November 8, 2022 | macro-economic research report

Research Report: The Fed’s Two-Step

BY: Richard Croft
It seems that economists are changing their views as often as Putin changes generals. Case in point: the International Monetary Fund’s (IMF’s) World Economic Outlook (WEO) published in mid-October, revised downward 2023 growth expectations. The IMF now believes the global economies will collectively grow at 2.3% in 2023, which is 0.2% below the previous WEO forecast released in July. Look for more of the same in the coming months as economists compete in a race to the bottom.



It seems that economists are changing their views as often as Putin changes generals. Case in point: the International Monetary Fund’s (IMF’s) World Economic Outlook (WEO) published in mid-October, revised downward 2023 growth expectations. The IMF now believes the global economies will collectively grow at 2.3% in 2023, which is 0.2% below the previous WEO forecast released in July. Look for more of the same in the coming months as economists compete in a race to the bottom.

According to the IMF, aside from the black swan events – i.e., the 2007 through 2009 global financial crisis and the 2020 onset of the COVID-19 pandemic – this is “the weakest growth profile since 2001.” If one could find a silver lining in the WEO, it was notable that GDP estimates for 2022 remained steady at 3.2%… albeit well down from the 6% level recorded in 2021.

Here is what we know: a recession in 2023 is all but inevitable and, in line with the hawkish tone espoused by central banks, it will feel more painful than it should. The IMF predicts that more than a third of the global economy will witness two consecutive quarters of negative growth, and the three largest economies — the United States, the European Union and China — will continue to slow.

As we have discussed in recent reports, there are three major events weighing on the growth outlook: Russia’s invasion of Ukraine; the cost-of-living crisis; and China’s zero-COVID policy. The challenge is trying to predict outcomes for events that cannot be measured across a normal distribution curve. Lack of predictability unleashes a “volatile” period… economically, geopolitically and ecologically.

The Russian invasion has destabilized the global economy causing a severe energy crisis in Europe, not to mention destruction within Ukraine. The price of natural gas has more than quadrupled as Russia now delivers less than 20% of 2021 levels to the European Union, and food prices continue to push higher as Russia engages in its on-again off-again maneuvering to limit Ukrainian grain exports.

The IMF has taken a strong stance that the global cost would be intolerable if the U.S. fails to aggressively tackle inflation. Even if the US Federal Reserve (Fed) remains resolute in its hawkish anti-inflation stance, the IMF predicts that global inflation will “remain elevated for longer than previously expected.”

Global inflation will likely decrease to 6.5% in 2023 and to 4.1% by 2024, according to the IMF forecast. The agency noted the global central banks must continue to tighten monetary policy (referred to as quantitative tightening) if we are to dampen inflation expectations and thwart the “powerful appreciation” of the U.S. dollar against other currencies.

China’s “zero-COVID policy” and its resulting lockdowns continue to hamper that nation’s economy and strain global supply chains. The tenuous decline in the real estate sector, which represents 20% of China’s economy, could emit shockwaves that will be felt globally. The impact will be most notable across emerging markets and developing economies, which are still dealing with the economic wounds opened during the pandemic.

The IMF also spoke of a “deteriorated” economic outlook in its Global Financial Stability Report. The global environment is fragile as policymakers around the world are facing an “unusually challenging financial stability environment” where further shocks “may trigger market illiquidity, disorderly sell-offs, or distress.”

According to Axel van Trotsenburg, the World Bank’s Director of Operations, it is clear that the global economy is slowing significantly with pockets of extreme poverty – people living on incomes of US $7 per day or less – representing 47% of the world’s population.

The report comes as analysts debate whether the Federal Reserve is acting fast enough on inflation in the U.S. The European Central Bank, meanwhile, has recently entered positive rate territory for the first time since 2014 and the Bank of England has had to announce additional measures this week to stabilize the British economy and to prevent an unwanted surge in bond yields.

The organization also highlighted that “fiscal policy should not work at cross purposes with monetary authorities’ efforts to quell inflation.” That comment was clearly directed at former British Prime Minister Liz Truss’s efforts to engage in an updated version of “Reaganomics” by cutting taxes to stimulate growth. It might have been a good idea but it was floated at exactly the wrong time. If we are to get out from under this inflationary spiral, monetary and fiscal policies must all point in the same direction.

The energy crisis is also weighing heavily on the world’s economies, particularly in Europe. Most importantly, we need to recognize that the energy wars are not transitory. The realignment of energy supplies in the wake of Russia’s war against Ukraine is broad and permanent. We expect the winter of 2022 to result in price shocks and shortages across Europe, and winter 2023 may be worse.


We share the view espoused by some prominent economists that Canada will experience a recession in the first half of 2023, with the expected decline fueled by aggressive interest rate hikes, a cooling housing market and slowing growth in the U.S. The question is one of degree: will a downturn be short-lived and modest or, as the IMF posits, longer and deeper than most expect? What we do know is that the path to a soft-landing is getting very narrow.

