Hello, and welcome to the Download. I'm your host, Dave Richardson, and we have a special guest today. We never get her enough. Maybe that may be the first question that I ask her, but we've got Dagmara Fijalkowski, who is the senior vice-president and head of the fixed income and currency at RBC Global Asset Management. A super important person. We just refer to her around the office as Dagmarvelous, because she is. And obviously, fixed income is on a lot of people's minds after last year and then where we go from here, because it's a critical part of people's portfolio. So, Dagmara, why don't we have you on more often? Is that my fault?

Yes, exclusively your fault.

Oh, okay, so I apologize to all the listeners. We'll get Dagmara on more often because as you'll see, she is marvelous. Dagmara, have you recovered from our chicken wing festival on Wednesday?

I'm almost hesitant to answer that because if I say that I recovered, will it lead to more chicken wing eating invitations?

So, if you're familiar with another podcast somewhere or a video series on the old internet that's called Hot Ones. And you basically answer questions, and you eat progressively hotter and hotter chicken wings with spicy sauce. And Dagmara and I both did this earlier this week. Dagmara was like a superstar through it again, as we go through these questions. I ended up eating about 15 really hot wings and nearly ended up in the hospital. So just for those of you in the 55 plus range, you might not want to do Hot Ones anytime soon. For younger folks like Dagmara, it's okay. But I'm glad you fared so well. You did it at lunch, and there were a couple of leftovers, mine was at 03:00. I was doing it with a different group, and I decided I would practice by having some of the wings that you left behind. And then I added on the wings during the question period, which again is why I'm just your happy, not that bright host. And I invite really smart people on to actually give the listeners some value.

Did you do the Pepto Bismol move before eating them? That’s Matt Graham's trick. He actually told me that you should have some Pepto Bismol before you eat them.

Well, that would have been nice if you'd shared that at lunch with me. And the other thing I found out from the paramedics was that water is bad. If you're eating really spicy food, no water. It just spreads the spice around in your stomach and up your esophagus and it's just not a good thing. Anyways, we'll leave it at that. People want to hear about bonds, not about my misadventures with chicken wings and your heroics. Dagmara, we've been pretty positive— I think all the guests, even some of the equity analysts— and maybe you don't want your equity colleagues talking about bonds that much, but they've been pretty excited about bonds, and you've been fairly positive as well. But we have seen yields continue to rise this year. So what's causing that?

Well, let's just start by saying that the key yield for the market, the ten-year yield in US, started the year at 3.88% and today we are at 3.80%. So the perception that yields have been rising is not entirely accurate. We actually have traded this year in a range between 3.30% and 4.10% and averaging around 3.70% or 3.80% for most of the time. And the returns on the bond universe have been right around coupon level, right where they should have been given the deals haven't moved that much. This range trading has been caused by the market shifting from growth optimism— and then referring to it as soft landing, no recession— to pessimism based on inflation. Our inflation is not declining fast enough. So when we were worried about stronger growth data and slower decline in core inflation, strong employment numbers, when these were in focus, that led to testing that higher end of the yield range at 4.10%. And we had been there for a very brief moment. When core CPI and CPI numbers started turning down and people actually looked with optimism towards the second half of the year, we have come off these highs and were trading in these levels around 3.80%, waiting for further evidence of slower inflation. Economy in the US turned out to be more resilient to higher rates. This is what we've learned in this first half of the year. US economy has been more resilient to higher rates than in prior cycles. And there are three reasons for this resiliency. One probably dominant one is the fact that majority of mortgage holders in the US have long-term rate fixed mortgages locked at really attractive rates. So guess what? When interest rates went up, did their mortgage payments go up? No, they didn't. The second reason is, because of the massive quantitative easing to stimulate the economy, the Fed itself is holding significant amount of Treasuries and mortgage-backed securities on its balance sheet. So again, guess what? When rates go up, does it hurt the economy? This portion of holdings, let's say roughly 3 trillion worth, is not hurting the economy because it's in the pockets of the Fed and the loss accumulates to the Fed. And the third reason is that millennials, which is a big demographic cohort— it's actually at 70 million, as big as baby boomers—, had a unique chance to save money during the COVID episode because of COVID stimulus checks, student loan pause, tight job market when anyone could get job and minimum wages have increased and many of them also living at home, saving money and being at the end of this in a better financial position. So as a result, this US economy has been more resilient to higher rates which means that what happened is that the terminal Fed fund rate estimate which at the beginning of the year was in the 5% neighborhood, changed to 5.50%. And that brought that range trading in ten-year yields towards the top of the range. So instead of 3.30% to 3.70%, we are now at 3.50% to 4% and waiting for evidence of lower inflation. US has not been unique in this. Canada is not far behind. The expectations for slowdown and weakness in Canadian economy had been high and I'm happy to say disappointed because this forever feared housing crash in Canada really has been more like a slow dip in house prices and the pause that we had seen. Jobs numbers are strong. Immigration impact is clearly evident both in jobs and in housing. So bank of Canada decided to resume hikes, lifting bond yields some more and in Canada as well, it leads to this higher range trading intents. But again, let's remember that we are very close to where the yield started the year and the bond universe delivered right on advertised coupon.

