CONTRIBUTORS
Franklin Bissett Fixed Income
Over the past year, central banks have made considerable progress towards meeting their inflation targets, but recent economic data does suggest a “last mile” problem.
Monetary policy tightening is a two-stage process. In stage 1, higher rates create sticker shock for new financing, leading to less marginal consumption. In stage 2, debt refinancing at higher rates also slows activity. Canada has experienced part one but has delayed part two with mortgage forbearance policies. Reduced consumption and (we anticipate) moderating home prices in Canada, as well as declining owner-equivalent rent (OER) in the U.S., should eventually counter increases in energy prices to take inflation lower.
Calling an end to this tightening cycle has proven unusually difficult, but in our view, central banks have completed most of their policy rate increases. While a few more hikes are possible in response to future data, we expect central banks to retain a hawkish tone to avoid loosening financing conditions too early.
As credit squeeze begins to bite…
With the Office of the Superintendent of Financial Institutions (OSFI) considering tighter guidelines on mortgage forbearance, it is reasonably likely that Canadian banks will tighten credit conditions more aggressively in 2024.
We also expect that depositors in the U.S., and to a more modest extent in Canada, will continue to pull savings from low-interest chequing accounts to place them in higher-return money market funds. This, too, should encourage banks to tighten credit conditions. Consequently, we expect more Canadian households will see higher monthly mortgage payments in 2024, reducing discretionary spending.
…consumption cracks will widen
Dwindling pandemic savings in both Canada and the U.S., in addition to increasing energy prices, will also reduce household consumption. And we expect the high cost of debt to continue to discourage new borrowing.
We believe Canadian consumers are beginning to react to tighter borrowing conditions, and we expect that the combination of tighter credit and rising unemployment will continue to drive change in household spending into next year, slowing economic growth.
We continue to see significant headwinds to economic activity and expect the effects to become more evident, with recession in the first half of 2024.
From pain to opportunity in 2024
Heading into 2024, rates will likely become range-bound with a near-term bias higher. We expect Canada 10-year bonds will continue to test the 4.00-4.25% range and the US 10-year note will continue to test the 4.75-5.0% range. As rates drift slightly higher, unemployment will be the biggest metric to watch. We anticipate labour markets will continue to moderate, as suggested by recent pockets of employment data. As investors factor in increased recessionary risks, markets will discount central bank rate cuts at the front end of the curve, steepening yield curves in the process.
Given this backdrop, we see the setup for fixed income for 2024 as bright, not least because fixed income yields are the most attractive since 2008. Although we believe corporate credit spreads remain expensive, we do see some idiosyncratic opportunities, especially at the shorter end of the curve.
In our portfolios, we continue to position conservatively given the softer macroeconomic outlook, waiting for volatility events to add exposures. We maintain a bias in favour of higher credit quality and expect the opportunity set to widen as credit markets respond to increasing economic softness.