Beutel Goodman's 3 Key Questions on Fixed Income - Beutel, Goodman & Company Ltd.

Beutel Goodman’s 3 Key Questions on Fixed Income

1 November 2024

In September, the U.S. Federal Reserve followed the path of the Bank of Canada and other major central banks worldwide to reduce interest rates. Bond markets have performed well in 2024 amid this switch to accommodative monetary policy, but what will further rate cuts mean for investors?

In the latest edition of our 3 Key Questions webinar series, host Marcia Wisniewski, Vice President, Private Client Group joined Derek Brown, Senior Vice President and Head of Fixed Income and Sue McNamara, Senior Vice President and Head of Credit to discuss the following three key questions:

The Bank of Canada and U.S. Federal Reserve have both started their cutting cycles. How have bond markets reacted to this shift in monetary policy and what might the implications be for borrowers?
Amid the backdrop of central bank easing and slowing economies in both Canada and the U.S., how might credit spreads be affected?
What are the main considerations for investors in a soft vs. hard landing scenario for the economy?

This recording took place on October 29, 2024. The following transcript is edited for clarity.

Note: The information in this transcript and recording is not intended, and should not be relied upon, to provide legal, financial, accounting, tax, investment or other advice. This is not an invitation to purchase or trade any securities. Beutel, Goodman & Company Ltd. does not endorse or recommend any referenced securities.

Marcia Wisniewski: Hello everyone and thank you for joining us for the latest in the Beutel Goodman 3 Key Questions series. I’m Marcia Wisniewski, Vice President at the Beutel Goodman Private Client Group.

Before we begin, we would like to acknowledge the land we are on is the traditional territory of many nations, including the Mississaugas of the Credit, the Anishnabe, the Chippewa, the Haudenosaunee and the Wendat peoples and is now the home to many diverse First Nations, Inuit and Metis peoples.

We also acknowledge that Toronto is covered by Treaty 13 with the Mississaugas of the Credit and the Williams Treaties signed with multiple Mississaugas and Chippewa bands.

I would also like to take a moment to bring you a quick legal disclaimer from our legal team.

The information in this webinar is not intended and should not be relied upon to provide legal, financial, accounting, tax, investment, or other advice. This is not an invitation to purchase or trade any securities. Beutel Goodman and Company Limited does not endorse or recommend any referenced securities.

Thank you for joining us here today for this discussion on all things fixed income, featuring our guest speakers and my esteemed colleagues, Derek Brown, Senior Vice President and Head of Fixed Income at Beutel Goodman and Sue McNamara, Senior Vice President and Head of Credit.

Following our 3 Key Questions, we’ll have a brief question and answer session. You are invited to participate by typing any questions you have in the Q&A box at the bottom of the screen. So without any further delay, Derek, this first question is for you.

The Bank of Canada and U.S. Federal Reserve have both started their cutting cycles. How have bond markets reacted to this shift in monetary policy and what might the implications be for borrowers?

Derek Brown: Okay, maybe I’ll back up a little bit first and just talk about why interest rates are so high. I think most participants probably know this already, but coming out of the pandemic, obviously, there was a very large spike in inflation. Most central banks thought that would be temporary or transitory, which was the word they used, thinking that within 6–12 months, you would see these supply chains fix themselves and ultimately goods prices would fall and there wouldn’t be that much inflation. As it turned out, that was not the case, the spike in inflation that we saw during the pandemic in goods prices then spread into services, which then moved into wage inflation. And it became this little bit of a cycle where higher wages led to more spending and more spending led to higher inflation. And they were caught behind the curve, forcing them to hike interest rates. They were the highest they had been in 20 to 25 years, with the Fed getting to five and a half and the Bank of Canada getting to five. And this was a huge move off of zero for both of them over the course of 2022 into 2023,

And that wasn’t great for fixed income markets. It wasn’t good for risk assets in 2022 either, as there was this this rip the band-aid off situation when it came to interest rates as they were chasing things higher. Now, after very high interest rates, which are meant to suppress demand, and so people spend less money, and people do not borrow as much, and do not buy as many houses — that’s the idea of higher interest rates. They pushed down on demand for the last little while, and that’s brought inflation back down, and goods’ prices are now negative. Actually, they’re in deflation, specifically cars and a few other things. And service inflation is now normalizing as well. So, in Canada, we see inflation roughly around 2% for core headline, it’s give-or-take around there. It’s a little bit higher in the U.S., maybe two-and-a-half, but getting close to the [Fed’s] 2% target. So, this has allowed the central banks, globally, but in Canada and U.S., specifically, to cut interest rates, starting in the summer. The Bank of Canada has cut interest rates by 125 basis points at this point, so 1.25% down to 3.75%.