The Canadian economy, as with much of the world, is already on a downward trajectory with most opinions suggesting a low water mark sometime in the summer of 2023. This slowdown, as unpleasant as it will be, is necessary if the Bank of Canada (BOC) expects to curb inflation expectations. Giving the robust employment data, we can expect year-end wage demands to continue to feed into inflation.

Fortunately, albeit still well above the BOC’s target, Canadian inflation is slowing as the September year-over-year price increase came in at 6.86%. In an effort to get ahead of the inflation curve, expect additional BOC hikes that could lead to a terminal rate of between 4.5% and 5.0%.

The most significant factor weighing on growth will be a cooling housing market. Since hitting a peak in February, home sales have fallen 31% nationally and prices have dropped 17%. That data point will spillover into domestic demand that, in and of itself, could be enough to orchestrate two consecutive quarters of GDP contraction as we enter 2023. If the housing market continues to cool, it will put the brakes on residential investment likely through the end of 2023.

Because residential investment is such a major component when calculating GDP, it will eventually impact the labour market causing unemployment to rise. That should temper wage demands by the third quarter of 2023, although that is a best guess given the jobs market is starting from a position of strength, highlighted by record shortages. Higher savings rates among Canadian households may also result in fewer households struggling financially, which reduces the need to find gainful employment.

A recession in 2023 might not be good news, but it should mitigate an even more painful outcome. If the BOC gets inflation back to the target range, it will foster stronger growth and greater stability going forward.


The latest read from the US Federal Open Market Committee (FOMC), which concluded its meeting on November 3rd, was a classic example of a Fed two-step. In this case, one step forward, two steps back.

First, we got some insight into what Fed governors were thinking. More hikes were anticipated but in smaller increments, and markets initially roared higher. Then Fed Chair Powell held his post FOMC press conference that clarified the committee’s position by inferring that the terminal rate may be higher than markets were anticipating. That clarification punctured the bullish balloon and stocks fell sharply. The Nasdaq, which tends to track growth companies, fell more than 3% within an hour.

What we know is that, wherever the terminal rate ends up being, we are closer to the end of this rate hiking cycle than we were before the FOMC meeting. From an investment perspective, the Fed two-step has spotlighted the renewed value of bonds in investment management.

On that point, it is time to re-visit bonds as a portfolio component. It has been more than three years since any significant allocation to bonds has been included in many of our income portfolios. Mainly because interest rates were at or near zero, which meant that bonds would not likely mitigate any fallout from lower equity prices. As well, investment grade preferred shares were providing much better yields than bonds. We generally substituted preferred shares for bonds because we believed that investment grade preferred shares were not significantly riskier than investment grade bonds and our clients could benefit from the dividend tax credit.

In the current environment, after a multitude of rate hikes bonds are looking attractive in terms of their ability to generate income and reduce portfolio variability. To that point, we felt it would be helpful to provide our clients with a primer on investment grade bonds.

An investment-grade bond implies a relatively low credit risk compared to other fixed income instruments. There are three major U.S. credit rating agencies (Standard & Poor’s, Moody’s and Fitch) that classify the creditworthiness of a bond. Each credit rating agency sets a minimum bond rank to be classified as investment-grade.

Investment-grade bonds, historically, have had low default rates (low credit risk), which is reflected in their lower yield that of non-investment-grade bonds.

Understanding Investment-Grade Bonds

An understanding of credit ratings is important as they denote the likelihood of the bond defaulting. To use one of the rating scales provided by S&P, the credit risk of investment-grade bonds ranges from the lowest level of credit risk to moderate credit risk. Which is to say, investment-grade bonds are likely to meet payment obligations. Bonds that are not investment-grade are called junk bonds, high-yield bonds, or non-investment-grade bonds.

In the 2018 Annual Global Corporate Default and Rating Transition Study by S&P Global, information regarding the global default rates demonstrates the value of seeking the best quality offerings. For example, S&P Global reported that the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade bonds) were 0%, 0.38%, 0.39%, and 1.02%, respectively. It can be contrasted with the maximum one-year default rate for BB, B, and CCC/C-rated bonds (non-investment-grade bonds) of 4.22%, 13.84%, and 49.28%, respectively. In our view, removing default risk from the investment thesis is paramount.

On the other side of the coin, higher rated bonds offer lower yields, defined as the total return one can expect from a specific security. For example, investors are currently demanding a yield of 4% to 6% for a 10-year investment grade bond with low credit risk and an 8% yield for a 10-year non-investment grade bond due to their higher implied risk.

For our portfolios, we demand that bonds be rated at least BBB (investment grade). We then apply our due diligence to the underlying company before we would include it in client accounts. We are interested in the value a bond provides in reducing portfolio variability against the cash flow the bond will provide.


A bond is a fixed-income instrument that represents a loan made by an investor to a borrower. Think of it as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are issued by companies, municipalities, provinces, and the federal government. Owners of bonds are debtholders, or creditors, of the issuer. Bonds are terminal in that they mature at a point in the future. If you hold the bond to maturity (that terminal point), you will receive all the accrued interest from the last interest payment as well as the original principal.

