Hello and welcome to The Download. I'm your host, Dave Richardson, and it is fixed income time. If you've been watching the bond market over the last week, we've seen a fairly significant move in Treasury yields. I think the primary focus is in the US Treasury market, but we've seen similar moves in Canada and other parts of the world. So nobody better to get on to discuss that than our good friend Mr. Pitts, Steve Pitts. Steve, welcome. We've been trying to put this together for a couple of days because this has been something we may be a little bit behind on why it's happening, but you're going to catch us up quick in terms of what's happening. So many Canadians have a significant allocation to bonds in their portfolio, oftentimes more than stocks. This is always a significant issue, and the bond market often portends for what may happen in the stock market. It tends to sniff things out a little faster, although it's a little bit more on the paranoid side. I'm sure we'll get into that part of the discussion. But Steve, what's going on and why is this happening and what are you seeing out there?

Yeah, thanks, Dave. So certainly, lots going on in the market in terms of news flow and no surprise that the big driver is the war in Iran in terms of affecting yields and the main driver of financial markets, I would say generally. And the main mechanism for that, if you will, is the Strait of Hormuz being blocked. And everyone, I'm sure, has learned about this strait in the last month that they never heard of before. And now suddenly it's driving financial markets everywhere. But the fact that you have such a significant amount of oil supply, commodity supply, things like helium and various fertilizers that are blocked from going through that strait. And ultimately the impact that will have on inflation is really what the market is focusing on. And so bond yields have moved higher. So maybe taking a step back on the inflation front, we did see, I think it was last week, the US inflation numbers came out. The headline was at 3.8%, but even if you exclude energy, the core number was still 2.8%. So still pretty high. And so I think there was some concern about that. I think there's still potentially some tariff impact happening there. The good news is in Canada was a little better. Headline was 2.8 and the core is closer to 2%. So inflation seems less of an issue at this point in Canada. But I think there's two things that this rise in inflation has done. The first is it's really changed expectations for central bank policy. And so if you think back to the end of February before this conflict started, the market was pricing in two cuts from the Federal Reserve. And now the market's starting actually pricing a hike from the Federal Reserve. And you look at Bank of Canada, it was flat to maybe chances of a cut and now is almost 2 hikes being priced in. So you have that change in central bank policy that's affected the front end of the curve. And then for longer-term bonds, the main impact there has been a change in inflation expectations in terms of market pricing in a bit higher inflation level. If we look at the US TIPS market, for example.

Sorry, could you explain what a TIPS is maybe, before we go into this.

Sure. It's a Treasury Inflation Protected Security. So it's a bond in the US. They have equivalent bonds in Canada, but they're not as liquid because they don't issue them anymore. So we tend to look at the US market. So these are bonds that give you essentially compensation for inflation over the life of the bond. So if you look at 5-year bonds, for example, if you take the difference between the real yield of a TIP and the actual nominal yield of a 5-year bond, that difference is called a breakeven inflation rate. So that's what the market is pricing in. So if inflation ends up being higher than that, you're better off in the TIP over that 5-year. If inflation is lower, you're better off in the nominal bond. So what's essentially being priced into that market, the inflation rate has gone from about 2.25 at the beginning to now 2.65, 2.7, roughly. So we have seen an increase in essentially what the market is pricing in from an inflation perspective and similar over the next 10 years.

Yeah, and the important point on that is that's not just inflation in the near term, that's inflation over an extended period of time being elevated. That's what these TIPS are telling us. Being elevated above the 2% target, which is where central banks—the Bank of Canada, Federal Reserve—would really like to get inflation down to, that 2% level. And the market and people who are buying and selling bonds are saying, we think inflation is going to be higher for a little bit longer here.

Yeah, and the bond market is essentially demanding compensation for this expectation that inflation might be higher than what the central banks are wanting it to be. And then related to that, at the longer-term end, you tend to get less on policy rates and more on risk premiums related to uncertainty around inflation. So there's more uncertainty around inflation now. So that causes that short-term premium or risk premium to go up. And then you also have this worry about fiscal spending around the world. It's true in US, Canada, Japan, Europe, which has in general caused the yields at the longer-term end of the curve to go up. And so you've had this confluence of factors. And more recently we've seen 10-year bond in Canada has gone from 3.1%, at the end of February, to 3.7% today. It's true across the 2-year, roughly about 60 basis points yields have moved higher. And so in terms of pricing for bonds, that's hurt the near term. You would see that the price of your bond has gone down as a result of that adjustment. I would say Canada actually has broadly outperformed other markets. The Canadian market is maybe down 0.3%, 0.4% this year, whereas the global bond index is down about 1.5%. So it may not make you feel much better, but it has been a little bit better here in Canada.