I'm not surprised the millennials were responsible for some of this. I knew that was coming. I have two Gen Zs at home and they're taking advantage of increasing their savings as well, basically by spending my money and my wife's money instead of taking advantage of the higher interest rates. But that's my financial problem. We're more concerned about what's going on in the broader economy. So you put that all together, Dagmara, do you still have a fairly positive view of fixed income? Where are you sitting in terms of your thoughts on fixed income in general right now?

Yes, because when we look at it from the big picture perspective, nothing changes in the end of the hiking cycle story. So, as I said, the terminal has been lifted slightly higher in Canada. After the pause, we have added hike, but we are very near to the end of the hiking cycle. A vast majority of tightening is behind. We are in the final stretch. Aside from Japan, all major central banks have the policy rates deeply into restrictive territory now. We know that historically yields have been declining following the last hike and we continue to expect that. The bias for us in our portfolios is to be long to neutral duration, depending on where we are in these ranges as we head into that last hike. When possible, we are also favoring the front of the yield curve and our expectations are for inflation numbers to continue declining, including the very important referred to as supercore inflation number, which is excluding shelter costs. But the headline CPI is expected to be declining because the shelter cost is expected to be declining and that will bring real rates higher, making the fixed-income universe even more attractive. By the way, something that came to our attention in the recent few months is that when we compare inflation in Europe and US on an apples-to-apples basis— so looking at so-called harmonized index of consumer prices, which is the index used in Europe, HICP, but there is a calculation of US inflation using European methodology— the US inflation number is actually much lower both at headline and core level than using US methodology. So you could say that US methodology, because it’s including this shelter component, has been underestimating how much inflation of other components has declined. And that actually puts US way ahead of the ECB or bank of England in its fight against inflation. Just to give you a sense of the difference— and it's hundreds of basis points—, in Europe, HICP is 5.5% and in US, 1.4%, so below 2% level. And that gives us further confidence that looking at these shelter numbers, which we know are formulaically calculated and the rent numbers are coming down, so it will flow through to shelter and owners’ equivalent rent in inflation calculation in the second half of the year, that gives us confidence that the Fed will get the drop in inflation. We are going to see it and therefore this end of tightening cycle is our high probability scenario.

Dagmara, just for the listeners, could you define terminal rate? You mentioned that terminal rate earlier.

That's a good question because sometimes when people speak quickly, they mix or interchangeably use terminal and neutral, and these are very different rates. Terminal is the rate which will be the highest Fed funds rate in this specific cycle. So now it's estimated to be 5.5%. Neutral is the long-term neutral rate that is supposed to neither stimulate nor restrict the economy and it's estimated now to be at 2.5%, according to the Fed.

Yeah. And it is really the debate around all of these different measures that these central banks use to actually define where inflation really is. And then, of course, in some ways, inflation is almost personal because we all feel it in different ways; we all consume in different ways. But all of these different analytics and these tools that you can use to compare and to really dig underneath and find out where you really think things are going.