The Fed just started cutting in September with a 50 basis point cut off the top because they probably should have started cutting a bit earlier, and so they’re now down to 5%. This is likely to continue over the next year or so, and the bond markets have priced this in. This is something that we have to communicate with clients — often they think that when the central bank starts cutting, that this means that bond yields will fall going forward, when in fact, the bond market’s priced in a lot of these cuts already. And so in Canada, they priced the Bank of Canada [policy rate] getting roughly to 2.50% to 2.75%. In the U.S., they priced the Fed getting to about 3.75%. We could debate that; it changes every day. It’s moving up and down quite a bit these days, but roughly 3.75%. And so that’s at the end of October [2024] where they see the rates are going. We agree mostly with that U.S. level, but I think that in Canada, the Bank of Canada is likely going to have to cut interest rates a little bit lower than that, probably closer to two and a quarter, maybe even a bit lower than that, depending on how growth plays out in the next year or so.

So, there might be a little bit more to go in Canada, probably not a ton in the U.S. from a bond yield perspective. What does this mean for borrowers? Well, because the bond markets have already priced these in, most borrowers don’t borrow at the Bank of Canada rate, they don’t borrow at the Fed rate, they borrow at bond market rates. If you think of a traditional five-year mortgage, a five-year mortgage in Canada is based off the Government of Canada five-year yield, plus some bank funding costs and a little bit of profit for the bank. A good proxy of that would be bank funding costs or senior debt available to banks. Those are in this four-and-a-quarter zone right now. When you see a mortgage rate out there around four or five years, about four-and-a-quarter to four-and-a-half percent, that’s already reflecting a huge amount of interest rate cuts from the Bank of Canada. While we do think rates will go lower, probably in the next few months, a mortgage in Canada for a five-year fixed probably won’t go much below 4%, maybe 3.75% to 4%.

What this means is there will be some stimulus to borrowers out there, but maybe not as much as many are expecting. I think we also have to take into context the breakdown of who actually has a mortgage. In Canada, these aren’t perfect numbers, these are estimates, but roughly 35% of people have mortgages, 35% of people rent, and the remaining 30% have paid off their mortgage. Within the 35% of Canadians that have mortgages, only 15% of those have these true variable interest rates. When the Bank of Canada cuts, they benefit from that. Another 15% have fixed payment variable interest rate mortgages. Those don’t change. Those are the ones that the amortization just extends. Those amortizations will drop as interest rates go down, but they’re not getting a monthly stimulus. Then the 70% remaining have fixed mortgages. So, they’re not benefiting from the Bank of Canada cuts today. Even with their mortgages renewing in next year and things like that, they’re still going to see, even with the interest rate cuts, about a 20% increase in their mortgage payment. So as much as there is stimulus coming from lower interest rates, people are still going to face higher costs from their mortgages going forward or on their credit cards or on their lines of credit.

So yes, there’s stimulus being provided versus where we were a year ago, but versus where people locked in their mortgages two years ago, three years ago, no, there’s actually going to be higher payments unless there’s significantly more cuts than anyone expects. And again, we don’t see that playing out right now. So, I guess where we’re trying to go with this is that it’s better for borrowers, but ultimately, there’s still going to be higher payments, and that’s going to restrain consumer spending over the next two years. That’s why we’re a little bit more negative, actually quite a bit more negative on the Canadian economy than the U.S., where they have 30-year fixed mortgages, and so they’re not really having to see those increases in payments. So that’s the big difference. Yes, it’s good for borrowers, but maybe not as good as many are expecting.

Marcia Wisniewski: Thank you, Derek. Interest rates can affect so many parts of the economy and the markets, and their ripple effects can be very hard to predict. I appreciate your detailed explanation on this. Our next question is for Sue, which is…

Amid the backdrop of central bank easing and slowing economies, both in Canada and the U.S., how might we see credit spreads affected?

Sue McNamara: Great. Thank you. Credit spreads so far this year have actually done very well. If you look at it, investment grade credit spreads in Canada and the United States, they are 22 basis points in Canada, 17 in the U.S., and high yield spreads are even tighter — they’re at about 44 basis points year to date. And that makes sense given the backdrop over the course of most of this year, but the economics are likely to be a little bit more difficult going forward. The economies have been very strong in both Canada and the U.S. Employment, inflation, consumer spending, when you look at those indicators, that does support credit spreads coming in.

