Fixed Income: The Swap Market vs. The Fed

4 minute read • November 22, 2023

The clash between central banks and swap markets is a high-stakes game predicting our economic future. As North American central banks stand firm on their “higher for longer” interest rate stance, the swap markets whisper a different tale, hinting at impending rate cuts. Are the central banks using their words as a subtle policy tool, or are the swap markets the true harbingers of what’s to come? 

Mixed Signals: Central Banks vs. Swap Markets

North American central banks are saying one thing, while the markets are saying another. Overnight interest rate swap markets are pricing in three 25-basis point rate cuts by the Bank of Canada before the end of December 2024. Meanwhile, U.S. Federal Reserve chair Jerome Powell and Bank of Canada governor Tiff Macklem are communicating that their overnight interest rates will stay “higher for longer.”  

These two sources of communication, the market and central banks, are currently at odds.  I won’t go deep into defining a swap market but note that interest rate swaps indicate the market’s future interest rate policy expectation.

Who has it right?

Perhaps communication from the central banks is just another “policy tool.” Let’s imagine a scenario where the market suggests rate cuts will occur next year, and central banks stop communicating that their interest rates will stay higher for longer. Or, if we take it even a step further, central banks indicate that they will likely need to cut rates near the end of 2024.

The likely impact is that consumers delay consumption and corporations delay capital projects, given they have a high degree of confidence that interest rates will be lower a year from now.

Lower interest rates mean a lower cost of capital, so consumption becomes less expensive, and capital projects for companies also become less expensive; waiting would seem wise. If swap markets and central banks were communicating lower rates soon, confidence in this happening would become twice as strong. Central banks understand that this scenario would lead to a faster deceleration of growth than we currently see in recent economic data.

Our view is that the communication from the central banks is being used as a policy tool to avoid an exacerbated deceleration in growth. They’re trying to execute the challenging balancing act of bringing inflation back in line with their target range, 1% to 3%, without causing a recession.

Important to point out two items:

  1. Although this balancing act is the goal, they seem to favour reaching their inflation target despite the economic damage it may cause. It’s a higher priority, end of story.
  2. Central banks’ record of increasing interest rates to moderate growth while not causing a recession is horrific.

The economic impact of increasing interest rates takes time to filter its way into the economy. So, to execute this balancing act, they need to know what economic data will look like three quarters from now. The Bank of Canada and the Federal Reserve must rely on backward-looking economic data to make policy decisions that will impact the future economy.

Perhaps this is the reason for their horrific track record in successfully using interest rates to calibrate the economy.

Investment Implications

We can’t rely on the central banks to tell us what they will do in the future. We’ve outlined why this wouldn’t help their cause; in fact, we’ve outlined how it would hurt it. For this reason, we’re more inclined to rely on the interest rate swap markets to indicate future interest rate policy.

It’s critical as an investment manager to understand the history of how the central banks operate and the history of their shortcomings in executing their intended outcomes. Investment management also requires proactive decision-making.

We’re humble enough to admit that we don’t know when the Bank of Canada and the U.S. Federal Reserve will begin cutting their overnight rates. But we are confident enough in our analysis to understand that interest rate cuts will outweigh increases over the next 18 months.

We can proactively adjust our Matco Fixed Income exposures to capitalize on lower interest rates.

Over the last 12 months, we have increased our duration exposure by 1.6 years. It means that we’ve been able to extend the term of the bonds we’re investing in to accomplish two things: increase the yield offered within our fund while increasing the interest rate sensitivity. Increased duration means that the fund will benefit from greater capital appreciation when interest rates eventually move lower.

These benefits will require some patience before they are realized. In the world of investing, patience can be a powerful tool. The last two years have not been kind to fixed-income investors.

At the beginning of 2022, yields in the market were very low, almost anemic. Since then, interest rates have increased dramatically, which has caused a depreciation of the value of bonds. It has meant paltry returns for fixed-income investors since the beginning of 2022. However, we believe the tide is poised to turn.

Tides don’t shift overnight, but if you’re not proactive, the water can hit your feet before you know it. Matco’s Fixed Income Fund is ready to embrace the tide.

Trevor Galon

Trevor Galon CFA

Chief Investment Officer

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