Both are very important because if you think about terminal being 5.5% and neutral 2.5%, the Fed is deeply, as I said, in restrictive territory. They have a lot of space potentially to start calibrating the rates when appropriate to lower them even by hundreds of basis points and still not be in stimulative territory, you’d still be above neutral.

So, Dagmara, with the diversified bond portfolios that you and your team manage, from a tactical perspective, what have you been doing over the last several months in those portfolios?

Well, quite consistently with the pause that we have been in, as the year unfolded and our conviction in this scenario has been growing, we have been holding risk wherever we feel we are appropriately or even generously compensated for it. That meant preference for Canadian short investment grade bonds. You know that we started adding to those late last year, build up significant overweight. The question was how long we're going to be comfortable holding it. Had we been worried more about recession taking place, we would be reducing those. We haven't. So we held that overweight. We also held some exposure to European investment grade. US IG, because valuations are not as attractive on a relative basis, we have traded them more tactically because we have these other options. We have also preferred to maintain our emerging market overweight because it actually started delivering on its promise. While we had been reducing holdings of high yield bonds which went from not generously priced to expensive and more expensive, we have also been reducing in portfolios where we hold preferred bonds very little, but we have been reducing those, started at lower allocations and taking them down. Within EM bonds, we made a small shift preference-wise from EM corporates towards EM sovereigns. And yeah, as the year has been unfolding and time to terminal is shorter and shorter, we know that within a few months our conviction of this long post scenario has increased and that meant patience harvesting, carry and returns where we put our positions in.

So Dagmara, what do you see coming over the next year in bond markets? What are your expectations of where we go from here?

That's a great question. And as you know, we continuously adjust and tweak our scenarios. And the most likely scenario, again, the one that's increasing in probability, is the long pause. And perhaps if you compare it to historic cycles, past cycles, that long pause would be longer than in other cycles before we can expect cuts. So perhaps one or two more hikes and then holding rates steady at the restrictive level for a year or so. That would give the Fed enough time to observe reduction in owners’ equivalent rent, which of course would lead to reduction in core inflation. And then combine that with slowing growth, higher unemployment, lower demand, so less pressure on goods inflation, that would give the Fed enough confidence that inflation target is achieved sometime in 2024. Bank of Canada recently lifted that towards early 2025. That's why they would have to keep those rates at restrictive level. You know, it's a decision in itself, normal hikes, but restrictive is appropriate and we're going to stick with it until we see evidence of our ability to achieve the target. In that case, in this long post scenario, the curve would remain inverted in two stances, significantly inverted. And that would mean about coupon returns for the benchmark for as long as the restrictive territory sticks. Another scenario— right now we look at it as another scenario—, that we would expect over this year to actually gain probability is the bullish steepening scenario, because that would mean that slower growth would be more evident sooner rather than later, corporate earnings weaker, so this restrictive territory translates and actually finds evidence in the economy, and market would start pricing cuts within their scenario horizon. Right now, that scenario in our view is low probability, but we expect it to be gaining in probability as we move through the next few months, next half of the year. And that would likely also cause spreads to widen, making high yield, which is priced at an expensive end, more vulnerable. But investment grades would likely suffer too, and returns would be lower because of these credit losses. So on a six month basis, perhaps 1%; twelve month basis, 2%. But in this scenario, I'm thinking about it again as gaining in probability down the road, but I'm not sure yet how long we expect it to last. And the worst outcome for absolute returns comes from the scenario of bearish steepening where inflation is sticky, not declining, and economy is robust. That would mean that the Fed clearly got the estimate of neutral wrong. It's not 2.5%, perhaps it's higher. So that would mean that conditions have not been as restrictive as the Fed is thinking. And this scenario would see actual losses in fixed income, perhaps 5% for the benchmark and new high in ten-year yields. This scenario has been steadily declining in probability. We had been talking and looking about at that for the past six or eight months. And with the progress that the Fed made, this scenario has been declining in probability. And if you note my previous comment about this harmonized inflation number in the US being now below 2%, I think that's justified that this probability is declining. So right now, the long pause scenario seems to be the highest odds in our base.

