Transcript
Hello, and welcome to the Download. I'm your host Dave Richardson and we're joined by a special guest today. You know, I have the privilege of talking to a number of just phenomenal investment managers and experts in their specific area of the market. Some are very general, some are very specific. And one of the biggest questions that investors have right now is related to interest rates both short and long term. Particularly we look at the US. Here in Canada, as much as we love Canada, we have to admit that we are kind of the tail of the dog and the big dog down south of the border wags us. So what they're doing on interest rate policy from a Federal Reserve perspective and how the bonds that trade in market move and their yields really come across the border. And for many Canadians we're investing because we're 2 or 3% of the global markets, we're investing a lot of money outside Canada anyways. And I've just found that no one articulates a view of interest rates in the US, what's happening in the US bond market—because Andrzej Skiba goes well beyond just the government bond market and we'll get into that— but just understanding what's driving the market, whether yields are moving higher or lower and then how it relates to decisions that you've got to make as an investor. So Andrzej, you're always so gracious with your time. I thank you so much for joining us this morning.
Always a pleasure to speak to you Dave, and thank you to all the listeners who will participate in this podcast.
Excellent. So Andrzej, I think the last time we caught up, not on this podcast, but offline, we were talking about yields in the US and the direction the Fed was going. And we're in a period of quite a bit of uncertainty, so we had our own thoughts about where that might go. And then we've just seen in the last three weeks the US ten-year treasury go up and kiss almost at 4.9%, settled back down. We're around 4.65% I think today. But what's driving that? These are relatively large moves in yields for such a widely traded bond. Is that not true?
Absolutely. We have seen a meaningful rise in government bond yields over the recent months and investors have been asking themselves this question of how far can we go? Are we done yet? And in our opinion, what has exacerbated the move in recent weeks, with 10-year closing in on the 4.9% level that you mentioned, is a dramatic difference in positioning that investors have in US treasury securities. So you have this tug of war happening at this moment between real money investors who have been overwhelmingly positive on the outlook for US treasuries and were long risk in those securities. And on the other side of that war, having hedge funds that have been pretty extreme short in the US treasury exposures, expressing a view that yields have to rise a lot higher before inflation can be contained. So we had this fascinating battle of very different perspectives of what is happening with the US economy. Will inflation cooperate and what will the Federal Reserve do over the coming quarters that has spilled into pretty aggressive move higher in yields that only reversed partially over the recent sessions.
So Andrzej, there was an inflation report out this morning in the US. It's mixed. I think you'd probably argue it was a little bit more on the hotter side or a little bit higher than expected. How did you interpret the report this morning and then how do you see that filtering into this tug of war and who does it give an edge to?
So from our perspective, the latest report was close to expectations. What we are seeing is that some of the benefits earlier in the summer that were helping to push inflation lower— with the lowest core inflation print that we had earlier this summer being at 0.16%— some of those one-off benefits have unwound. So we're now back in the realm of 0.3% core inflation numbers. But that is fine. That is not a source of particular concern. Where the market is struggling to reconcile views is about the direction of travel from here, because the inflation on a year-over-year basis has been gradually decelerating. We have moved into high 3s or 4% type range and the expectation is for that to continue. However, the key question is, will it happen at a pace that is sufficient for the Federal Reserve to be comfortable about the level of inflation, for them to pause rate hikes and then look towards the prospect of rate cuts in 2024? And many investors, particularly real money investors, expect the slowdown to happen, expect inflation to continue moderating as wage pressure abates and goods inflation remains very low. But at the same time, investors at the other side of that argument are saying, well hang on a minute, look at the labor market. The latest data from the labor market was way stronger than expected. You have indications of some sectors that were struggling in recent months starting to pick up some pace in the level of their activity. So if the answer is that US economy is actually re-accelerating, then the idea of moderating inflation sounds like science-fiction. And if that is the case, then the Federal Reserve will have no choice but to hike further. So there's this conundrum that investors have to address, and from our perspective, we do believe that the slowdown will happen. We do believe that the impact of things like student payments, loan payments having to come through since this month, some of the other benefits fading away within the economy, limited ability on the fiscal side to help the economy over the current quarters, given that the deficit is already running quite high, all those things should conspire towards cooling down of the economy. But we also have to admit that so far, the economy has been much more resilient, much stronger than investors have expected. And there is this big disconnect between what's happening in Europe, what's happening in China and what's happening in the US. So as we await further data, that battle of perspectives rages on.
Andrzej, particularly as you look out at the long end of the yield curve, how much is all of the government spending, all of the debt that's floating out into the market— and a lot of that money also then hitting the economy in terms of infrastructure and investment in different industries—, how much is that skewing what's happening at the long end of the yield curve?
