Much has been made of increasing correlations, but Rose Devli reiterates the underlying value case for government bonds
Amid economic data in both Canada and the United States that appears to green-light a new round of interest rate cuts, Rose Devli argues that significant pockets of opportunity remain in bond markets. The Portfolio Manager for fixed income at Dynamic Funds explained why she remains constructive on longer-dated US treasuries, despite potential headline risk and headwinds for that end of the yield curve. She predicted that both the Bank of Canada and US Federal Reserve will cut interest rates at their meetings on Wednesday, and offered a view of where she now sees opportunity and risk on fixed income markets.
“We still do think that there is value in the US, even though it has been outperforming Canada as well as Europe. We think that there's not going to be a recession in the US, but a gentle slowing. So from euphoric levels of GDP around that 3.5 to four per cent and an inflation rate around three per cent, coming down to a rate of growth around that one to one and a half percent, makes some sense to us,” Devli says. “That would leave us around, anywhere through that four per cent level in the 10 year. To us that still seems like there's some value, especially to that seven to ten-year part of the curve.”
Devli notes that many of the funds her team operates come with Canadian mandates, allowing total freedom of allocation for 49 per cent of the portfolio. Seeing US yields upwards of five per cent, her team placed a relative value trade to go long on US 10-year yields against the rest of the world. Some of the logic there was that the Bank of Canada has already completed most of its cutting cycle, while the US hasn’t moved nearly as far down. Data from the US show a slowdown in economic growth and softness in the labour market, which Devli believes ought to drive a new round of cuts beginning on Wednesday. In the meantime, Devli and her team have been able to enjoy high yields from these bonds.
Canadian bonds, conversely, look more fairly rated amid a more rapid economic slowdown. Devli also predicts the Bank of Canada will cut on Wednesday, but argues that the lack of a federal budget and a US trade deal make for greater uncertainty in Canadian bonds. She sees the potential for greater upside on the shorted end of the Canadian yield curve, with a view to risk premiums associated with policy actions taken in the coming months.
Devli says she and her team favour the longer end of the US yield curve despite the ways political events have impacted that duration. Presidential threats to Fed independence were greeted with a steepening in US yields, while forward inflation risk and even some US deficit risk continues to impact the 10-year and other longer-duration bonds. However, Devli argues that the story of slowing US growth is now superseding those issues of political interference and deficit risk. As a result, 10-year treasuries are looking more favourable in a story more shaped by growth, rather than inflation.
There are signs, however, that the US may not be the key source of safe haven assets that it once was. Devli notes that US dollar depreciation has raised many questions for investors. While US government spending and policy decisions are being felt in the greenback, Devli notes that this is a relative system and while the US may be running large deficits, so is most of the world.
Recent years’ turbulence on bond markets, in addition to runs in other safe haven assets like gold, have made some analysts question the utility of government bonds as a non-correlated asset class and a source of ballast for investors. Devli, for her part, notes that inflation scares can result in positive correlation. However, growth scares see bonds revert to their traditional non-correlated nature. She stresses the century of past evidence that shows bonds ability to protect against the downside and dampen volatility in portfolios. Traditional bonds, she says, can continue to hold that utility while also offering meaningful yields. The trouble can arise when overall volatility spikes so much it impacts bonds, but when events tend to calm down that traditional utility resumes.
“If you look at what happened in April, when ‘liberation day’ was announced, bonds did what they should have done, yields fell and prices rose, the problem arose when VIX started popping,” Devli says. “a lot of investors look short-term, especially these days. But if you're an investment advisor, you should be thinking about the next 25-30, years and what makes sense in your portfolio or not. Bonds give you that running yield that no one could take away from you, that can offset those short-term losses while things calm down over the long-term.”