Companies’ health is fairly strong. Balance sheets are strong. I think a lot of companies did take advantage of the time period where the economies were strong to bring leverage down to strengthen their balance sheets. EBITDA growth has been there. So that really does support credit spreads coming in this year. I think it’s where you then have to flip to looking forward. Especially in the U.S., credit spreads are very close to their ultimate tights. When you look historically, they don’t tend to stay this tight.

So there is a little bit of a warning signal there. In Canada, credit spreads aren’t at the historical tights, but they’re certainly pointing towards there. There is a little bit more room that Canada can run, and I think that is reflecting a little bit of the differences that we see in the economies. Both central banks are trying to engineer the soft landing or the no landing. It does look maybe that the U.S. Federal Reserve will be successful. Canada probably has a little bit more of a challenge to achieve that, and especially with the immigration policy that was announced last week that Derek may go into detail on in the next question. And so I think credit spreads are tight, but I’m not sure we think that they can continue to tighten. And we’re starting to see what I would say are late-cycle type of credit cracks in the market and one of the things that we’re looking at, leverage, although it has been very much contained, is starting to slowly creep up. You’re seeing an increase in M&A. That can signal that if a company can’t grow organically, they buy growth. And that can show that maybe the economy is slowing.

And then there’s just little things you see, sector rotations. It always seems in the fixed income market that you reach for yield up until the last moment until the end. And so you start to see issuance from sectors that should be out of favor but still have a higher yield, like REITs or consumers. And also anecdotally, you see a lot of companies that are new issuers to the market. They usually fund in the bank market, but now they’re funding in the fixed income markets. To me, that is that a signal that the banks are protecting their balance sheet and they won’t lend to them, so they come to the fixed income market.

These are grey hair pieces of wisdom that I share from having lived through several credit and economic crises over my career. And so I think we’ve had strong flows into fixed income. New issuance has been strong. That has been positive for credit. I think we have to be a little bit wary going forward and a little cautious. We have positioned ourselves defensively in credit. And the one thing that we know is that when the credit market breaks or when you’re in a situation like this, the way I like to describe it is that I don’t think the risk on credit is being assessed properly in markets.

Credit spreads are tight. There’s very little differentiation between sectors, very little differentiation between high yield credits and investment grade credits, very little differentiation, even in investment grade between single As and triple Bs. To me, it’s showing that the market is just looking for yield and thinking credit spreads are going to continue to tighten and they’re grabbing for anything. And this [credit spread tightening] will reverse and break. And usually it can break because a company does something that shocks the market slightly and requires a reassessment of risk, or it starts to break if the economic data slows, it does make you to relook at certain companies and especially certain sectors to say, okay, these companies should not trade at spreads that are similar. So we’re looking for that to happen and continue to look at the warning signals that we’re seeing. And the one thing that we usually see always happens with credit spreads, too, is that once that risk assessment comes back into the market properly, it is the equal and opposite effect. Everybody tends to sell credit, it’s everybody out of the pool at the same time, and you get a massive widening in credit.

And then it’s that final take a deep breath moment. Okay, let’s look at things. Now credit spreads are out of whack to the other side, and you start seeing that these spreads shouldn’t be this wide, and they start to come in towards normal. So that’s where we think we are. We’re starting at that dangerous level of credit where you could see that widening event, and that’s why we’re defensive. And then we’re also preparing for that widening where we will see tons of relative value opportunities.

Marcia Wisniewski: Well, thank you, Sue. I find the subtleties of the credit market and credit spreads very interesting to hear about, and I appreciate your clarity on this. The last of our three key questions is…

What are the main considerations for investors in a soft versus a hard landing scenario for the economy?

Derek, if you don’t mind providing your thoughts on this.

Derek Brown: Sure. Yeah, this is a tough one as well. Sue mentioned it before. We do think it’s 50/50, whether or not the U.S. gets a soft landing or not. I think it’s below 50% chance that Canada is able to achieve one. I know a lot of people talk about recessions as the key driver for central banks and risk assets and things like that, but it’s not really. It’s actually the unemployment rate. I think one of the key things and main considerations for investors out there is to really keep an eye on the jobs market. If you were to look at Germany or the U.K. recently, they were hiking through recessions in 2023. The U.S. hiked through a technical recession in 2022. It’s really not recessions that central banks will react to. It’s really that unemployment rate spiking higher. The reason for that is there’s a feedback loop. If people lose their job, they spend less money. If people spend less money, then more people lose their job. It’s that domino effect. When you look at the unemployment rate, as we say, it takes the escalator down and the elevator up, and it just spikes higher. That’s really the key thing that people need to focus on to understand if there’s going to be a soft or hard landing.

