We Have Lift-Off

Alfred Lee
CFA, CMT, DMS, Director, BMO ETFs, Portfolio Manager & Investment Strategist, BMO Asset Management Inc.
Mar. 28, 2022

For the first time since the onset of the pandemic, both the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) have raised their overnight rates at their recent March meetings. The overnight rate for both central banks now sit at 0.50%, marking what’s widely anticipated to be the beginning of a series of further rate hikes. Based on the Overnight Index Swaps (OIS), the market is currently pricing in moves by the BoC and Fed of seven and six further quarter-points respectively for the remainder of the calendar year. It should be noted that there are only six remaining meetings for 2022, which opens the door for hikes of more than a quarter point at some of these meetings. This of course assumes that the current market assumptions are correct, which we believe is a bold one given all the unknown variables that could impact the broader economy.


Bank of Canada Interest Rate Expectations for 2022

Source: Bloomberg (WIRP calculated using OIS as of March 182022).

U.S. Federal Reserve Interest Rate Expectations for 2022

Source: Bloomberg (WIRP calculated using OIS as of March 182022).

Reading the Yield Curve

The volatility in interest rates has notably increased since Russia invaded the Ukraine. This has been due to various news headlines, each of which has had opposing effects on the yield curve. On the one hand, a war that has the potential to escalate has led investors to pare back risk and move towards safe havens. This flight to safety has led to an increase in demand for federal bonds, which initially caused a flattening of the yield curve. More recently however, inflation continues to not only rise but also gain momentum, as evidenced by recent figures for the consumer price index (CPI).1 With inflation showing no signs of slowing down, investors are demanding to be compensated with higher yields for taking on any kind of term risk. Furthermore, unemployment continues to grind lower, which suggests that slack has been removed from the economy, paving the way for further central bank tightening. Both inflation and the expectation of further rate hikes have placed upward pressure on interest rates, which in combination with the flight to safety has created a push and pull effect on interest rates. This has resulted in the recent up-tick in interest rate volatility.

Source: Bloomberg (Canadian Sovereign Yield Curve, December 31, 2021 to March 172022).

While the current expectations indicate that the BoC and the Fed will be extremely hawkish, there are many ways in which the remainder of the year can unfold. Here are some considerations to keep in mind.

  1. The ongoing Russia-Ukraine conflict could limit how aggressively either central bank acts. If the demand for safe havens continues to increase, yields across the term structure could flatten out. Continued hikes by the central bank could then cause an inversion of the yield curve, which could potentially send the economy into a recession.
  2. Both the BoC and Fed had to make a move, despite concerns of an escalating conflict. With both central banks behind the curve, they needed to make a move in order to gain credibility. Further rate hikes in the coming months would then allow the banks to pause and wait for the effects of this tighter monetary policy to set in. A number of successive hikes also allows the central bank to use forward guidance to potentially reign in inflation without putting the economy at risk.
  3. It may be better to undershoot than overshoot. While inflation is an ongoing problem, rising prices have not been entirely driven by monetary and fiscal stimulus. Lockdowns, shortages and changes in inventory management have led to supply-side constraints, which cannot be solved through higher interest rates. As such, overtightening may cause economic growth to slow without solving inflation, thus leaving us in a worse scenario (i.e., stagflation). Both the BoC and the Fed may start aggressively and then take a more cautious approach as the year progresses.
  4. So many things can change, which could lead the central banks to be less hawkish. While the market is anticipating successive rate hikes from here to the end of the calendar year, a lot can change. Any potential headline risk that is not currently priced into the market could take a rate hike or two off the table.

Portfolio Positioning Themes Using ETFs

  • Do not abandon fixed income. Outside of defaults, rising rates and inflation are the major risk items that bond investors need to worry about. Investors however still need exposure to fixed income assets to offset equity market volatility and potential black swan events. The BMO Aggregate Bond Index ETF (Ticker: ZAG) provides cost-efficient core exposure to the Canadian fixed income market. 
  • Offset duration risk with inflation-protected securities such as U.S. Treasury Inflation-Protected Securities (TIPS). The BMO Short-Term US TIPS Index ETF (Hedged Units) (Ticker: ZTIP.F) provides protection against rising inflation by investing in U.S. TIPS on the short-end of the curve. This short-term exposure, in addition to the currency hedge, allows ZTIP.F to provide pure exposure to inflation protection without having to worry about duration and currency risk respectively. 
  • No need to sacrifice on quality. With recent spreads widening in sub-investment grade credit, investors can still harvest yield through high quality assets. The BMO Canadian Bank Income Index ETF (Ticker: ZBI) provides exposure to funding instruments issued by the banks. This ETF is constructed where 60% of the ETF is invested in bonds issued by Canadian banks, with the remaining 40% going down, one notch in the capital structure to include preferred shares, institutional preferred shares and limited recourse capital notes (LRCN). The latter part of the portfolio allows for yield generation and protection against interest rates while still focusing on the investment grade quality of Canadian banks. 
  • GO Canada! Canadian equities have outperformed their U.S. counterparts on a year-to-date basis, given their higher weight towards energy, materials and financials.2 Should inflation and higher rates continue to be a concern, Canadian equities through the BMO S&P/TSX Capped Composite Index ETF (Ticker: ZCN) can potentially be better positioned than their U.S. and global counterparts. 
  • Remain in equities through Low Volatility ETFs. Low volatility ETFs such as the BMO Low Volatility Canadian Equity ETF (Ticker: ZLB) and the BMO Low Volatility US Equity ETF (Ticker: ZLU) allow investors to remain invested in equities through a diversified portfolio of stocks that have a lower beta than the broader market. Low volatility ETFs allow investors to better navigate though market turbulence.
  • Harvest the volatility in Technology. The U.S. technology sector has been one of the laggards year-to-date. Rising interest rates tend to create headwinds for technology companies, particularly those that tend to carry higher debt. The BMO Covered Call Technology ETF (Ticker: ZWT) allows investors to monetize the recent volatility in technology through the higher premiums it receives through its call writing process. Technology companies in this ETF also tend to be more mature, cash rich companies that have been indiscriminately sold-off due to the recent rise in interest rates.

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