Dagmara Fijalkowski explores compelling value opportunities in fixed income markets, highlighting attractive yields on government and corporate bonds while cautioning against expecting significant capital gains. Dan Mitchell analyzes recent U.S. dollar strength amid Middle East tensions, noting the temporary nature of this shift, and discusses emerging market currency strength and Canadian dollar recovery in the second half of 2026.
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Dagmara Fijalkowski, Managing Director, Senior Portfolio Manager & Head of Global Fixed Income & Currencies
Daniel Mitchell, Managing Director & Senior Portfolio Manager, Global Fixed Income & Currencies
Where do you see value in today’s fixed income market?
Dagmara Fijalkowski
When headlines become alarmist, I find it helpful to pause and take stock of what we really know about the bond market. First, it is finally offering something we haven't seen in a while -- a meaningful premium for lending over a longer time periods. You can earn mid-single digit returns in government bonds compared to just over 2% in cash. Second, markets expect a little change in monetary policy of main central banks for the next year or two.
And frankly, I think that's unrealistic. We have a massive investment being made in AI and ongoing disruptions to global trade. We should know a lot more about where things are heading well before then. Third, bond investors are wary of government debt. Why? Because economies are growing at a decent pace, governments are running large deficits, and we have just lived through a significant inflation surge.
Investors are rightly demanding better compensation. That's why yield curves have steepened globally. This makes it tough for central banks to justify cutting rates further. So, our view is straightforward. Don't expect much in the way of capital gains from bonds over the next year. Bonds should deliver returns modestly above cash thanks to those steeper yield curves and absent a significant economic downturn, that's a very realistic picture. Where we see value? Important to note that not all bonds are created equal. Aside from the U.S., many markets outside of Canada, offer higher yields on a currency-hedged basis, which is why we are recommending overweight positions in non-Canadian bonds. And here is a call that might surprise you. We are overweight Japanese government bonds.
I know, Japan used to be the cautionary tale about fiscal risk. But Japan's actually got its fiscal house in order better than the U.S., UK or France now. The budget deficit is lower. Yes, they have high gross debt, but they also have the largest net international investment position in the G7. The market is compensating investors handsomely for risks that we think are overstated.
We also continue to recommend holding more investment-grade corporate bonds. Corporate balance sheets remain strong. In fact, corporate debt burdens have declined since the financial crisis, while sovereign debt has ballooned. Credit spreads are tight, sure. But all in yields still look attractive, and we see any widening as gradual rather than sudden. To wrap up, we're leaving with plenty of known unknowns. Geopolitical risks, old and new, like the war with Iran. Policy uncertainty. All these things could materially impact markets. But we are also grounded in what we know. Inflation is normalizing. Economies are resilient and bonds are finally offering reasonable compensation for term risk. That's why we focus on building resilient portfolios that can weather markets grappling with unwelcome surprises, putting us in a position to add risk when the compensation for taking it will be generous.
How is the U.S. dollar faring with the conflict in the Middle East?
Dan Mitchell
Prior to this conflict in Iran, the dollar had been in decline for about a year and had shed about 20% of its value on a trade-weighted basis. That move was led by the euro, which rallied from about 103 last April to 120 in January. But really was broad based in the sense that most other emerging and developed market currencies had benefited from dollar weakness.
For context, some of the more volatile Latin American currencies posted returns of upwards of 20%, whereas Asia posted single-digit returns, since central banks in that region tend to be more active in temporary fluctuations. So going into this Middle Eastern conflict, traders and investors had become accustomed to a falling dollar, and they were very much positioned for that to continue.
So when oil prices spiked and the overall market volatility rose, there was a rush to close out some of those positions in a hurry and buy back the dollar. We think this largely explains why the greenback was strong in the past couple of weeks, but we suspect that it'll be temporary. You know, the key for us is how long this conflict lasts. How long oil prices remain elevated. And as long as we keep talking about this geopolitical event in terms of weeks rather than months, we do see good reasons why domestic investors in the U.S. will continue to expand and diversify into foreign equities and why foreign investors may continue to hedge their U.S. dollar exposure. Once the positioning washout is complete, we do think that emerging market currencies will be the main beneficiaries of dollar weakness. And that in turn, should be positive for EM equities. We also think that the Canadian dollar can stage a bigger rally in the second half of 2026. It's been held back by concerns about a big wave of fixed-rate mortgage resets that are due to hit this year.
And also concerns about the successful negotiation of the U.S.-Canada-Mexico trade agreement. Once investors get a bit more confidence that those two concerns should pass, we think the loonie should have a bit more room to perform. So for now, we've penciled in small gains for the loonie, and are forecasting an exchange rate of 130 per dollar at the end of 2026.
