Hello and welcome back to the Institutional Beat Podcast, where we cover interesting and relevant topics for institutional investors. I am your host, Haley Hopwood, and I am joined today by two senior members of our Canadian fixed income team, Kristian Sawkins and Matthew Dubras. Kristian, Matt, thank you so much for being with me here on the podcast today. 

Thanks for having us back. 

I guess I should say, actually, welcome back to the podcast. Is this the second time you're joining me here? So evidently you weren't too scarred from that first experience. 

No, no, we're happy to be back. It's, you know, it's been a really quiet 12 months since we were last on... 

Oh, totally. Okay, so why don't we jump right in? Although tariffs are still featuring quite heavily in the headlines, I wanted to focus the conversation today on something else that's been driving markets, which is this concept of fiscal expansion. So just to provide a little bit of context, in the U.S., Trump's Big Beautiful Bill is projected to increase the fiscal deficit by trillions of dollars over the next decade.

And meanwhile, here in Canada, although we don't yet have a formal budget in place, the Carney government has been pretty clear that that we can expect to see some increased spending on things like defense infrastructure, resource projects, as well as just general support for Canadian individuals and businesses as they deal with impacts from tariffs. So with that background in place, maybe we can start off by having you talk about the impact that this has had on the bond market so far this year.

Sure, I can jump in there with some comments. I think it's important to note that the spending taps are still open. You know, we're not talking only in Canada and the U.S., but we're also seeing some more, you know, call it historically restrained countries like Germany increase their spending, too. So it's really a global phenomenon out here.

You know, to your question of what the impacts have been on the bond market so far, I think, primarily, you know, we've seen pressure for higher yields, sort of across the board. It's not been dramatic moves in yields, but the pressure has definitely been for them to be higher rather than lower, due to these fiscal effects.

We've also seen, you know, arguably a much bigger effect on the steepness of the yield curve. And by steepness of the yield curve, I mean that longer rates have gone up higher than shorter-dated rates or shorter-term rates. And that's because there's more uncertainty out there around growth, inflation, supply of new issuance.

So investors are really demanding more yield for taking on more term. And that's something we haven't seen in a long time. A few other things I think that we've seen: we've seen bonds that are – bond markets and yield moves that are much more sensitive now to the day-to-day fiscal announcements that we seem to be getting on both sides of the border.

And, I mean, all around the world for that matter. We see more general volatility, volatility’s definitely elevated. And something that's a relatively recent development I'd say, is that government bond auctions can also be more volatile. And that's not something we've been used to. So you know again, nothing dramatic, nothing anyone should be worried or scared about, but just, you know, things have been increasing a little bit on the volatility side.

Okay, perfect. Thanks for that overview, Kristian. So clearly this has been a driver of what we've seen in bond yields and just general market dynamics that have been going on so far this year. One of the things you mentioned was this expectation of higher supply. And obviously this makes sense because presumably all this spending does need to be funded somehow.

What kind of impact are you expecting to see on government bond issuance in Canada? 

Sure, Haley, I'll tackle this one. So, as you know, we don't have a budget from the new government;  we expect one to come in the fall. But if we look at how issuance has sort of behaved since a new government has taken over, presently it's roughly the same. The issuance patterns are roughly the same.

You know, consistent with what we've seen before, albeit that the sizes are larger. So, you know, increased spending, larger sizes, but altogether, issuance patterns are similar to what we saw before. Looking ahead, though, obviously the government has two core funding choice needs to make. Is it going to fund itself with T-bills, which is short-term debt, or is it going to fund itself with bonds, which is longer-term debt?

Our expectation is that the government is likely to want to avoid locking in longer maturities at the yield levels that we see right now. We expect – and I think this is for the expected out there in the market, too – that the government's likely to tilt more towards T-bill issuance with the increase in deficits that we're likely to see, you know, with the refinancing needs that they have.

Also, you know, the other tool that they have, and this is something that they've done historically, fairly consistently, is that within the bond programs, so within that longer-term debt program, they tended to want to shift issuance towards the shorter tenors. So that would be a two-year or five-year debt, as opposed to looking at rates for sort of ten years and thirty years.

