Episode 14

AUGUST 11, 2021

Three interest rate questions for Randall

Steve sits down with Randall Malcolm, Senior Managing Director and Public Fixed Income Portfolio Manager at SLC Management, to discuss interest rate anomalies, yield curve expectations and credit spreads in the Canadian and U.S. fixed income markets.

Steve Peacher: Hi everybody thanks for dialing into this episode of “Three in Five,” this is Steve Peacher, I’m President of SLC Management. I’m really happy to have Randall Malcolm with us today, he's a lead portfolio manager on our Canadian bond desk, managing both the general account at Sun Life but also portfolios for institutions around Canada. Randall, thank you for taking a few minutes today.

Randall Malcolm: Thanks for having me, Steve.

Steve Peacher: You know one of the things that you see in the press today reported on daily is inflation, so we see many different measures of inflation going up. But something that's a bit odd, at least from my perspective, instead of the last couple of months, while inflation measures have been accelerating interest rates have actually been coming down so help us understand.

Randall Malcolm: Yeah, Steve it's been a tremendous year this year with the change in sentiment this year really in the first quarter versus the second quarter was pretty amazing. At the start of the start of the year inflation much more of a concern and that in the second quarter really morphed into more concerns about economic growth. In the first quarter it felt like the markets were starting to anticipate a clean break from the virus, but unfortunately pandemics don't just disappear. We’re not fully vaccinated until we're all vaccinated, unfortunately. You know as the variants have places to fester, we’re likely to continue to see the variants like Delta that are highly transmissible and can overcome resistance still working their magic unfortunately. And it's really a right now, it's in your face with the Olympics right now, it's a daily reminder the Covid is still an issue globally. We've seen some really unique market items throughout this last year and a half we've been in Covid. It's really unprecedented central banking intervention through quantitative easing. We've seen significant changes and consumption patterns globally and challenges in the supply chain, like shipping and labor market supply issues and volatile commodity prices to boot, really. You know there's still a significant amount of savings in the system and we see this through traditional asset values, we see bond values inflated, we also see equity values relatively inflated, but we also see evidence of excess in non-traditional asset classes like we see non fungible tokens and we've seen alternative currencies as well. So with additional consumer savings building it seems like we could see businesses have a bit more flexibility to pass through higher supply costs to final consumers. Throughout this whole time though central banks continue to push the narrative that inflation is transitory and manageable. And that they need to err on the side of higher inflation to promote a more inclusive recovery. It really feels like the markets have bought into this narrative. Right now we see breakeven 10-year inflation protection in Canada RRBs at 170, that's actually below the 20-year average of 1.8¹. It's 55 basis points below the U.S. TIPS² as well, and as well below current headline inflation, so we are seeing bond markets really buying into this, the narrative that we have inflation being transitory and very manageable.

Steve Peacher: You know, when you look at thing about interest rates, interest rates have come down lately, but they are higher than they were at the beginning of the year, which is, which means that the curve, the shape of the curve has steepened the shape of the interest rate curve is something I know as a bond investor you think a lot about. What are your expectations for the shape of that curve, if you look out say a year or more from now?

Randall Malcolm: I think we think about it in in in two phases, right now, we can think about a short-term and long-term horizon. I mean we think policy is definitely going to remain accommodative for longer than usual, as our central bank seek that inclusive recovery for the first time. We're really starting to see some of the abnormal policies for abnormal times kind of ebbing away as we slowly return to a more normal economy, though you know the Central Bank, the Fed has started talking about decreasing the quantitative easing programs and the Bank of Canada has already begun this process. So, in the near term, we can see the longer terms of the yield curve moving higher in both Canada and the U.S. of a curve steepening out as a significant buyer disappears from the Federal markets in both the U.S. and Canada. And the markets revert back from a bit more of a technical evaluation to a focus on economic fundamentals that we really haven't seen in some time. Tapers expected to happen as well in advance of really any central bank overnight rates normalizing. Overnight rates really aren't expected to move until late 2022 to early 2023. When the overnight rates begin to move to more normal levels, the gross level load a bit as the stimulus moves out of the market, and we should see the yield curve get a little bit flatter at that time. So first Steve I think we see it steepening out mainly driven by the long end, and then we see it flattening out driven more by the short end. 

Steve Peacher: Randall, let's talk a little bit about credits spreads. Obviously, a market you're very focused on and we've seen credit spreads tighten dramatically over the course of the pandemic, maybe more than people would have expected, because the economy's have done better than people have expected. Do you think that credit spreads can continue to rally or do you think that credit is overvalued?

Randall Malcolm: Well, from a global perspective Steve U.S. and European Credit spreads are very tight by historical standards. Canadian credit may have still have some room to tighten. But realistically when you consider how the credit quality of the North American market has evolved and how the duration has extended, the risk and credit is higher overall. We're very tight spreads across North America, not even considering the changes in the market, and one of the biggest changes has been the trend and credit quality in the indices. It's been declining overall in terms of ratings as issuers continue to find the more receptive audience for lower rated credits in the lower interest rate environment we've been in for some time now, so investors, you know, as rates go down investors look more and more to add to their yield as rates fall. But there's still value in individual credits, the risks are certainly skewed to widening spreads so investors need to be very selective. It's not unusual right now to see corporate credit spreads trading actually tighter than they were in their pre Covid levels.

Steve Peacher: So, one final question Randall that has nothing to do with interest rates, so I was surprised to find out that you're this conservative bond guy, but you happen to be also been enthusiastic motocross racer. So I what I, what everyone wants to know is how did you get into motocross?

Randall Malcolm: Well Steve I’ve done it since I was a kid and it was my kind of dream to have a few different motocross bikes and my family is luckily also into the motocross, so we do get out there as a family and we ride through the trails and the tracks and we just have a great time.

Steve Peacher: Well I’m gonna definitely be looking for you, the next time I’m watching the X Games. So Randall thanks for taking the time to explain some of the anomalies in the fixed income markets and thanks to everyone for listening to this episode of “Three in Five.”

Randall Malcolm: Thanks very much for having me Steve.

¹ https://www.bankofcanada.ca/markets/government-securities-auctions/real-return-bonds/

² https://www.wsj.com/market-data/bonds/tips

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