The borrower (referred to as the issuer) sets the terms of the loan, interest payments that will be made, and the time at which the loaned funds (bond principal) must be paid back (maturity date). The regular interest payment (the coupon) is part of the return that bondholders earn for loaning their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

Pricing A Bond

The initial price of most bonds is typically set at par, or $1,000 face value per individual bond. The actual market price of a bond depends on many factors such as the credit quality of the issuer, the length of time until maturity, and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be paid back to the borrower when the bond matures.

Most bonds can be sold by the initial bondholder to other investors after they have been issued. In other words, a bond investor does not have to hold a bond all the way through to its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates decline, or if the borrower’s credit has improved, and it can reissue new bonds at a lower cost.

Face value (par value) is the amount the bond will be worth at maturity; it is also the reference amount the bond issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium of $1,090, and another investor buys the same bond later when it is trading at a discount for $980. When the bond matures, both investors would receive the same $1,000 face value of the bond.

The coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1,000 face value = $50 every year.

Coupon dates are the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual.

The maturity date is the date on which the bond will mature, and the bond issuer will pay the bondholder the face value of the bond.

Two features of a bond – credit quality and time to maturity – are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit rating, as described above the risk of default is greater and these bonds must pay more interest to offset. Bonds that have a very long maturity date also typically pay a higher interest rate. Although, with the current inverted yield curve, that is not the case, which is why we are looking more closely at shorter-term maturities.

Bonds will rise or fall in value as interest rates change. The sensitivity to changes in the interest rate environment is called “duration,” which is calculated using the present value of future interest payments.

A bond’s “modified duration” is the calculation of how much a bond’s price will change given a 1% move in interest rates. A bond that will mature within the next three years would typically have a modified duration of about 2, which would imply that the bond’s price will rise or fall by 2% given a 1% change in interest rates.

In that sense think of bond prices and interest rates as opposite ends of a teeter totter. When interest rates are rising, the price of the bond will decline and vice versa. Of course, if you hold a short-term bond to maturity, none of this matters.


The yield-to-maturity (YTM) of a bond is another way of considering a bond’s price. YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled.

YTM is a complex calculation but is quite useful as a concept for evaluating the attractiveness of one bond relative to other bonds of different coupons and maturity in the market. The formula for YTM involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:

Categories of Bonds

There are four primary categories of bonds sold in the markets. Corporate bonds are issued by companies. Companies issue bonds rather than seeking bank loans for debt financing because, in many cases, bond markets offer more favorable terms and lower interest rates. Provincial bonds are issued by the provinces, municipal bonds are issued by cities, and treasury bonds are issued by the Government of Canada.

Bonds issued by the Government of Canada with a year or less to maturity are called “bills,” bonds issued with one to ten years to maturity are called “notes,” and bonds that mature after ten years are called “bonds.”

Varieties of Bonds

The bonds available for investors come in many different varieties. They can be separated by the rate or type of interest or coupon payment, by being recalled by the issuer, or because they have other attributes. Below, we list some of the most common variations.

Strip Bonds

Strip bonds do not make interest payments but rather are issued at a discount to their par value that will generate a return once the bondholder is paid the face value when the bond matures. Government of Canada treasury bills are examples of a strip bond.

Convertible Bonds

Convertible bonds are debt instruments with an embedded call option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions.

For example, imagine a company wants to borrow $1 million to fund a new project. They could borrow by issuing bonds with a 12% coupon that matures in 10 years. However, if they knew that there were some investors willing to buy bonds with an 8% coupon if the investor could convert the bond into stock, they might prefer to include a conversion privilege. The convertible bond may be the best solution for the company because they would have lower interest payments while the project was in its early stages. If the investors converted their bonds, the other shareholders would be diluted, but the company would not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution because they can profit from the upside in the stock if the project is successful. They are taking more risk by accepting a lower coupon payment, but the potential reward if the bonds are converted could make that trade-off acceptable.

Callable Bonds

Callable bonds also have an embedded option, but it is different than what is found in a convertible bond. A callable bond is one that can be “called” back by the company before it matures.

Assume that a company has borrowed $1 million by issuing bonds with a 10% coupon that matures in 10 years. If interest rates decline (or the company’s credit rating improves) in year five when the company could borrow for 8%, they will call or buy the bonds back from the bondholders for the principal amount and reissue new bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called when it is rising in value. Remember, when interest rates are falling, bond prices rise. Because of this, callable bonds are not as valuable as bonds that aren’t callable with the same maturity, credit rating, and coupon rate.

Puttable Bond

A puttable bond allows the bondholders to put or sell the bond back to the company before it has matured. This is valuable for investors who are worried that a bond may fall in value, or if they think interest rates will rise and they want to get their principal back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in return for a lower coupon rate or just to induce the bond sellers to make the initial loan. A puttable bond usually trades at a higher value than a comparable bond without a put option because it is more valuable to the bondholders.

Richard Croft, Chairman & CIO

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