So Dagmara, as we start to look, with that long pause and then the likelihood that on the other side of that pause, rates are coming down. And then you talk about slowing economy, in that slowing economy, potentially even a recession, that's when high yield bonds, the spreads are going to pop up. So then at some point that's going to create an opportunity for you to shift into those high yields down the road to take advantage of when you get to the other side of that recession. I guess what I'm trying to paint a scenario for is pretty decent bond returns in the 12-to-24-month range, but even the potential for bonds to be a pretty attractive asset for the investors that really rely on bonds in their portfolio for an extended period of time. In other words, that pain that we had last year as rates were rising creates higher coupons and the dislocation in the economy from that creates opportunities for you to maneuver tactically within credit and duration, to really add a lot of value and deliver some really solid returns for clients. Not ridiculous— I think we don't want to set expectations too high—, but pretty solid returns that people who want bonds in their portfolio, it'll do the job for them.

It's an important period for fixed-income managers to be taking full advantage of valuations. As I said, we have really been disciplined about holding excess allocations to sections of the market where we believe we are generously compensated and very low allocations to sections of the market where we don't believe we are generously compensated. This discipline is very important at this stage because there is a lot of uncertainty. We are in such highly unusual historic episode, when we had this 500 basis points of interest rate hikes. Historically there is something bad that's happening after that. In investment grade where we feel we're compensated, we feel comfortable holding it. If valuations become less attractive, we will not hesitate to cut those and prepare also to be able to load up on that risk when the compensation improves. I know that it all comes down in cycles. And down the road, if there is a recession, we would expect widening of spreads in high yield in particular. Maybe not to the highs as before, because the market has changed, the quality has improved. There is a lot of reasons why high yield is so resilient. But they will be more attractive than they are now and at that time it will be appropriate to add to them. So we don't think about credit as one big blob. We analyze each layer of credit, comparing potential reward to risk that we believe we are taking and adjusting. It’s like directing an orchestra.

Exactly. And this is one where I think often investors think of bonds as just a very simple asset, very basic. But bond markets are deeper and broader than equity markets. And the level of sophistication, the range of different types of credit and what a really good bond or fixed-income manager can do is really incredible to watch. I mean, I've been watching you for 25 years.

It's not one bond manager, it's a team of highly skilled, highly experienced professionals. Because realistically, you said it right, the bond market has changed so much in size, sophistication layers. It's impossible for one person to be an expert on all of these. And that's why we have such a broad team.

And so, Dagmara, because you also are a currency expert, one of the main theses you have around what's going to happen in the global economy is around the US dollar and weakness in the US dollar. Now we've already seen some of that. Is this something you expect to continue? Is that still a core to where you think things are going in terms of the US dollar and relative to other currencies.

Absolutely. That's one of our strong convictions for next few years. So for us, that conviction means a bias that our positions will be neutral or short US dollar. And of course, within this kind of structural bear market for US dollar, there will be periods when it's gone too far, and it has to backtrack in various tactical opportunities. But the US dollar is still overvalued, and we believe that there is a number of factors— and we're going into our risk meeting over the next couple of weeks, so we'll refresh our article that's available on the website—, but we expect that dollar weakness to be one of the important factors that affect also other asset classes, emerging markets among them.

Yeah, it just makes sense that with everything that's happened and then once rates start to go down in the US and we know that that's coming, that creates that weakness in the US dollar. Just finally, because we talk a lot about on the podcast— with our various guests and just in general— about the psychology of investing and for an individual investor. What we really want to do is we want to expose investors to professional investors and get into the mindset that a professional investor working with a team of professional investors, how they approach the market relative to the way somebody like me might do it. A little bit of knowledge. But I'm an emotional person and my emotions swing. I met you back in the late 1990s and that was a really tough period in the bond market. 1999, in particular, I think, if I nail it right, was a really difficult period but nothing like last year. Last year was a once-in-a-lifetime kind of bond market. What was your experience emotionally through that? Because I know you care deeply about driving results, particularly for the people who invest with you. But what was it like going through that? Again, the one in the nineties was early in your career, so you were still learning. Right now, you think you've seen it all and now you see this. What was it like going through that last year?