One of the things, when I'm out doing speeches with investors or advisors for that matter, and I raise the idea that Canadian debt levels are actually better than most. We've heard about Canadian debt for our entire lives. And if you look at our debt-to-GDP, which is closing in on 100%, you wouldn't say that that's a good situation. But hey, if everybody else is at 125% or 130%. And that debt-to-GDP is, if you think about it, the debt the government has compared to everything the entire country produces in one year. So other countries are running like the US 130%, Japan's 250, 260%. Hey, Canada doesn't look too bad at all if we're sitting in 95, 100% a range. And we're getting that credit in the bond market right now.

Yeah, for sure. And even the deficit element too. The deficit to GDP, much higher in the US, 7 and change versus I think around 2% last time I saw here. So it's very different picture.

Yeah, absolutely. And so, in tandem, because of the inflation expectations, which in any country is going to be reflected in their government bond yields, those yields are up in Canada. And the changes in the expectations about what's going to happen with the Bank of Canada and what's already happened with those longer-term bonds—unless we get a sudden reversal around inflation, which I'm sure we'll get into because that is a possibility—that's going to start to affect mortgage rates again. And mortgage rates had been falling significantly, expected to fall further, and now there's much more uncertainty about that. And if anything, leaning from going down, the lean is now towards going up.

Yeah, that's particularly true in the US market. The US market, their mortgage rates are priced off the 30-year, and the 30-year bond hit a 20-year high yesterday when it cleared at 5.1%, which is the highest it's been since just before the financial crisis. So that tends to be a driver for mortgage rates in the US. Here in Canada, we tend to have shorter-term mortgages, so it tends to be more of a 1-to-5-year part of the curve that's gone up, but I would say, not to the same extent as what we've seen in other countries.

Yeah. So, by the way, I'm a Strait of Hormuz expert, Steve. You probably don't know that. I'm going to be starting my new deep into geography podcast. I'm having trouble finding guests though. But if you like this financial podcast better with guests like Steve Pitts who can tell you what's going on in the bond market, please subscribe wherever you listen to your podcast. Follow us on YouTube, give us a 5-star review. And Steve only comes back for 5-star reviews, so make sure you give a 5-star around this episode, and 5-star is not where we are on inflation right now. The war is not getting a 5-star review from anyone really. We haven't gotten a final result yet. The results we have in the interim are significantly higher energy prices, which have been higher now for long enough that it's starting to filter through the economy. And this has been the real impact of it on the world, which is you've got these higher bond yields, interest rates might go higher. So anything else that you'd comment around the war and the impact that it's having across markets?

Yes. Related to that, the longer this goes, I think the central banks are concerned. At this point, if it's short, central banks are willing to look through it and say—not to use the transitory word again from, from back in the day— but they're willing to accept that this is likely transitory. The longer this goes, the longer commodity prices, oil prices, gas prices stay high, the more likely it is that people start demanding higher wages and it starts to feed through to other parts of the economy. So that's really the risk. And the longer that this gets prolonged, it becomes more risk that this is more than just a short-term blip in inflation and that it starts to become a bit more embedded into other parts of the economy.

So then the people who were involved in the bond market in 2022, the last time we saw a spike in oil prices and other things create an issue with inflation, go, uh-oh. Am I seeing a repeat of what happened there? Because they said it was transitory at that point. And they said if this happens and it's over quickly and blah, blah, blah, that everything is just fine. Does this situation have a significant risk that we see a repeat with 2022?

Well, I do get questions from people like drawing the parallels. There was the Russia-Ukraine war started in 2022. That had an impact on commodities. And inflation started to become a problem. And so there's things that align. But honestly, outside of that, I think we have to remember it was a very different environment in 2022. When the war started, policy rates were still at 0.5%. And if you can remember back then, inflation was at 8% or 9%. And so the central banks had a lot of work to do to really get caught up. And in addition to that, you had the labor market. The economy was just reopening, so you still had that chip shortage, you still had shortages in labor. The labor market was very tight getting people back to work. And the shelter impact on CPI was pretty significant back in 2022 as well. It was a very different environment. You fast forward to today and bond yields at the start of that were 2%, they started at 4% today in terms of the US. And also, central bank policy is in the US probably higher than neutral. So if anything, it's likely restrictive today as opposed to being super stimulative, which it was back then. And so I think we're entering this. So if you think back to 2022, it was really the war just layered on to a number of other issues that led to the inflationary problem. And those issues aren't there today. If anything, before the war, maybe outside of tariffs, we were starting to see inflation return back to normal levels. And certainly in Canada, like I said, we're still seeing that at this point, core inflation at a low 2 handle. So we do think it's a very different environment than 2022. So we don't see the same level and the same risk of the magnitude of rate hikes and the magnitude of bond yields needing to go higher to adjust for that environment.

