The Bond Market is in Flux. Here's What you Can Do.

The pendulum is swinging back toward rate cuts for the Bank of Canada (BoC), while at the same time, expectations for cuts by the U.S. Federal Reserve (Fed) are getting pushed out as they await further progress toward their 2% inflation target. With the central banks getting pulled in opposite directions, the gap in interest policy has the potential to widen—thereby creating investment opportunities. Here’s what you need to know about the potential impacts on the economy and markets.

Outlook: Are We Getting Closer to Rate Cuts?

In the United States (U.S.), the economy remains resilient, with a solid pace of job creation and little financial stress within households. Conversely, Canadian consumers—who tend to be more highly leveraged and sensitive to interest rates than their southern neighbours—are experiencing the pain of higher interest rates. With the inflation surprise in 2022, the BoC has been slow to get going, and rate-cut delays continue to cause concern over another potential policy error if rate cuts were to come too early. However, we believe the inflation and economic outlooks are making a strong case that it’s time for the BoC to cut, but that doesn’t mean the policy will be stimulative. While the market is anticipating the first rate cut in June or July, the bigger question in our view is: how many will there be in the next 12-18 months? For now, markets are hesitant to price in a significant amount of easing despite the slow economic backdrop.

As interest rates fall, the “cash is king” era might fade for some fixed income investors—but we are not there yet. For now, we are still in a very high-interest rate environment. However, expectations are that the BoC will act in the near term, and successive cuts could arrive over the next year or two. As we sit on the cusp of the first cut, investors may want to consider adding longer-duration bonds to their portfolios. One way to leg into this trade is to use a quasi-barbell approach. You can pair the BMO Ultra Short-Term Bond ETF Fund, which aims to maximize yield on the short end with the BMO Aggregate Bond ETF Fund to get the benefits of full-term exposure. If rate cuts come to fruition, having exposure to the long end of the curve can provide investors with some upside. On the other hand, if the BoC holds its stance and keeps rates higher for longer, the BMO Ultra Short-Term Bond ETF Fund could provide a stable return stream and downside protection.

Weathering the Mortgage Renewal Storm

In 2020 and 2021, many Canadians locked in record-low mortgage rates, and these loans are now nearing the end of their terms. While much resetting has already occurred, we expect to hit peak renewal over the next 12-18 months—meaning more homeowners will experience the full burden of the higher-for-longer narrative. Depending on when households lock in, they could see upwards of a 30-40% increase in mortgage payments, according to the Canada Mortgage and Housing Corporation (CMHC).¹ Even if the BoC were to cut 100 basis points (bps), people would likely have to renew at considerably higher mortgage rates, which we believe will directly impact things like retail sales. Due to these rising expenses, on top of inflation and a higher cost of living, those feeling the financial strains might have to reduce their discretionary spending.

Future rate cuts will help ease some of the tight financial conditions many are experiencing; however, they won’t necessarily solve any structural problems. In that environment, we could see growth and spending slow and credit spreads widen. As such, you’ll want to ensure your investments have built-in protection from that volatility ahead. The BMO Aggregate Bond ETF Fund is an all-in-one solution that can provide investors with broad fixed income market exposure (a little bit of everything) to manage during periods of uncertainty—which we see as we look ahead further in 2024. If some growth sells off, the diversified duration² is likely to help as rates decrease. And the sector allocation, which is about 70% government bonds, can provide some downside protection. The Fund offers a solution to help Canadians stay invested in the bond market without having to take anything off the table.

Loonie Under Pressure As the Greenback Soars

The anticipated gap between the U.S. and Canada’s policy interest rates is likely to create headwinds for the Canadian dollar (CAD), raising questions about how much room the BoC can lower rates this year and whether it will make the first move. Some think the BoC is handcuffed and made to follow a dedicated rate path with a pace set by the Fed. We believe, however, that this is a slight exaggeration. Historically, periods of policy divergence, while rare, reflect the undergoing relative strengths and weaknesses across the two economies. When you look at the past six months, almost any major currency is struggling versus the U.S. dollar (USD)—and it’s not strictly because central banks chose not to tighten policy. Although everyone is looking at the Fed to dictate the next trend for the USD, we’d likely see a weaker loonie with or without rate cuts from the BoC if the Fed delays rate cuts.

For investors concerned about currency risk or the depreciation of the CAD, allocating some fixed income exposure outside of Canada might help. Consider adding either U.S. government exposure for some protection or U.S. corporate exposure for more yield. The key is to consider buying the unhedged version of the mutual fund or exchange traded fund (ETF) to take advantage of the USD appreciation relative to the CAD. In the near term, unhedged currency exposure could work as an alpha³ generator within your fixed income sleeve.⁴

Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.

¹ (2023, November 10). ‘Interest rate shock’ ahead, with nearly half of Canadian mortgages up for renewal within 2 years: CMHC. CityNews.

² Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).

³ Alpha: A statistical measure of the value a fund manager adds to the performance of the fund managed. If alpha is positive, the manager has added value to the portfolio. If the alpha is negative, the manager has underperformed the market.

⁴ Changes in rates of exchange may also reduce the value of your investment.