Well, the one in the 90s, I knew nothing, so let's just start there. Last year, it was definitely a lesson in just when you think you've seen everything, you haven't. But that lesson came at the tail end of a highly unusual decade when we had as much as 30% of the sovereign bond universe traded with negative yields in sovereign space. So when you see central banks intervening in the market so much, you ask yourself as an investor, well, when is the bill going to come for all these excesses? Well, the bill came in 2022, to a large extent. I think your question about psychology is a very important one. And I always talk to people who are looking to have a job in investing, especially institutional investing: think about yourself whether your psychological makeup is more of a long-term planner, delayed gratification. Are you a person that has plans A, B, C and D, or are you a seat-of-your-pants decision maker? And I think by nature I am very much a planner, and I am very much a long-term thinker. To me this new information means «adjust, adjust, adjust». But where are we going in the long term? And the focus that we have always had on again being paid for the risk taken meant that as the prices were becoming more attractive in a maybe counterintuitive way— not counterintuitive, when you think about it—, but we were actually more excited about investing in fixed income at the end of Q3 last year than for many years before. Because for the first time in a long time we could see that if you believe that the Fed will achieve the inflation target and we had conviction that they don't want to repeat the 70s, then we are compensated for this long-term inflation for the first time in many years in fixed income. So, it's actually a good environment. That's the message that of course you're putting; this long-term message out against short-term losses on portfolios which is very difficult to describe. And that's where you are so good in talking to clients and conveying that. But for us, it actually ended up in an attractive environment.

And I do want to point to the third quarter of last year— October and November— where nobody wanted to touch bonds. Nobody. I've watched now for 26 years, I've seen every day what a big chunk of Canadian investors are doing with their money, the decisions that they're making, day to day. And you just saw back towards the end of October last year, nobody wanted to touch bonds. Bonds had failed us in some way. And again, you're highlighting that, over a 40-year period, they'd given above-average returns as rates came from 20% down to zero. And now all of a sudden, they back up. You pay a little bit of the bill and now I don't want to touch them anymore. And that's the emotional decisions you see in a typical investor. Whereas you and your team are sitting there, almost chomping at the bit to get in to buy at that point because you can see how that backup in rates has created opportunity for you. And that's just the difference, again, as I spend time with lots of investors of which I would categorize myself— non-professional investors— and then I get to spend time with you and Stu Kedwell and others who are professional investors. And that's just the big difference I see, where and when and how you see opportunities and take advantage of it just from a clinical perspective, with a plan. ABCD versus just off-the-seat-of-my-pants. Oh, I'm scared of that; I'm running away.

Absolutely. You mentioned the longevity of my career, but I also want to highlight the longevity of our team; we have been through many crisis together. And the advantage of that is that we have a well-defined investment philosophy. We know that we have biggest opportunities from taking advantage of cycles in the market and investing in a countercyclical way, which again, resonates with this being paid for the risk taken. But that means basically, for an average investor, you buy when there is fear, and you sell into strength when everybody else loves it. So you sell into very tight spreads and buy when spreads are extremely attractive. This is mostly possible because of our focus on our investment horizon. We're not thinking about next quarter, we're thinking about two, three years out and whether we're going to have a better opportunity to invest or worse than now. And that allows us to manage large portfolios efficiently.

And I think that's such a critical point. Thinking out two or three years. And again, the decision today is, is this the best opportunity that I'm going to have over the next two or three years? Not just, is this the bottom? It's a much different framework of coming at it. Anyways, Dagmara, that was just fantastic. Thank you for always being so gracious with your time. We'll get you on again shortly. And again, really interesting time in fixed-income markets and currency. It’s just always great to see you.

Thank you so much. And thank you for bringing the fixed-income closer to clients.