What global forces mean for Canadian fixed income assets
Each month at WP we take a deep dive into a topic highly relevant to Canadian financial advisors. This April we’re focusing on fixed income.
Fixed income volatility might just trigger a trauma response from investors who lived through 2022. The scars of that bear market, papered over by subsequent strong years of equity returns, could start bleeding again in the face of an energy supply shock that has introduced some volatility into equity markets and seen an overhaul in prospects for central bank rate policy.
In the past six weeks, Naveed Sunderji has seen geopolitical shocks drive real volatility in interest rates. The portfolio manager and research analyst for Franklin Templeton Fixed Income explained how this conflict has impacted fixed income and why, despite some moments of similarity, investors should not be treating this moment like 2022. He factored in other overhangs for the Canadian economy that could shape Canadian bond performance and highlighted how advisors can help clients manage when the part of their portfolio that shouldn’t wobble, suddenly does.
“I think a lot of investors still have 2022 in the back of their minds and the impacts from Russia-Ukraine and how that flowed into inflation metrics. And with that in mind, there's a concern that you have this shock to oil and gas as well as a number of products coming out of the Middle East and how that'll be impactful to inflationary metrics,” Sunderji says. “And that changes the situation for rate policy and rates in general, even if you're coming into a situation where we really saw inflation slowing and we saw slower economic data coming out of Canada. There's this situation where, even if the backdrop is slowing in Canada, we might see what's happening on a geopolitical basis in the Middle East change that narrative a little bit, or at least complicate it.”
Notably, fixed income markets have shifted their outlook on the Bank of Canada this year. At the peak of bond volatility in March, investors were pricing in three 25 basis point hikes in 2026, while the year had started with a 50 per cent chance of an interest rate cut. That bet on a hawkish BoC has since come down slightly, but the whipsaw in expectations has introduced more volatility into bond performance.
Sunderji accepts that 2022 had a host of other factors driving its inflation spike beyond just a conflict-driven energy shock. Post-pandemic supply chain issues and demand spikes from generational fiscal stimulus also played a role. He says that his team is paying close attention to fiscal responses in the face of today’s inflationary shocks, including smaller actions like the temporary rollback of fuel tax in Canada, or potentially larger responses like a cost of living benefit.
There is the potential that, despite only a single mandate focused on inflation, the Bank of Canada looks past energy prices’ impact on CPI and focuses on weak economic growth and jobs market data. Sunderji believes that the BoC’s view of this inflation spike will be crucial. If Governor Macklem describes it as “transitory” or another word to that effect, we may see less willingness to hike. If there’s a view of that inflation as stickier, then we may need to watch for those interest rate increases.
Canadian fixed income is also subject to global forces, and Sunderji notes that there has been some correlation to US weakness in credit spreads as well as rate increases. He notes that while Canadian credit markets tend to follow US trends when spreads widen or tighten, Canadian credit behaviour is more muted on both sides.
Given that this inflation spike has been caused by an energy supply issue, and Canada remains a large energy exporter, the increase in energy prices should see a net economic benefit for Canada despite cost increases. Sunderji notes, though, that the GDP boost will be somewhat marginal, between 0.2 and 0.4 per cent.
While ongoing risks tied to conflict in the Middle East remain central to Franklin Templeton’s view of fixed income risks for Canada, Sunderji notes that other overhangs like CUSMA renegotiations remain a factor. He also notes that current issues in the private credit market could pose risks for the banking system, and his team is watching to see how that flows through.
Sunderji says he sees opportunity for investors on the shorter duration of government bonds. Given the potential for inflation and ongoing geopolitical uncertainty he argues that now is not the time to take longer duration bets. On the credit side he notes a growing preference on his team for higher credit quality from companies with more stable cash flows. The energy sector, he says, looks promising as many companies in that space have already de-levered and now offer very strong free cash flows. He argues that this approach focused on shorter duration in bonds and quality in credit can help keep clients invested, despite volatility in the portion of their portfolio they most want to stay stable.
“Now's not the time to take the big duration bets. Now's not the time to kind of go too far down the risk spectrum where you're not getting paid to take on more risk,” Sunderji says. “You might want to stay closer to home.”
