Guides

Quarterly Fixed Income Strategy – Q2 2022

In this report, we highlight our fixed income positioning strategies for the second quarter ended March 31, 2022 (calendar year).

Alfred Lee
CFA, CMT, DMS, Director, BMO ETFs, Portfolio Manager & Investment Strategist, BMO Asset Management Inc.
Mar. 31, 2022

In this report, we highlight our fixed income positioning strategies for the second quarter ended March 31, 2022 (calendar year).

Duration

  • As was widely anticipated by the markets, both the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) initiated its tightening monetary process at their March meetings. This marks the first time they have raised rates since the pandemic, which kicks off what is anticipated to be a number of rate hikes this calendar year. In fact, the BoC recently followed this up last week with a 50bp rate hike, with the Fed likely to follow suit at its May meeting. Currently, based on the Overnight Index Swaps (OIS), the market is expecting at least 8 more quarter point moves from both central banks for the remainder of the year. This would boost the overnight rate to be at least 2.5% in both Canada and the U.S.
  • Economic data such as unemployment rates and gross domestic product (GDP) clearly suggest that much of the economic slack has been removed, which paves the way for both the Fed and BoC to aggressively fight inflation. The latest report on the consumer price index (CPI) for the U.S. and Canada showed that it remained well above its target rates, where it sat at 8.5% and 5.7% respectively. Its clear that both central banks need to act as they are well behind the curve; they need to maintain credibility given that one of their primary mandates is to maintain price stability in the economy. Additionally, with many countries starting to view COVID as an endemic versus a pandemic by fully reopening their economies, demand will likely come back much faster than supply, meaning inflation will likely get worse before it gets better. This runs the risk that central banks may panic when inflation data may overstate inflationary growth as the world reopens in the next several months.
  • We believe both the BoC and the Fed will have difficult choices ahead of them; navigating the current environment will be no easy task. With the yield curve that highlights the difference between 10- and 2-year yields having temporarily inverted several weeks ago in the U.S. (and very close to doing so in Canada), further rate hikes will potentially send the economy into a recession. Furthermore, as a portion of inflation is driven by supply chain disruptions, rate hikes after a certain point may have a limited effect in directly addressing inflation.
  • We anticipate both the BoC and the Fed will continue to aggressively raise rates through to its July meetings. Some of these moves may even be additional 50bp moves given how far behind they currently are. At some point, it’s likely they may take a pause and use forward guidance as a tool to control inflation in order to avoid choking off economic growth. An overshoot on rate hikes by the central banks is a real concern as changes in monetary policy take months to exhibit their full effect. Stalling economic growth without solving inflation would leave us in a much worse predicament, which would be the dreaded stagflation.
  • Although there have been peace talks, there has yet to be any resolution in the Russia-Ukraine conflict. Should tensions escalate and NATO countries begin to provide more than just economic sanctions, a risk-off sentiment would warrant having duration exposure in a fixed income portfolio. However, the reopening of the economy as COVID-19 restrictions continue to ease will place further upward pressure on yields. As a result, investors will need to pair duration exposure with positions that hedge against rising rates and inflation.

Credit

  • It’s encouraging to see China support the peace process given their earlier refusal to condemn Russia. Credit spreads both in the investment grade and high yield space widened on the back of Russia’s act of aggression against Ukraine. They have now begun to tighten, though they still remain considerable wide in spite of the economic tightening. We believe the majority of Canadian and U.S. corporate credit is well insulated from the geopolitical risk outside of North America. Adding to our BMO Mid-Term US IG Corporate Bond Hedged to CAD Index ETF (Hedged Units) (ZMU) position will provide investors with spread compression opportunities as an improving economic backdrop likely offers benefits for issuers over the longer term. 
  • Although we believe an overweight to corporate bonds is warranted, it does not mean government bonds should be excluded from a portfolio. As previously noted, the threat of the Russian invasion escalating into a more encompassing war suggests that treasuries and federally-issued bonds will mitigate risk if they see a flight-to-safety event. 
  • While wider credit spreads have weighed on the BMO Laddered Preferred Share Index ETF (ZPR), its issuers are also well insulated from the ongoing conflict in Europe. We anticipate that once credit spreads normalize, the notable moves in the five-year Government of Canada yield in recent weeks will provide some potential upside for ZPR.

Currency

  • The Canadian dollar has been relatively range-bound against the U.S. dollar over the first quarter, though it has gained momentum in the month of March. What is difficult to determine at this point is whom amongst the BoC or Fed will be the first to become less hawkish. We do anticipate higher commodity prices will be supportive of the Canadian currency over the coming months. As a result, we will continue to prefer a USD/CAD currency hedge for a fixed income portfolio, with the exception of the BMO Long-Term US Treasury Bond Index ETF (ZTL), since in this case the greenback exposure would provide additional safety to a potential black swan event.

Delete/​Trim

Change (%)

Intitiate/​Add

Change (%)

ZAG

-3%

ZMU

3%


Source: BMO Global Asset Management, Bloomberg.


Model Portfolio*

TickerETF NameWeight (%)Duration*Yield-to-MaturityMgmt. FeeExposurePositioning
ZAGBMO Aggregate Bond Index ETF57.0%7.732.89%0.08%CanadaCore
ZMUBMO Mid-Term US IG Corporate Bond Hedged to CAD Index ETF25.0%6.423.35%0.15%United StatesCore
ZTLBMO Long-Term US Treasury Bond Index ETF3.0%18.862.62%0.20%United StatesCore
ZTIP.FBMO Short-Term US TIPS Index ETF (Hedged Units)5.0%2.580.36%0.15%United StatesNon-Traditional
ZPRBMO Laddered Preferred Share Index ETF5.0%3.014.76%0.45%CanadaNon-Traditional
ZHPBMO US Preferred Share Hedged to CAD Index ETF5.0%5.005.27%0.45%United StatesNon-Traditional
Portfolio100.0%7.102.82%0.14%



Credit Summary*

Credit Summary


Term Summary*

Term Summary

* As of March 31, 2022. 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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