And so we think that that's going to be something that they’re likely to do as well.

Right, okay. So likely to see more shorter-term issuance, just given that it's more expensive right now for them to issue in the long end, but still overall expecting more issuance this year coming up versus last year. So, do you think that the market is prepared to be able to absorb this additional supply? 

We think so. There's a couple of reasons. So the first reason would be what I just talked about, which is, you know, the bond program is likely to grow, but depending on where they issue, we expect them to want to favour issuance towards the shorter end of the curve. We think that that's going to be less likely to be a problem for the bond market to digest at this point in time.

The second factor is, the Bank of Canada is going to be starting to buy T-bills again in Q4 of this year. You know, given what we expect in terms of the additional deficit, we think that when the Bank of Canada steps up and starts to buy T-bills again, that that will probably absorb most of the incremental T-bill supply we expect from higher deficits, and as a result, probably absorbs most of what we're expecting to see from that deficit. So I think overall, our judgment is that the market's probably going to be able to absorb this. 

Okay, well that's reassuring. Now Kristian already mentioned some of the curve steepening that we've seen already, sort of on the back of expectations of this fiscal spending. As we look out over the next three to six months or so, could we see additional curve steepening from here? 

Yeah. So, so far obviously what we've spoken about with respect to steepening has been the impulse of steeper curves from fiscal expansion. So that's just one impulse that we can see toward steeper curves. I think where we think there could be more room for steepening actually is not the fiscal side, it's more the monetary side that we think we could get that impulse from.

So on the monetary side, we think that, you know, from a longer-term standpoint, if you look at where yield curves are, we’re at levels of steepness that are kind of close to average, but the front end of the curve in Canada is only pricing in one more cut than the Bank of Canada.

So, you know, effectively the market thinks that one more cut and the Bank of Canada is done cutting rates for this cycle. We think that there's potential there for the market to be too hawkish about the Bank of Canada right now. You know, if we think about households in this country, many of them are very highly leveraged.

We look at the mortgage market, roughly 60% of which is going to be renewing over the next 12 to 18 months in November. You know, everyone has a story to tell. And so when you think about the money that needs to be drawn from within households, away from something and into higher debt service costs, we expect that could be from consumption.

And so, you know, you could see a rejection towards a weakening of consumption in the economy. The other area that we think, you know, you could see an impulse, towards a steeper curve, and this could matter for the Bank of Canada, is on the inflation side. So, you know, there's been a lot of talk, in the market over the last six months, especially in Canada, about how sticky inflation has been.

You know, inflation is making progress back towards, the Bank of Canada’s 2% target but core measures in particular, which is what they tend to focus on, are still hanging around 3%. The thing about the stickiness that we're seeing in inflation is when you look under the hood, you find a lot of the stickiness that we're seeing right now is coming from the shelter component of inflation.

That's quite large; it's about 30% of our inflation basket, so it's very meaningful. Specifically within shelter, a lot of that stickiness is coming from two things: rents and mortgage interest costs. Both of those components follow the market with a lag. You know, anywhere between sort of 8 to 12 months. And so when we look at market rents, we see market rents declining year over year in the market.

This is, you know, most major metropolitan cities in Canada. You have a generally weakening condo market, you generally have less pressure on rents. And of course, the population growth story goes along with that, too. On the mortgage interest cost side, it's very mechanical, it just follows where rates are going. So rates in the front end have been coming down, mortgage interest costs will follow that.

And so we, you know, when we combine those two things, if we think about a scenario where inflation pressure from shelter is starting to cool, you know, that's going to impact core inflation – it is likely to come down. That's happening. Similarly, if this is happening at a time when consumption softens, you could have a sort of an economy there where the Bank of Canada might feel comfortable to cut rates and potentially cut rates more than what's priced in right now. 

