economic data. Positions, such as the BMO Mid-Term US IG Corporate Bond Hedged to CAD Index ETF (ZMU), provide investors to investment-grade U.S. corporate bonds.
- Although we believe an overweight to corporate bonds is warranted, it does not mean government bonds should be excluded from a portfolio. The safety of treasuries and federally issued bonds provide a flight to safety, particularly against equity market beta.
- In addition, credit exposure through the BMO Laddered Preferred Share Index ETF (ZPR) would also help mitigate duration risk, given its dividends are tied to the five-year Government of Canada bond yield.
- Over the short-term, we believe the US dollar will likely outperform the Canadian dollar, given the difference in interest rate expectations. Even though its probably unlikely the Fed gets to the four rate hikes that are priced into the market, it is far more realistic than the expectations of the BoC. Consequently, we anticipate the US dollar to outperform at least for the first quarter this year, until rate hike expectations are tempered to three to four rate hikes by the Canadian central bank.
|BMO Aggregate Bond Index ETF||ZAG||-2.00%||BMO Mid-Term US IG Corporate Bond Hedged to CAD Index ETF||ZMU||2.00%|
|BMO Long-Term US Treasury Bond Index ETF||ZTL||-2.00%||BMO Short-Term US TIPS Index ETF (Hedged Units)||ZTIP.F||2.00%|
|BMO US Preferred Share Hedged to CAD Index ETF||ZHP||-1.00%||BMO Laddered Preferred Share Index ETF||ZPR||1.00%|
Source: BMO Global Asset Management, Bloomberg.
|Ticker||ETF Name||Weight (%)||Duration*||Yield-to-Maturity||Mgmt. Fee||Exposure||Positioning|
|ZAG||BMO Aggregate Bond Index ETF||60.0%||8.43||2.61%||0.08%||Canada||Core|
|ZMU||BMO Mid-Term US IG Corporate Bond Hedged to CAD Index ETF||22.0%||6.54||3.05%||0.15%||United States||Core|
|ZTL||BMO Long-Term US Treasury Bond Index ETF||3.0%||19.07||2.27%||0.20%||United States||Core|
|ZTIP.F||BMO Short-Term US TIPS Index ETF (Hedged Units)||5.0%||2.52||0.32%||0.15%||United States||Non-Traditional|
|ZPR||BMO Laddered Preferred Share Index ETF||5.0%||3.01||4.76%||0.45%||Canada||Non-Traditional|
|ZHP||BMO US Preferred Share Hedged to CAD Index ETF||5.0%||5.00||5.27%||0.45%||United States||Non-Traditional|
* As of December 31, 2021. Please note yields will change from month to month based on market conditions. Source: BMO Global Asset Management, Bloomberg.
The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.
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