Yeah. And you've got a new head of the Fed incoming here. And along with what you can do on policy rates—we don't know exactly what way he's going to lean there. There's some concerns about influence from the Trump administration directly, because he's their choice, but at the same time, if you look at his history and track record, particularly, he's talked about quantitative tightening which is selling some of the bonds, which could create an even tighter environment without raising rates. So again, this comes back to there's lots of different tools that the central banks have to play, to manage this, what again is hopefully more of a temporary rise in inflation and a much more modest rise in inflation to have a similar concern to what we saw in 2022 when you basically had bonds about, from a relative perspective, as expensive as they'd ever been to a point now where bonds even before this move were relatively inexpensive and they've just gotten less expensive as the price has gone down.

Like I say, you have a lot of term premium, risk premium that's already built into the market in terms of inflation expectations. And in terms of the new central bank governor, Kevin Warsh, the one thing to keep in mind, he's one vote on the committee. And so, as much as there's concerns about him making decisions based on the will of the current U.S. administration, there is other members. He's only one of 12 votes. So he would have to convince other members to go along with his views. And to your point, I would say he has generally been advocating for lower rates on the basis of a lot of the growth in AI and what that's going to do to productivity. And with high productivity, you have less risk of inflation, so you don't need rates as hot, as high. And there's certainly some credit to that, some validity to that argument. But I think today, especially in the last meeting, you had more dissenters who were actually looking to hike interest rates. And so I think to get the committee on board with cutting rates, at least while the war is on and while inflation is still a risk, it's going to be quite difficult for him to do. And I don't think there's anyone really expecting him to be able to do that unless the inflation picture changes significantly.

Yeah. My comparison to that would be my wife, my two daughters who are home from university for the summer, and I've got my mother-in-law living with me, so I'm one vote. And I believe, if I calculate properly, that is 12 votes against me.

Don’t forget the dogs too.

Yeah, I got the 4 dogs too. So yeah, I got to do a lot of convincing to get anybody on side. And so all of these institutions are built with constraints and controls. I don't think we want to go overboard, again, just because. We expect to still get pretty solid policy coming out of central banks, keeping an eye on inflation, but also recognizing that this could be something that is not long-lasting. Steve, you started to get into the counterbalance to what we're seeing with the rising price of oil, which filters through the economy, which is some of these longer-term factors that are driving productivity growth. And ultimately, you'd almost describe them as disinflationary, would you not?

Yeah, there's a few, to your point, disinflationary forces that our fixed income team has been talking about that we don't think is necessarily getting captured in the day-to-day media feed. And I talked about the AI one, and certainly I think that is valid as you get this growth in AI, there is a productivity enhancement from that. I think there might still be some, maybe in the near term, inflationary impacts of the buildout of data centers and that kind of thing. But the productivity element, we've started to see some signs of that. And as that continues, that is in itself a disinflationary force. I talked about it, 2022 shelter was a big component. So the way the CPI is calculated, there's a bit of a lag to how the shelter impacts CPI. And it's a big piece. I think it's about a third of CPI. But now we're seeing that lagged impact work the other way. And there is a disinflationary impact to the shelter component being less of an inflationary factor. And the third big one is China and the exporting of deflation in a lot of cases. So China has really developed its technology manufacturing. And it has a lot of excess capacity as well. And so it has been building very strong in terms of green technology, in terms of electric cars. And we’ve seen that growing its exports. Since 2019, it's grown exports to Europe by 30% and imports from Europe have declined 30% since that time. And it's exporting that and it's exporting things generally at lower prices than what is out there. So there is an impact here, I think, a disinflationary impact from all three of those that doesn't necessarily get picked up. And probably for each of those it maybe takes a bit more time to play out, whereas the oil price is very immediate, very today. Those are in the backdrop disinflationary factors that we think once we're through some of the oil impact on CPI, could be something that can be a suppression of the CPI data.

Pretty incredible with the Michael Jackson movie out that back more than 40 years ago, his hit song BYD predicted those Chinese electric vehicles coming over here to Canada and making a big difference. But more importantly, and on a more serious note, one of the presentations I saw from an equity analyst over the last couple of weeks looked at, in Canada, when you look at mortgage renewals and for such a long period of time, we'd been particularly in 2022, '23 when rates were significantly higher, the idea that all of the rates that had been locked in on mortgages in 2020, 2021 that were going to start to come due 4 and 5-year mortgages, that that would create a real issue in the economy because people were going to see this big bump up in their mortgage payments, which filters through all rental costs. Well, we've seen a real significant change in that because when you actually do the analysis, there's more people who are going to benefit from rates that are relatively lower to 2022, '23, '24 than people who are going to see the big bump in their mortgage payment coming from rolling out of a 4 or 5-year mortgage. So that's very interesting, along with on top of that, the rental market in Canada and the entry-level housing market in Canada has gone from tight and expensive to relatively loose and prices falling. So it's amazing how quickly things can turn from one side to the other and actually take away those inflationary pressures, put them down, along with something like this war in Iran that can pump up the price of oil overnight and create other pressures. I know we think overall that we've got to watch this war in Iran. And again, you look at what's going on in the markets today, while all the yields are down, the oil price is back down under $100 a barrel. Stocks are risk-on, it's all the crazy stuff that's going up again today. That was an overnight thing. And hopefully, this is leading towards some end to the war in Iran, which will start to stabilize things, get us back to where we were pre-war in Iran, where the bonds were not as exciting as they were in 2024, '25, but also not an awful place to be. And with decent yields, you could sit and get insurance against your stock portfolio and still generate a decent return.

