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Analysis of the financial markets usually starts at the yield curve since it essentially puts a price tag on risk in the market. When rates are rising as they are now, it makes the risk-free rate of return higher*, which therefore makes riskier assets less attractive. The decision to invest in a broad-based stock index that returns around 8% per year with a lot of risk when you could invest at the risk-free rate, for a 3% return at no risk, is a more difficult decision for investors.

The yield curve has historically been touted as a predictor of recessions, especially when it inverts. An inverted yield curve occurs when the long end of the yield curve decreases while the short-end increases. Many players within the financial markets believe that when the yield curve inverts then a recession is likely to occur. This is not always the case and it usually depends on numerous other factors as well as the length of the inversion and the severity of the inversion.

Implications for Canadian Investors

So, what does this mean for Canadian investors?  Essentially, there is a higher probability of a recession, not only due to rising interest rates but a litany of other factors, including:

• High inflation – inflation has remained higher for a lot longer than anticipated by the Bank of Canada. In order to cool the red-hot inflation, the Bank of Canada has had to aggressively increase rates to avoid prolonged high inflation and inflation expectations
• High uncertainty – there is no guaranteed timeline for when inflation will return to normalized levels, therefore many financial participants do not know when the Bank of Canada will taper the rate of hikes. While this uncertainty remains, it is likely that riskier assets will have poor performance
• Food and energy crises around the world – the global economy is very interconnected and while there is not an immediate food and energy crisis within Canada, the impacts from other economies are almost certain to have an impact here in Canada

This combination of rising food and energy prices, the invasion of Ukraine by Russia, and sticky inflation is certainly contributing to the risk of a prolonged recession. So while an inverted yield curve does not necessarily mean an imminent recession with 100% certainty, the fact that all of these negative developments are occurring simultaneously significantly increases the risk.

Where to Position?

In uncertain periods such as the one the Canadian economy is currently experiencing, an intelligent approach to protect a portfolio would be to balance riskier investments with an allocation to low-risk or even risk-free investments. Economists expect bonds with a short duration to be the best place to position capital in the short term given the current environment. This is because short-term bonds can be reinvested at higher yields in this period of rising rates, meaning more prospective returns in the future.

Short-term bonds are easily accessible through an ETF wrapper. Some examples of short-term bond ETFs include:

XSB (iShares Canadian Short Term Bond Index ETF)

• AUM: $3,280.1M
• 1mo Performance: -0.46%
• Expense Ratio: 0.10%

VSB (Vanguard Canadian Short-Term Bond Index ETF)

• AUM: $1,197.5M
• 1mo Performance: -0.23%
• Expense Ratio: 0.11%

ZST (BMO Ultra Short-Term Bond ETF)

• AUM: $786.8M
• 1mo Performance: +0.20%
• Expense Ratio: 0.16%

Data for this article is as of September 8, 2022 & September 21, 2022.

Please note this article is for information purposes only and does not constitute investment advice.

*The risk-free rate of return is the rate an investor can expect to receive with zero risk, and is largely determined by the central bank of a country e.g. the Bank of Canada