Is This It?

Current Market Narrative(s)?

First and foremost, it's crucial to discern the dominant narrative shaping the market. Currently, the prevailing sentiment is the surprising resilience of the US, Canadian, and European economies in response to the significant rise in interest rates. We are continuing to witness one of the most aggressive interest rate hiking cycles in recent history, with the Fed Funds rate having increased by 525 bps over 1.5 years, yet the economies remain stable. A significant subplot, having been demoted from the prior dominating narrative - is the persistence of elevated inflation. It still lingers within the 3-4% range, and can spike at a moments’ notice, whether driven by rising energy prices or ongoing wage negotiations. The drivers of inflation have changed over the past quarters, but the overarching trend remains elevated compared to historical norms. ?

Another more recent narrative that has been influencing the bond market is the balance of supply and demand. The previous cycle was characterized by quantitative easing, where central banks would buy bonds, providing support to the market. However, we have witnessed a shift towards quantitative tightening and additionally also the fear of lower foreign investments in US Treasury bonds. The challenging “spend-first” fiscal dynamics in many of the major economies (US leading the charge here), higher interest costs, and significant corporate debt financing needs are simultaneously leading to an anticipated influx of bond issuance. Bringing this back to a fundamental lesson, we have declining demand and increasing supply, collectively presenting downside risks for bonds. These factors undoubtedly contributed to the currently bearish sentiment, as the market waits to determine who will foot the bill for rising expenses.?

Central Banks: Last hike is a good one?

Bonds are not equal to the central bank policy rate – but they are also not independent of each other. Historical patterns, while not always replicable, can give further insights. One observable trend is that fixed income typically performs well after the last interest rate hike. Predicting the exact timing of this is challenging, but if you can gauge central bank policies, it should inform your bond market strategies. My best guess for central banking action is: In Canada we are either done or will see one more, and the US likely follows the same narrative. However, the risk for further hikes is larger in the US than in Canada, lending favour to Canadian short-term rates over their US counterparts.?

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Looking Ahead: Catalysts and Future Scenarios?

Staying with central banks, they often play a meaningful role in changing the narrative for bonds (and other asset classes), by signaling an end to their current policies. We have heard in the past few days more dovish tones coming our way – not a U-turn, but more generally more constructive for bonds. Besides that, when bonds become attractively priced outside of a predicted policy pivot, investors often begin to recognize value, outweighing the risks associated. Let’s take a look at that angle:?

My preferred way to do this is to begin by looking at inflation linked bonds, or TIPS in the US. These bonds consist of two components: a fixed coupon and an inflation adjustment. The fixed coupon is often relatively small, but the principal and payment stream of the bond increase with the Consumer Price Index (CPI), effectively providing an inflation-adjusted return.?

Now, why are these bonds so essential in our discussion about valuation??

1. Real Yields: The yield on TIPS, after accounting for inflation, is referred to as the real yield. This is a fundamental metric that investors should monitor. A positive real yield indicates that investors are being compensated above inflation expectations, while a negative real yield suggests that investors are willing to accept returns below inflation, likely indicating concerns about future economic growth or other market risks. ??

1. Inflation Expectations: This is the dominant reflection of market expectations of future inflation. When yields on TIPS are compared with yields on regular, non-inflation-adjusted bonds, we can derive a measure called the breakeven inflation rate. This rate represents the market's expectations for future inflation and can serve as a critical indicator of overall market sentiment.?

1. Benchmark for Value: One might argue that TIPS provide a more genuine "risk-free" rate than even traditional government bonds because they account for inflation. By isolating the inflation component, investors can focus solely on the growth component of the bond equation. This "stripped-down" view offers a clearer perspective on the underlying economic fundamentals driving bond prices.?

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On the real yield side – bonds already look attractive to history, with current levels of 2.4% over 100bps above the ~25 year average of 1.4%. From an alternative perspective, throughout TIPS history, real yields tended to positive correlation to real GDP growth. The higher growth rates were, the higher real yields. The average discount to the real GDP growth is 80bps, we are currently trading at the level of real GDP growth. While growth has performed solidly in the past quarters – we have not seen a re-pricing adjustment higher in long-term growth expectations. My base case here is that real yields look attractive. ?

On the inflation side, the market is signaling that inflation expectations are:?

All are generally in line with history, albeit marginally elevated. The question is, do these rates reflect a market that's overly pessimistic or optimistic about future inflation? Given the recent data and global economic dynamics, there's a case to be made that these expectations could trend higher, suggesting higher yields for nominal bonds.

Bringing the inflation and real yields together, the net for overall bonds here is: Positive on real yields (i.e. yields lower) and positive on breakeven inflation rates (i.e. yields higher). Since my view on real yields is stronger than that on breakeven rates – I would land on a slightly attractive stance on nominal bonds and very attractive for real yields (I.e. Inflation Linked Bonds, TIPS).

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Differentiation and Decision Making: Putting it together

Minor aspects can also influence decision-making. Market behaviors such as sell-offs stopping at round numbers or contrary reactions to significant economic data might indicate market exhaustion. It's essential to understand that markets operate in cycles. A homogenous trading strategy can lead to increased market fragility. Remember, crowded trades work until they suddenly don't.

Our team frequently employs the Hegelian Dialectic when discussing ideas. For those of you who this may sound more like chaos than clarity, we can break this down into three steps: a thesis, its antithesis, and the synthesis of the two. In fact, in our above example evaluating real yields, we used this exact framework; Further, take the bond market for example.

Thesis: Currently, there are signs suggesting bonds may be attractive at current yields and valuations.

Antithesis: Market momentum and associated risks are still substantial, considering fiscal headwinds.

Synthesis: Our directional conviction in the overall bond market overall remains limited, but slightly positive.?

Whilst the waters may remain muddied, different regions may offer clearer opportunities. For instance, the situation in Canada seems to be weakening ahead of the US, attracting risk-averse investors to the bond market. As a result, the confidence level for the Canadian bond market is currently higher than its US counterpart. The below matrix shows the level of confidence we have in the various countries and their respective curves. % indicates a neutral stance – with 10 being max bullish and 1 max bearish.

From the above chart, we can see a few key trends:

• Long end rates reflect significant risk in both yield curve level and shape.
• EM continues to offer attractive carry yields as central banks transition to rate cuts.
• Short term rates, particularly in Canada look to be the gold standard for fixed income investors.

However, if this year has proven anything, it is that complacency can be deadly in a rapidly changing world. In this market, it is critical that we are actively monitoring the macro-rates, in order to ensure that our strategies align with incoming information and prevailing views. With even the highest conviction trades, the entry is only one variable, and should the underlying data deviate significantly from expectations, this may necessitate strategy adjustments.

Congratulations on making it to the end - while on the longer side, I still hope you found this piece enticing and educational.

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?

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