Quarterly Fixed Income Strategy – Q4 2023

Duration:

• As we expected, inflation has drastically improved year to date due to supply-side healing and central bank monetary tightening. In August, the headline consumer price index (CPI) inflation was 4.0% and 3.7% in Canada¹ and the U.S.,² respectively — showing signs of reacceleration. We believe inflation continues to be one of the key variables in determining the outcome of the markets and whether the economy finds itself in a ​“soft,” ​“hard,” or ​“no landing” scenario. The other variable, of course, is how the Middle East conflict unfolds in the coming weeks and months. 
• A worst-case scenario, from a humanitarian and then an inflationary standpoint, would be an escalation of the conflict in the Middle East. Oil prices would likely increase, and a potential oil embargo could cause higher energy prices to trickle into input costs like transportation, thus causing a reacceleration in inflation. This would force central banks to move back to tightening monetary policy like in 2022. So far, there are no signs of this potential, as many surrounding countries in the Middle East have chosen to stay on the sidelines. We remain optimistic that inflation is slowly subsiding, though persistent. 
• The yield curves in Canada and the U.S. remain inverted, with the five and ten-year yields reaching levels we haven’t seen since before the Great Financial Crisis in 2007. Given that we don’t anticipate the Bank of Canada nor the U.S. Federal Reserve (Fed) to cut rates until late 2024 at the earliest, yields would likely have to move well beyond 5.0% to become upward-sloping once again. 
• Aside from a steepening yield curve, there is a silver lining in yields rising on the mid and longer end of the curve. It could allow central banks to ease off on rate hikes, given certain products, such as mortgages, are priced off of 5-year yields or other parts of the yield curve.
• To position for the yield curve, we believe investors are better off overweighting the short end. Shortening duration would be advantageous whether the yield curve normalizes through lower short-term rates or higher long-term rates. We prefer short-term U.S. investment grade credit, which offers higher yields than the Canadian equivalent and provides diversification from a sector perspective. 
• Breakeven rates for the U.S. two-year are at 1.9%,³ so we continue to see short-term Treasury Inflation-Protected Securities (TIPS) as low-cost insurance should inflation come back. Furthermore, focusing on short-term U.S. TIPS avoids the long-end, which would likely reprice higher should inflation re-accelerate. 

Credit:

• As shown by the CDX Investment Grade and High Yield indices, credit spreads have recently risen — though this has been a function of higher rates. As bond yields have increased in the mid-part of the curve, the cost of refinancing debt has become more expensive, increasing the risk of some issuers. 
• We believe investment grade bonds are more attractive than high yield from a risk-adjusted standpoint. On an absolute level, the yield on investment grade is in line with what the non-investment grade was offering years ago. Though yields need to be adjusted for inflation, the difference between the 12-month T-bill and CPI (year-over-year) has been positive, suggesting inflation, using some measures, has subsided. In addition, high yield was an asset class that benefited from lower interest rates in the past decade but will probably face greater defaults. 

Currency:

• Rising yields in the U.S. have provided a recent tailwind for the currency after a less hawkish Fed this year caused it to lose some momentum. Many fixed income investors want to reduce volatility, which means we typically look to hedge our U.S. dollar (USD) exposure, with our long-term U.S. Treasury exposure being the exception. Long-term U.S. Treasuries tend to be used as an equity market hedge, with the USD providing additional benefits in a market crisis scenario. 

Model portfolio^*

Credit summary^*

Term summary^*

^*As of July 17, 2023. Please note yields will change from month to month based on market conditions.

The portfolio holdings are subject to change without notice. They are not recommendations to buy or sell any particular security.

Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.

Definitions:

Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).

Yield Curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.

Credit Risk: An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payment.

Q4 2023 BMO ETF Portfolio Strategy Report >

Visit bmo.com/etfs or contact Client Services at 1−800−361−1392.

¹ Statistics Canada, ​“Consumer Price Index, August 2023,” Statistics Canada, September 19, 2023.

² The White House, ​“The August 2023 Consumer Price Index,” September 13, 2023.

³ Bloomberg, as of October 10, 2023.