Dilok Klaisataporn
The bond market had its best month in almost 40 years in November. Hafiz Noordin, Vice President and Director for Active Fixed Income Portfolio Management at TD Asset Management, explains why the market’s recent performance could carry into next year.
Greg Bonnell: The bond market wrapped up its best month of performance in close to 40 years in November. Of course, that came after a big run-up in yields throughout the fall. So, is 2024 shaping up to be the year that fixed income investors were hoping for in 2023?
Joining us now to discuss, Hafiz Noordin, VP and Director for Active Income Portfolio Management at TD Asset Management. Hafiz, it's great to have you back on the program.
Hafiz Noordin: It's great to be here.
Greg Bonnell: So it was a pretty impressive month in November. Of course, we had some real strains throughout the fall. What's taking shape in the bond market right now? Why are we seeing this wild shift in yields?
Hafiz Noordin: Well, like you said, we had the strongest month for bond returns in almost 40 years. That, obviously, came on the back of several weak months for bonds. So there was some giveback there. And that is allowing for bonds to, right now, track for a positive year in terms of total returns.
I think what we saw in terms of what caused a shift in November was, first of all, the economic data. So we saw inflation prints missing to the downside across a number of economies. That provided some more of a conviction that this disinflationary trend that started to take hold in the second half of the year really can sustainably happen going into next year.
And other growth data, as well as labor market data, is starting to look still solid. Not recessionary levels, but starting to look a little bit weaker than what we saw at the beginning or throughout most of 2023. So when you have that kind of environment, that's generally good for bonds.
And fiscal concerns as well from the us that were causing a lot of volatility in September and October largely got priced in. So for the most part, it's a better starting point for bonds. And that's why we saw those strong returns in November.
Greg Bonnell: I know when investors see a run like this in a short period of time, they think that I missed it. I only think of the magnitude– I'm looking at the 10-year treasury yield on my screen right now — 4.28%. We were above 5% several weeks ago. This is a big move in a short period of time. So I will ask for those investors who are watching right now — did they miss the run? Or is the run just beginning?
Hafiz Noordin: Well, I think the way to think about it is that you, first of all, look at the short end of the curve. Look at the two-year yield, which is around a little over 4.5% in the US. And you compare that to where the Federal Reserve is expected to take interest rates over the long run, basically looking at their long term thoughts — and if we use that as a guide of kind of neutral level of rates over the next few years, the neutral level is around 2.5%.
So there's, call it, over 200 basis points of adjustment in yields that could happen in the two-year yield down towards that neutral level, assuming that inflation comes back to target. And that could happen quicker. If we actually have a recession, then they'll have to cut more quickly. But even in a scenario where we don't have a recession, it's just a nice, gradual, slowing growth and slowing inflation, they'll eventually get to that policy rate.
And as that happens, the 10-year yield and the rest of the curve would also start to get pulled down as well. So I think, arguably, there's still a lot of room to go in terms of where even the 10-year yield can go. Even if we're getting to somewhere in the 3% to 4% range from a total return perspective, there's still a lot to catch up on for bond returns.
Greg Bonnell: So it does have the feel of, perhaps, the early innings of the turnaround. So does that set us up for 2024, now that we're in December, and we started almost closing the door on this year, we still have a few weeks to live through– does that set us up for next year delivering the kind of year in fixed income we thought, perhaps, we were going to have this year?
Hafiz Noordin: Yeah, I think that's an interesting way of putting it, because at the beginning of 2023, the expectation, the consensus economic forecasts were for fairly low economic growth– call it 0.5% to 0% growth in Canada or the US. In the US, in particular, that surprised meaningfully to the upside. We got growth of more like 2.5% is what we're tracking to for this year.
So similarly for next year, we're seeing kind of tepid economic growth expectations, but I think there's probably more of a reason to believe that that can be met — even if we don't get to a recession, low growth with the removal of a lot of the fiscal stimulus we saw this year, with the labor market starting to look still strong, but not as strong as it was before, consumption maybe won't be as resilient as it was this year.
So I think conviction in the economic outcome of low growth is probably a little bit stronger now than it was, say, a year ago. And so what that means is that with the starting point for bond yields still fairly high, yeah, I think there's definitely some good asymmetry in bond returns that in a low growth scenario, you can still get this high coupon level of 4% to 5% depending on the type of fixed income product you're in. And if we do get a recession outcome, you could see 100 basis points lower, say, in the US 10-year, which could boost your total return by 5% to 10% above the coupon level.
Greg Bonnell: Now, in recent days, we've seen a lot of economic data coming out in this country. South of the border when it comes to the PCE, which is the Fed's preferred gauge, as all that started pouring in, what did you find most interesting? What is it telling us?
Hafiz Noordin: Yeah. So a lot of data– and I won't get into individual ones, but I think the key themes to get out of it are, first of all, that growth is, indeed, slowing. And a good way to reflect on this was the ISM manufacturing PMI that we saw on Friday, which showed another miss to the downside– so well below the 50 level, which would be consistent with trend like GDP growth.
It was kind of in the 46 to 47 range– so convincingly in a kind of a slowing growth territory. We'll see an ISM services PMI this week which we'll be really closely looking to see if the larger services part of the economy is showing a similar message or not. The other key theme would be the labor market, which has been resilient.
It's still adding jobs every month. We saw that in Canada and the US. And the Canada print came out on Friday. But at the end of the day, what we are starting to see is a gradual increase in the unemployment rate.
Whether that really starts to go parabolic and really is more of a recessionary type of signal, I think that's still yet to see. But we're at least not seeing the kind of strength in the labor market that was causing concerns around runaway wage growth, which would then cause inflation to also start to get a little bit more dislocated. So I think that's been a good theme.
And then the final theme would be more just the inflation data itself. You mentioned PCE and the other forward-looking indicators for inflation. And it definitely shows that you know on the good side of the market, really in a disinflationary environment where we're closer to kind of 0% momentum on goods growth, and services inflation also kind of coming down in a gradual way.
So I think all kind of points to this environment where we're seeing a cooling off in the economy just enough that bonds can be supported and equities can be supported. And that's kind of this Goldilocks environment we're in right now.
Greg Bonnell: If we take it back to central banks and everything that they're watching right now, the short form of what I've been reading as you're bringing all these different reports is that Bank of Canada done seems to be accepted wisdom, Fed maybe one more. Is that how the situation looks right now?
Hafiz Noordin: Well, it kind of looks like both are done. And especially with some of the data I just mentioned, that really shifted the scales towards a pause by the Fed for next week. And the market's really now caught on to this narrative of cuts getting priced in, potentially as early as the end of Q1. But more likely now, I think the base case is more that that's a Q2 story for next year that we could start to see initial rate cuts– not necessarily because there's a forecast for a big downturn in growth, but it's just because with inflation coming down–
Greg Bonnell: The work's been done.
Hafiz Noordin: The work's been done. You can start to recalibrate from this really restrictive policy rate to something a little less restrictive. It'll still be above the so-called neutral rate for central banks, but a little bit less off that peak level. And same idea for Bank of Canada, where for Q2 of next year, that's when rate cuts are starting to get priced in.