Inflation still lurking

Even after rate cuts, yield-curve control a possibility

We will look back at September 2024 as the month that initiated the fourth Federal Reserve rate cutting cycle of this young century. The first of those cutting cycles terminated in 2003 with a Fed Funds rate of 1%. The other two, commencing in late 2007 and mid-2019, respectively, both ended with the Fed Funds rate pegged close to zero.

Are we going back to zero again? It is always possible. But we believe the drivers of inflation have changed from the last decade. We see a spiraling increase in demands on the public purse. Western democracies face, amongst other challenges, the new military threat of Russia and its autocratic allies; the cost of dealing with a growing spate of climate emergencies; and unfunded demands for spending on pensions and medical care for retirees who represent an increasing share of the population.

And while the demands for public spending seem only to increase, the more finite supply of prime-age workers to service such demands suggests that governments in Canada, the U.S. and elsewhere must confront an expanding public sector funding gap. And, given this equation needs to ultimately balance in cash terms, the difference looks likely to be met by money creation.

So, we expect that an economic slowdown, such as we have seen in the wake of the Fed’s unprecedented rate hiking cycle of 2022-23, may not produce the same degree of disinflation observed in past cycles. And therefore, our core view is that we will have a relatively short hiking cycle that leaves Fed Funds a couple of points lower, but which will be terminated amid resurging and persistent inflation.

In the long run, our guess is that North America is ultimately headed back to some form of yield curve control, along the lines of what we currently see in Japan and, from time to time, in Europe. And that environment, from an investing perspective, should favour investments in scarce real assets, like energy commodities or precious metals, and in highly predictable income streams, such as the ones that come from monopolies and regulated utilities.

There are other potential winners. TIPS and Real Return bonds ought to do well in such circumstances. And small, high growth companies may also deliver strong returns in this context. We believe good, distressed debt opportunities should be in fairly abundant supply. So, overall, we think the coming years will offer not a bad environment for a credit investor to invest in, but this will not be your father’s bond bull market.

Geoff Castle is Lead Portfolio Manager of PenderFund Capital Management’s Fixed Income Portfolios, including the Pender Corporate Bond Fund. Excerpted from the Pender Fixed Income Manager’s Commentary, September 2024. Used with permission.

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