Okay, perfect. So it sounds like we could see some more steepening indeed, and certainly some interesting dynamics there with both monetary and fiscal factors at play. Maybe a question in terms of positioning and what you guys are looking at –  does this impact, or how does this impact what you're doing, across the yield curve? 

Oh yeah, for sure. Like this is probably, on the interest rate strategy side, the most interesting and important dynamic we have going on right now, as far as our portfolios go. So, you know, we're definitely more cautious, as I think you’ve sort of gotten the sense of, talking to Matt and myself, we’re more cautious on long-term bonds here.

So we're underweight that that part of the yield curve in favour of shorter-term bonds, or more overweight the shorter term or the more front end part of the yield curve – so you know, colloquially, in the cool world of bonds, that's known as a steepening position. So we have a steepening position on right now. You know, on the overall level of rates side, we don't have as strongly a conviction; rates, interest rate strategies as a whole are generally difficult to, you know, have a lot of conviction in.

And so, you know, the way I would characterize ourselves right now is, we have much more conviction about where the yield curve is going, or the steepness of it, relative to the absolute level of interest rates right now.

Right, okay. Thank you, that makes sense. So I want to pivot slightly to something a bit unusual that we've seen this year. So normally in risk-off environments, bonds act as an offset to stocks and other risk assets. So, yields move down while equities sell off. But post-Liberation Day we actually saw bond yields rise as stocks fell.

And that negates what has historically been a pretty reliable relationship. Do you guys see this as being tied to fiscal expansion, almost as if the debt itself is being treated as more risky? 

Yeah, that's a really good question, Haley, and a great observation. I think just to take a step back, first, I don't think it's easy to say what's normal insofar as the stock/bond relationship, over a longer periods of time. You know, I think, post the Great Financial Crisis of 2008, and then pre-COVID, so that 2008 to 2020 period, we had a really strong and sustained time of bonds and stocks offsetting each other from a return point of view.

I think we have to keep in mind, though, during that period of time, there were two key elements that were at play here. One is that inflation was very contained, if not below target for a good portion of that period. And on the fiscal side, deficit spending was much more modest. There were many more fiscal hawks out there in the government side, the elected officials, much more so than there are now.

So we have to just keep in mind that I think that period from 2008 to 2020 may have been an unusually long period of stability in this type of relationship. Since 2020, though, I would say, you know, as you noted, this bond/stock relationship has kind of flipped where, they have either sold off at the same time or rallied at the same time, as opposed to kind of offsetting each other.

And, you know, if you think about why that is, the first thing that I would point to is inflation, which as I mentioned was really stable from 2008 to 2020. It's, as we all know, had a giant move up in ‘22 and ‘23, after Covid eventually subsided.

It's, you know, clearly higher inflation is not good for bonds. And so that's where the stock/bond relationship kind of got flipped on its head from pre-2020 periods. You know, now in the world we're living in, inflation is less of an issue. Obviously it's still somewhat elevated relative to what the central banks would otherwise want or are otherwise targeting, but that level of inflation has come down quite a bit.

Now, what we're seeing, though is, you know effectively what we've been talking about on this entire podcast, which is, fiscal expansion is much more persistent, and it's continued to be persistent, even as growth has maintained strength in economies, etcetera. And so, that clearing – you know, we have continued fiscal expansion, that means more issuance – and as a result, that clearing rate of yields where the supply needs to eventually hit the market at, is much higher than it had to be prior to that 2020 period again because, you know, more fiscal expansion, more spending, etcetera, and then so higher clearing rate again, not good for bonds.

So you kind of see that these dynamics have changed between what's driving bonds post this 2020 period versus the pre 2020 period. I think we bring it all together. We don't think this is a permanent reversal of any correlation. I think the way we would characterize it is, it's less stable of a correlation than it was before.

And really it's going to be, I think, dependent on what the underlying factors are, whether it's that fiscal side or if inflation maybe re-emerges. You know, we'll have to see, and those will really be the underlying factors will be really what drive this correlation. 