In Canada, as Sue alluded to, an immigration plan came out last week about effectively freezing population growth. I can understand from an infrastructure perspective, and I get the rationale behind that. But you can’t just drop from 3 % population growth to zero without having some economic impact. And there will be one, and it’ll be, I think, bigger than a lot of people are expecting. I think if you look at what most economists are projecting, they are saying, well, over the course of three years, it’ll be a minimal impact, a small drag on growth, but not too bad. The thing is, the timing and the sequence matter, and I think a lot of people are really overlooking that. Growth will be materially weaker in 2025 than it would have been had we had another 2% population growth. It’s going to be materially weaker. Well, that will likely force the Bank of Canada to cut below the 2.75% neutral level.

The neutral level is the level where they have no impact on the economy. They’re going to need to provide stimulus to the economy, likely getting down to two and a quarter, even 2%. And then because we have less population growth, what’s called capacity or potential growth is not as big because the economy won’t be as big in 2026 as we thought it was going to be because there’ll be less people. In theory, the unemployment rate will fall faster and we will recover from the recession quicker. So, 2026 or 2027 will look a little bit rosier in that sense. And so net-net GDP will be lower in 2025, but higher in 2026 than we actually thought. Most economists are saying it’s a marginal impact. From the market’s perspective, there is an impact, and it’s one where 2025 will be weaker. The Bank of Canada will react to that. Bonds will likely rally from that. Canadian credit spreads, however, are a trickier one. Most risk assets care about what’s going on in the U.S., including Canadian corporate bonds. And so, we are very close to our tights despite the fact that we have an unemployment rate at 6.5 % and probably going higher to 7 %.

The Bank of Canada cut by 50 basis points last time to try and speed up economic growth. But credit spreads remain very tight because they’re reacting to the good chance, it’s at least a 50% chance, that the Fed does engineer a soft landing in the U.S. Now, that is because primarily there’s a massive fiscal deficit in the U.S. that is offsetting the economic weakness that should be there. They’re running around a 6% deficit, 6% of GDP. And this is likely to continue post the election, regardless of who is elected. I think that the key thing for everyone for risk assets is what happens in the U.S., and specifically what happens to the U.S. unemployment rate from a risk asset perspective. From an interest rate perspective in Canada, it is what happens to the Canadian unemployment rate and the impact of the immigration change.

Marcia Wisniewski: Thank you, Derek. I feel that we could continue this discussion for far longer than 30 minutes, but in the interests of time, I will move on to Q&A. We have received some excellent questions from attendees, so I would like to ask a couple before we wrap up today.

Firstly, let’s address the elephant in the room …. the upcoming U.S. elections. Sue, how are you and the Fixed Income team looking at November 5?

Sue McNamara: Sure. I think the biggest concern that we have from a fixed income perspective is, will we know who won immediately? Because if you go back to previous elections, it does seem within the statistical error in most of those swing states on who is leading. So, we could very much have a case similar to what we’ve had in previous elections, where you don’t know who won on election night, and it could take a few weeks, especially in certain states, where they’re going to manually count votes. So fixed income markets, in general, and I would say equity markets are the same, in that they hate a vacuum, and they hate uncertainty. So if you go through that two week period where you don’t know who the President of the United States will be, that is going to weigh on markets. And you could have less liquidity in the markets because people do not like to trade into uncertainty. I think there’s so many different types of things that can play out depending on who ultimately does win. A lot of the other concern, too, is who controls Congress. Because that will determine whether the president can really enforce all of their agenda or not.