I think that's a very astute point, Dave, that a lot of what is happening right now is impacting longer duration part of the curve, further out on the maturity curve. One of the reasons for that is that the government has been very aggressive in financing using treasury bills, but that cannot continue. And the volume that we have seen in terms of financing at the very front end of the curve— with the hope that rate cuts will happen, yields will fall, and they will not have to lock in those coupons for too long a period of time— well, that hope is fading away because it's pretty clear that the Fed might have to be higher for longer. And yes, we do expect rate cuts to happen in 2024, but unlike expectations earlier this year, maybe those cuts will not be happening in the winter or spring of 2024, but in the summer or autumn 2024 at the earliest. So what we are hearing from the government that the funding plans will now entail a lot more issuance of longer duration securities, a lot more pressure on the US treasury market from longer maturity supply. And that is something that will have to be absorbed by a new group of investors because you will not have money market funds gladly buying treasury bills at those elevated yields. You will rely on a different type of investor to buy 10- or 30-year issuance. From a technical perspective, that will put a pressure on yields further out the curve. Also, what is important to recognize is that you had a lot of investors that were long front end of the curve, given the inverted nature of the curve, and short the back end of the curve. And again, as people pile into those trades, that can put additional pressure on securities further out. On one hand, you have to balance the fundamental development in the economy, how slowing down of the economy should bring yields lower with the technical factors, with things like supply that will prevent some of that rally from happening as quickly as some investors might hope to see.
Andrzej, let's just keep the circle spinning round and round— and with all of these things just coming together and creating all kinds of uncertainty— is there an element that these higher yields at the long end actually end up helping the Fed and put less pressure on them to have to raise rates or maybe not have to lower, but at this point into the latter half of next year, but maybe don't have to do anything more in terms of raising rates. Is that an element of this balancing act as well?
So to that question, we had actually pretty clear answers from a number of Fed speakers over the recent days and they have highlighted that the rise in the government bond yields that we have experienced in recent weeks has helped to tighten financial conditions. And by extension, that is doing some of the work that the Fed was trying to achieve in having a restrictive monetary policy. Having said that, they gave a pretty clear caveat that if economic data continues to be robust, if economic data does not show any signs of slowdown, whether in the labor market or general economic activity, well then, those higher bond yields will be warranted by that better-than-expected economic activity. And actually, in that world, the Fed has to hike rates further from here. So their argument is, if the economy is gradually slowing down and we have higher yields than previously was the case, then yes, we might not have to hike rates. We might be on pause sooner than expected and then cut rates at some point next year. However, if those higher yields are also a reflection of much stronger than expected economy, then they will have no choice and will have to hike further.
See, this is why I have you on today. That's such an unbelievable explanation. And the listeners know that the guests do the heavy lifting of higher yields to slow the economy. I'm just like the Fed. I'm just there to sit in the background and try and help out a little bit. So Andrzej, you also operate in the US corporate world. So how is this affecting what's happening in the corporate bond market?
So there's two sides of that coin. On one hand, you have a lot of investors who believe that locking in current yields— whether it's high-grade or high-yield markets, where in US high grade you can get about 6% yield, and in US high yield, it's over 9% yield— a lot of investors are saying that those are very attractive yields in a medium term. And yes, there might be volatility ahead, but there has not been a time in the past where on a medium-term basis people lost money locking in those kinds of yields and getting exposure to the credit space, at those levels. The yield of the asset class, the carry of the asset class pays for a lot of sins. So even if yields were to rise further or spreads went to widen in response to whatever's happening in the economy, because you are getting paid all this carry, all this yield on a forward-looking basis, you could easily end up with a positive return, even in a negative scenario for government bond yields or spreads. That is dramatically different compared to the setup last year when we had double-digit losses in fixed income that caught a lot of investors off guard. So that starting level of yield helps to offset a lot of negative pressures. That's the positive in terms of the impact of higher yields on the credit demand. On the negative side, however, you have quite a lot of issuers who were hoping for lower yields in 2024 and were waiting to issue debt on the expectation of locking in lower coupons than are currently the case. And if those issuers decide, hang on a minute, rates will stay higher for longer, the prospect of dramatically lower yields is just not on the cards anymore, some of that issuance can start hitting markets sooner rather than later, creating a bit more of a technical pressure, especially in high grade markets. In high yield, there's literally no maturities on the horizon in the US in 2024, so we do not expect a lot of supply. But in high grade credit, you could see front loading of that issuance. Still, we would expect that issuance to be very well absorbed because global investors are very keen to source high-quality, high-grade paper, but it would create a short-term technical pressure for the market.