Right, okay. That's very interesting and comforting also to hear that you don't think that this is necessarily a permanent reversal. But, while we are in this period of instability with this relationship, in terms of how you manage portfolios if you aren't able to, you know, use duration to hedge risk or hedge credit risk, or does that just mean you're less willing to hold credit, or are there other tools that you can rely on in this kind of environment? 

Yeah, it's a good question Haley. So I think, you know, short answer: Yes, it means that duration is a less reliable tool that you can use when you have credit in your portfolio to use it to hedge your risk. There's been times over the last couple of years where being long duration has provided these sort of traditional insurance-like qualities that you would want out of it based on sort of longer-term historical correlations, but also short duration has proved to be as good, during certain periods. So again, unstable.

I think, where we have found a bit more sort of confidence, if you will, is in using the yield curve positions to sort of protect us or hedge our credit risk in the portfolio. And certainly, if you look over the last year, you know, a good example of this would be how yield curves globally moved, during the month of April, duration itself performed quite poorly – initially it did rally, as you would have expected in response to the Liberation Day announcement, but that was very short lived.

Yields then rose very aggressively. But that rise in yields was a steepening of the yield curve led by the back end of the yield curve and so, you know, that's just an example of where using duration might not be as reliable a hedge for the credit risk in your portfolio, but you might be able to come up with scenarios where steepening of the yield curve could provide you that benefit.

Okay, good. I'm going to take a step back now for a moment and ask, what do you see as being some broader implications of sustained fiscal expansion? 

So I think, like when Kristian and I were talking about coming on this podcast and sort of maybe one of the biggest ideas or thoughts that we wanted to bring across or bring forward was the trade-off that we see from deficit spending. So, you know, if we think about the positives, when we think about the negatives … on the positive side, I think sustained deficit spending, as we've seen post-Covid, definitely supports growth in the near-term.

We can debate, of course, the quality of that growth. You know, I think we could probably spend an entire podcast talking about that but, you know, the bottom line is that post-Covid economic growth has been supported by fiscal policy. The negative side, in our view, is the deficit spending does not appear to be a free lunch.

You know, we think about the costs, what we've been speaking about. So far, the costs we view as being borne out in higher interest rates and rising term premium, which is what we've been seeing in markets. Why this really matters to us from an economic standpoint is that we think we can make a pretty compelling argument that rate levels right now, are too restrictive for the private side of the economy.

That's households and businesses. One place that we like to look for evidence of this, is in the composition of bank lending. So when we look at bank lending right now, what we see here is very low overall rates of credit growth relative to history. That means the lending to households and businesses. We also see banks accumulating securities as opposed to expanding credits.

And I think that that's really the essence of what we think about when we talk about this idea of, you know, fiscal policy and deficit spending crowding out the private sector of the economy. And that's what we believe is happening. If you think about the longer term, you know, clearly, I think most of us are very sort of dialed into what the longer-term concerns might be around deficit spending.

That would be, you know, if deficits persist and we don't get the same growth return from those deficits, you know, we would expect servicing costs to rise and you know, sustainability concerns to come to the fore. You know, we're very used to seeing this in the discussion, around U.S. national debt. But you know, supposing we have a situation where globally developed market governments are all expanding on the fiscal side, expanding policy, you could definitely see that becoming more of a broad-based issue.

I think one of the other topics that's come up very recently has been this idea of fiscal dominance – this idea that fiscal policy, if it remains very expansionary, it raises the risk of fiscal dominance. And that is essentially a point where central banks start to face pressure to accommodate fiscal policy, maybe at the expense of, say, the inflation side of their mandates. 

Okay, I mean, this sounds very interesting, and I just want to make sure I'm understanding and our listeners are understanding this correctly. So if I am understanding you correctly, you're saying that with higher rates due to fiscal policy, individuals and businesses are less willing or able to borrow. And so that's crowding out of the private sector.

And then ultimately this has negative implications for growth. And at the same time, we're seeing higher debt servicing costs. And so the fear is that over the long term this becomes unsustainable, and we become reliant on persistent fiscal expansion. Did I get that right? 

