FIXED INCOME COMMENT - " Moving on up.... Cautiously"
Global growth was better than expected during 2017, causing the International Monetary Fund to raise its GDP growth estimates for both 2017 & 2018 to 3.6% and 3.7% respectively. The synchronized global expansion has shifted the “dovish tone” surrounding several advanced economies central banks towards a more “hawkish" tone”. A few central banks were committed to reversing emergency low interest rates put in place after the financial crisis (Canada & United States) or acknowledged the need to reduce accommodative monetary policy (Europe & England).
There were many challenges in 2017 that will carry forward into 2018. The most noticeable was the lack of inflationary pressures globally. Shrinking economic slack and low unemployment rates should have provided the backdrop for wage and price pressures. However, that was not evident leaving central bankers struggling to understand the rationale. Are these structural changes? Or delayed transitory issues? In addition, many are concerned with the sustainability of global expansion given an aging labour force, low productivity growth and continued geopolitical events. Regardless, monetary policymakers will remain cautious.
At the Fed’s mid-summer meeting Janet Yellen’s remarks regarding the U.S. economy proved more hawkish. On December 13th, the Federal Reserve raised its Fed Funds Rate by 25 basis points to 1.5% which was fully anticipated by the market. Since September, the movement in interest rates has not been parallel (2 Year Treasuries have continued to increase while the long end has remained stable). This is referred to as “flattening of the yield curve” and throughout 2017 there has been a lot of debate on what it signifies. We don’t believe the flattening of the yield curve is signalling a recession. There are several factors impacting the long end of the yield curve including continued accommodative monetary policy, low and stable inflationary pressures and European demand for treasuries searching for yields. We expect the Fed to raise the Fed Funds rate three times in 2018. However, if inflation shows no sign of ticking upward, the Fed may deliver less. Finally, with the changing of the guard at the Federal Reserve from Janet Yellen to Jerome Powell and the addition of new members to the committee, uncertainty has arisen regarding how aggressive the new Fed will be.
The European Union growth momentum will continue in 2018. The European Central Bank (ECB) raised their growth forecasts for both 2018 and 2019 to 2.3% & 1.9% respectively. However, inflationary pressures continue to remain subdued (less than 1% in November) and are forecast to hit 1.7% by 2020. As a result, we don’t expect the ECB to pull the trigger on monetary tightening anytime soon. However, we anticipate the ECB reducing their asset purchasing program (QE) in January 2018 and announcing the completion of the QE program at the end of 2018.
Regarding Japan, growth continues to gradually improve. However, it too is facing weak inflationary pressures. We do not anticipate the Bank of Japan to change their overnight rate in 2018.
On November 2nd, 2017, the Bank of England (BoE) increased the overnight rate 25 basis points reversing its emergency rate cut which was implemented after the Brexit vote due to stabilized economic data and strong inflation pressures. The BoE will continue its cautious approach taken in 2017. Moving into 2018 the second phase of Brexit negotiations will take place and the BoE will remain accommodative to support its economy through rigorous trade negotiations. We anticipate one rate increase from the BoE.
The Bank of Canada will continue to take a cautious data dependent approach to monetary policy. Canada’s economic output gap narrowed during 2017. The output gap is the gap between potential GDP growth and actual GDP growth. With unemployment reaching a 40 year low of 5.7% in December and wages beginning to accelerate, the Bank of Canada will be hesitant to act on policy decisions until new mortgage lending rules take effect and more clarity is found on NAFTA negotiations. During 2018 we expect the Canadian economy to grow above potential and inflation to hit 2%. We are anticipating two to three rate hikes in 2018 taking the overnight rate to 1.5-1.75%. We see 10 year Government of Canada bonds trading near 2.7% by year end. However, one factor impacting the responsiveness of Canada 10 year bonds is the strong international demand for Canada bonds (see chart).
During the fourth quarter, bond returns were positive. At the short end (1-5 years) Government of Canada’s returned 0.12%, Provincials returned 0.36% and Corporates returned 0.49%. In the Mid-market Government of Canada’s returned 0.66%, Provincials returned 1.35% while Corporates returned 1.33%. Our strategy going into the first quarter of 2018 is to maintain our defensive duration position and continue to overweight corporate and provincial bonds.