Yeah, and I think one of the things that listeners have really picked up on as we've dug deeper into fixed income, particularly over the last year, is how much supply and demand, like any market, drives pricing and of course, price. It's an inverse relationship with fixed income, but price drives yield and the supply demand dynamics in different parts of the bond market have been quite impactful in terms of where yields have been going in recent months.
Absolutely. Just take the example of US treasuries. This month in October, we are having negative supply of treasuries of about $50 billion. So what's maturing is more than what is being issued. However, next month we're flipping to 200 billion positive supply. So it can show you how that balance between demand and supply can dramatically impact markets and should be taken into account.
I think another thing that we've tried to emphasize Andzrej, on the podcast over time, and this is not just in fixed-income markets, but in stock markets as well. If I'm an investor, what's happened in the past has already happened. Okay, so the negative year we had in bond markets last year, the more recent struggles in the bond market are behind us. We're making a decision every day in terms of where we put new money or where we continue to hold our existing money. And that's always a forward view. The more we can eliminate what's happened in the past and make the best decision from today is what's going to help us do the best possible going forward. And so I think one of the arguments, with the pain that we've experienced in fixed income, that investors need to understand is all of this is setting up a five- to ten-year period, looking forward, particularly for people who are moving into retirement who want to balance out their portfolio between stocks and bonds. The fixed-income market is set up pretty nicely from where we are right here. Is that not fair to say?
I think that's spot on. And look, you wouldn't expect me to say that fixed income is a horrible place to put your money to work, but it's our job also to learn from what worked well and what hasn't worked well in recent years. But looking forward, absolutely. I would look at the market with a clean slate and decide on what is the opportunity set right now. And to put it in a perspective, let's say your starting point of a yield is around 6% for credit for US credit right at this moment. Well, in order to generate 10% plus return, all it will take is maybe 10 to 15 basis points spread tightening, which is not a big expectation, that would still be a spread meaningfully wider than at the end of 2021. And treasury yields moving from mid high 4s to maybe low mid 4s. So nothing dramatic in terms of a request for the market to cooperate. But those two things, those two small requests combined would conspire to help have double digit positive returns in the asset class on a go-forward basis. And that's something that we have not seen for a long time in fixed income markets. We want to have clarity about inflation cooperating, about Federal Reserve not having to kill the cycle. So it's important to watch incoming data. But in our opinion, the setup for fixed income is really strong and investors should look favorably at opportunities within the fixed-income space over the coming quarters.
Yeah, and there's things that need to shake out and the whole discussion we've had really suggests that. But you're left with yields that are quite attractive from a historical perspective. And again, bonds play a critical role in a balanced portfolio. And this is a period, at least from my perspective, that bonds are much more attractive than they've been in at least 15 years. I'm always thinking of my mother, who's 80, and for her, this is just going to be a fantastic boost to her income, looking forward. A tough year and a half over the last 18 months. But to set her up for the rest of her life I think these higher yields actually are a positive for people who are like her in that situation.
Absolutely. And it's important to consider the risk reward of the asset class as well, as we mentioned earlier, because the carry of the asset class pays for a lot of negative developments that could occur on a risk-adjusted basis. It provides you with a really good return going forward. And of course, if circumstances were to change, we will shout from the rooftops to all of our clients to change the allocations. But the way we're seeing the world, what we're hearing from policy officials, what we're hearing from corporates on the ground, all of that makes us comfortable with a favorable view on fixed income over the coming 12 to 24 months. This could be a good period for returns within the asset class, as long as you're careful in your selection, as long as you listen to what the economy is doing and reflect on that in your day-to-day investing.
Yeah, that is such an excellent point, Andrzej, you've got to be careful with your selection. You have to know what you're doing when you're meandering around the global bond market, US bond market, Canadian bond market as well. And that's what you're so good at, you and your team. Andrzej, that was fantastic. Thank you very much for your time and the update. A lot of great information for people who are looking at the bond market and wondering what they should do.
Brilliant. It is always a pleasure to speak to you and good luck to your mom's investment portfolio and all of the listeners ones on this. All the best.
And then Andrzej, we're going to track for the listeners when you come to Vancouver. I'm in Vancouver today. And Andrzej and I have never seen rain in Vancouver, and I know that for people who actually live in Vancouver, they'll say that's not possible, but when we arrive in Vancouver, the sun comes out. So we'll let you know when we're here so you can enjoy your time on the west coast of Canada. Thanks, Andrzej.
Absolutely. All the best. Thank you, Dave.