I think yeah, I think that was a good summary, Haley. I think, you know, the basic idea of what you described is the crowding out effect of fiscal policy. Okay so, you know, if we take a really, really big step back, fiscal policy, you know, during normal times, when do we expect fiscal policy to expand?

We expect it to expand when the economy is weak. So we expect fiscal policy to be countercyclical, right? And, you know, historically, we see that governments spend more money when the economy needed it, when it needed the support, usually when it needed the support, rates were low because central banks were also trying to stimulate the economy with low rates.

If we are in a situation now where fiscal policy is just running, irrespective of the point that we are at in the cycle, and that's leading to rates being too restrictive for the private side of the economy to borrow and spend, you know, that's effectively what we're talking about. You know, and this is all well and good, it's all fine if we think that government spending at the expense of the private sector leads to stronger, more productive economic outcomes. But I think, certainly Kristian and I, and I think many people listening to this podcast would probably agree, that that might not be the case. 

Right. So regardless of, you know, whether this exact scenario, you know, plays out fully or not, it certainly seems like fiscal expansion puts central bankers in a tough spot. So, how do you think this impacts or influences their decisions in terms of monetary policy? 

Yeah, I mean, certainly this is a factor that does not make their job easier. It definitely makes it more difficult. There's something else, you know, it's not that it’s a new thing that they didn't focus on before, but the prominence of it just makes it that much more important and critical for them to take into their already tough decision-making role.

You know, deficit spending, as Matt mentioned, can be growth focused, so you can have an impulse in the economy that is strong from this deficit spending, which as a side effect, obviously depending on how much excess supply you have in your economy – and again, sorry to bore all the listeners with this silly economic jargon but, you know, if we have cut out some of the surplus because of the deficit spending, then you can get inflation from this.

And we have to keep in mind that the Bank of Canada has an inflation mandate. That is their goal, to keep inflation within their target band, over the long term. So, if inflation does happen to come to pass because of deficit spending, they might need to keep, you know, the Bank of Canada might need to keep rates higher than they otherwise would like to.

And as we mentioned about fiscal dominance and that whole sort of concept, you know, the flip side is that higher rates increase the costs, to two main parties: one would be, of course, the Government of Canada and other borrowers in the government realm, and then households, just because, you know, higher rates mean higher costs when you borrow to buy a house or other things that you might borrow for, and that's just going to cause potentially more fiscal stress.

So, it's really a two-sided sort of debate here about how fiscal spending could affect the Bank of Canada. And it's really difficult to know what the inflationary impact will be. And as we mentioned, there's other things that obviously go into the inflationary impacts you had mentioned earlier.

There's, you know, trends we're seeing right now that suggest that maybe the stickiness of inflation is not persistent and could trend lower, for some reasons related to housing. And similarly for the Bank of Canada, there's many things that go into their decision making, so this is only one of them. I think the net of it really is that we have to keep in mind, the world we live in now, fiscal policy, or the expansionary fiscal policy is not going away anytime soon.

So it's really something that we will be considering as investors and, and fixed income managers and something the Bank of Canada will have to be considering and weighing, to a much greater deal than they've had to in the past. 

Yeah, it sounds like quite the balancing act. I'm happy it is not part of my own job description! Okay, Kristian, Matt, this brings us to the end of our discussion today. So, thank you both so much for being on the podcast, and for sharing such valuable insights with our listeners. 

Thanks, Hayley. It was a real pleasure to be here again. 

Yeah. See you in a year! 

Yep. Okay, perfect. Good to hear. Okay. And then just lastly for our institutional listeners out there, these dynamics just underscore the importance of working closely with your investment managers to navigate the evolving market environment, with fiscal expansion influencing things like bond supply, yield curves, and cross-asset correlations, it's critical that your managers are actively assessing opportunities and risks.

And additionally, this temporary dislocation in the traditional bond/equity relationship, or the instability that we mentioned, it just highlights the value of a diversified multi-asset strategy.

Okay so thank you everyone for listening to the Institutional Beat. We hope you can join us again next time.

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