I think if you take it into fixed income, certainly there are concerns with the Trump administration about the independence of the Federal Reserve, about the composition of the Federal Reserve. There could likely be a new Fed chair. So that was something that we would monitor very closely. Derek brought it up — certainly budget deficits have been high under the Democrats. It could be high under both candidates, depending on who wins. Nobody seems to be at all addressing any fiscal austerity. So that is obviously going to be a concern for the bond markets as well. So I don’t want to get too much into the partisan politics as I could go down a rabbit hole here. But obviously, things like the continuation of the IRA, which is the stimulus that is provided to most of the United States, is another thing that we would look at. And ultimately, if it is Trump who is elected, you do have to take time to analyze his tariffs and if he’s able to deploy it in the way that he wants, and is that going to have a long-term reflationary effect? But that is a long-term outlook. I think in the short term, our biggest concern is probably that there isn’t too much uncertainty over who actually won the election.

Marcia Wisniewski: Well, thank you, Sue. That was brave to provide some commentary and I appreciate it. We also have elections in the pipeline for Canada at both the federal and provincial levels, albeit not in the coming week or so.

Derek, purely from the perspective of a fixed income portfolio manager, I’m wondering what are some of the implications of a Canadian federal election in 2025 on fixed income markets?

Derek Brown: So, somewhat similar to what Sue just mentioned about the fiscal deficit side. Generally, when there’s an election, you tend to get an election budget, and then that election budget tends to have spending initiatives in them for the most part. And so that could obviously create larger deficits. So from the fixed income standpoint, we have to figure out, is there enough buyers for this level of supply, whether it’s on the provincial or federal level, because that can impact our yield levels or the spread that people are willing to pay for the bonds. We’ve seen some elections recently, and because of that, different provinces have seen their spreads widen because of the election budgets that were launched, in British Columbia and Quebec and a couple of other places. It is possible that this could happen on the federal level as well. We probably will get a fall update on the budget from the federal government, which probably won’t have much to it because of everything that’s going on right now. But next March, I think you’ll see a more fulsome budget, which would likely have more initiatives in there that they would likely want to go campaign on.

We’d have to be very careful about that and what that means for fixed income. That’s the hard part for us — just because there’s a proposed budget, it doesn’t mean it’s actually going to get enacted at all. We can’t react to proposed budget, as Sue said about the tariffs in the U.S. In theory, those are inflationary and they’re bad, but are they actually going to get it enacted? It’s really hard to position ahead of this stuff. You have to be more reactionary than potentially proactive in this. If things get enacted in Canada, you’ll likely see a bigger budget from the federal side, but there’s a good chance it won’t get enacted. Where I think we’re a bit more concerned, as I mentioned before, is the immigration plan, where that can just be enacted right now because they’re in charge right now and they don’t need parliamentary approval for that. And we think that’ll have a major, as I mentioned, a major drag on growth. And so the concern is that it’s a complete change from the recent policy, and that is something that’s being done from a political sense.

It’s being done for an election. They’re prepping for an election. That’s why they’re launching this plan and then a couple of housing plans and things like that. You have to be mindful that some of these can be enacted and some cannot. It’s really understanding which ones. Even the immigration plan itself, it’s a huge drop in the population. I’m not sure if they can actually accomplish that. I’m not sure ambitious is the right word, but it’s an aggressive plan to drop the population. I’m not sure if it’s even feasible. But should it get enacted, as we mentioned, in a vacuum without some other level of stimulus to offset the fiscal drag, it’s going to be bad for the Canadian economy. It really will. We’ve been in a per capita recession for the last 18 months, and now they’ve started to focus on that and say, oh, we need to get per capita spending higher. One of the ways to do that is to bring in less people, and then the math just changes because there’s less people coming in, which makes sense, and I understand why they’re focusing on that.

But you actually have to get consumer confidence in people wanting to spend, which will require lower interest rates or some fiscal spending at that point. Whether it’s on the provincial or federal level, I would expect it will get more fiscal stimulus, at least proposals in the next 6-12 months. But again, I’m not sure that’ll be enough because it’ll take a while to work through the system where if enacted as proposed, the immigration plan would start almost right away in 2025. And again, from our perspective, it’s really underappreciated on how much impact it’s going to have economically.

Marcia Wisniewski: Well, thank you very much, Derek and Sue for all of your insights today on the bond markets, interest rates, the economy and even a bit of politics. I think we covered a lot here today. There are questions we received from attendees that, unfortunately, we are not going to get to today. If you have a question for the Fixed Income team, please contact your Beutel Goodman representative, who will be very pleased to follow up directly with you and with our bond desk.

You can also visit our website at beutelgoodman.com where you will find a library of white papers, Insight articles, and previously recorded webinars on a variety of investment themes, including fixed income. Thank you all for joining us, and I hope you have a great day.

Beutel, Goodman & Company Ltd.

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