Yeah, absolutely. And one of the benefits of this rise in yield, say 50 basis points rise in bond yields, is that your expected return going forward is much better. Your best predictor of future returns on your bond portfolio is your yield and it has gone up, your bonds has gone up over the last little while. I think it does highlight this. I always talk about this because I think sometimes people forget it. There's a difference between when, say, equities or gold declines and when bonds decline. Ultimately, a bond, we know what the cash flow is going to be with all the bonds in the portfolio. As long as you don't get a default, you're going to get your coupon payment. You're going to get your par value at maturity. Along the way, the value of that bond will go up and down and it'll be revalued over time. But ultimately, that's what you're going to get. If gold goes down, there's no assurance it's going to come back. If a specific equity goes down, it might be an impairment. So this is not an impairment of the bonds. This is just a repricing of those future cash flows. To get technical term, the discount rate has gone up. And that's really the only difference here. So something to keep in mind, I think, for bond investors, that it is more just a repricing of future cash flows and it ultimately leads to better returns going forward.

So we've talked a lot about government debt. When we get out into corporate and even high yield, or we get out into the credit space, has any opportunity been opened up out of this? Have we seen any spreads kick out, or is it still the same, very narrow, and which leads you to stay away from those areas because you're just not getting rewarded for taking on the additional risk that is out there?

Yeah, it's pretty interesting with all the news and volatility that's gone on, much like the equity market, credit markets really haven't done too much. Spreads widened out a little bit in March, but basically since then, since end of March and April, they've come back into where they were. And so now you look at the spread levels and the yield premium you're essentially getting for buying corporate bonds, high-yield bonds, emerging market bonds is roughly about the same as it was at the start of the year. So we haven't seen really at the end of it all a significant increase in that risk premium. And ultimately, I think it is a reflection that the economy has been pretty resilient. The labor market's been pretty resilient. Earnings have been pretty resilient. And so the spreads much like we've seen in the equity market, have reflected that resilience of the economy. It's pretty interesting on the investment in Canada, the investment-grade corporate bond market, we continue to see very strong issuance from corporate bonds. Last year was a record level and this year we're running about 70% ahead of last year's level at this point this year. And a couple weeks ago, we actually had the largest corporate bond issuance ever in Canada. Alphabet came to market with a Maple Bond. This is the first of the hyperscalers coming to Canada. They were looking to get $3 billion. They ended up raising $8.5 billion across a few different maturities. I think there was about $20 billion of demand for those bonds. And it was the largest Maple Bond. So Maple Bonds are when foreigners come and invest and buy and issue a bond in Canadian dollars in the Canadian market—Alphabet being a U.S. company. Not only was is the largest Maple Bond, but the largest corporate bond issuance ever in Canada. The previous was Coastal Energy a few years ago at about $7 billion. So it does show you that there's still an appetite for corporate bonds. Yields are attractive. And it's true in the US too, with both investment grade and high yield corporations have been able to fund through those markets. And so it does tell you that the market continues to function well. It is reflected as well in the risk premium. So, to get back to your question, we are still somewhat cautious on credit, I would say. We're happy to hold some credit in a number of our portfolios and be able to take advantage of some of those higher yields. And this is part of the cycle where you want to be pretty selective about the credits you're investing in. And so the way I would frame it is your range is here to here in credit allocation, we're at the lower end of that range and in wait and see to have some dry powder if we do get an opportunity in the credit markets to add at a more attractive levels.

Yeah. And for regular listeners and many others, I get accused of being the ultimate Canadian optimist. I'm going to put another little tick mark beside Canada for a Maple Bond being able to raise that much money, even with a U.S. company, but they came here to raise it. It's just a sign that there's a lot of great stuff going on in Canada, which we'll continue to talk about on future episodes of the podcast. And hey, Steve, we even have a Canadian team still alive in the Stanley Cup Finals. So just more tick marks for Canada there. But overall, Steve, thanks for spending a few minutes with us just to update on what's going on. This is a situation we're going to continue to watch and we'll get you on if things escalate again after a little calming down period today. But thanks for your time, Steve, and your expertise.

Sounds good. Thanks, Dave.