Why interest rates remain so low

David Stonehouse, vice president and member of the fixed-income team at AGF Investments Inc. He is responsible for a wide range of income-generating mandates including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond.

Michael McHugh, vice president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond.

David Gregoris, managing director, fixed-income at Beutel Goodman & Co. Ltd. His mandates include Beutel Goodman Income, Beutel Goodman Short-Term Bond and Beutel Goodman Long-Term Bond.

This three-part series continues on Wednesday and concludes on Friday.

Q: What is the economic backdrop to the global fixed-income market? Are the actions by central bankers affecting its functioning?

Stonehouse: We remain in the same moribund global economic environment that we have been since the financial crisis towards the end of the last decade. There are anemic growth prospects for most of the world, particularly for developed economies. A primary reason for this is the continuing debt overhang. There is a massive amount of leverage in the global system. This has weighed on economic expansion and prevented monetary policy from being as effective in stimulating economic activity as it has been in previous cycles.

McHugh: Since the global financial crisis, there has been an absence of structural reform to improve productivity within some countries. Europe and, to some extent, Japan are most impaired by that. Within the industrialized, developed countries, the legacy of social spending has created a structural level of government spending that is difficult to sustain in a lower-growth environment. This has contributed to the high debt levels. The aging population in some of these countries has also been a factor. A principal impact of this anemic growth on the financial markets has been the actions by central banks. With respect to fixed income, these actions have become a dominant, distorting influence.

Gregoris: This is the debt, demographic and deflation challenge. It leads to lower potential global economic growth.

Q: There have been massive purchases of fixed-income securities by central banks, so-called quantitative easing, with the aim to lower interest rates and increase money supply so as to boost economic activity and help meet inflation targets.

Gregoris: The quantitative-easing policies of key central banks have distorted the fixed-income market. The Bank of Japan, for example, owns in excess of 40% of the Japanese government bonds outstanding.

Stonehouse: There are two aspects to central-bank monetary policy. One is this quantitative easing and the second is use of the central-bank policy rate to influence short-term rates. On quantitative easing, the central banks of the developed world have had an impact on their respective bond markets through these massive purchases of fixed-income securities, mainly sovereign bonds. In those markets, where there are negative fixed-income yields, there are clear signs of distortion. Most people view a fair 10-year bond yield for developed countries as being higher than it is now.

McHugh: Bond yields are likely to remain low for an extended period of time. When it comes to their policy rates, aimed at influencing short-term rates, some central banks have lowered their rates into negative territory. Examples of this are the European Central Bank, (which represents the Eurozone), the Swiss National Bank, the Swedish National Bank, the National Bank of Denmark and the Bank of Japan. Central-bank asset purchases have contributed to a flattening of the yield curve as they cause longer-term yields to be lower than they might otherwise have been. Quantitative easing crowds out the private-sector investor and creates the perception that yields will remain low. The low-yield environment has encouraged investors to assume greater credit risks in search of a higher yield. It has created an environment where the yield spreads over government bonds have compressed, particularly in the last four months.

Gregoris: There are some US$12 trillion of sovereign (government) bonds in the developed world trading at negative nominal yields or 25% of that market. This magnitude is unprecedented. If it were not for central banks buying these securities, they would not have these negative yields. Central banks are looking to stimulate domestic economic growth by devaluing their currency, increasing exports and boosting domestic inflation by raising the cost of imports into the country. We are in a controlled currency war.

Stonehouse: We should also point out that the negative central-bank policy rates, which impact the short end of the yield curve, have repressed savings. Central-bank actions have also put pressure on financial institutions, banks, pensions and insurers, which do better in a steepening-yield-curve environment.

McHugh: The eventual reversal of these highly accommodative policies by key central banks, such as the European Central Bank and the Bank of Japan, could contribute to a significant amount of turbulence in financial markets. At present, the expectation is that these policies will continue indefinitely.

Q: The U.S. Federal Reserve Board concluded the third round of its massive quantitative-easing program in October 2014. There were bumps in the financial markets in anticipation of this conclusion. What happens when the Fed, which has a positive policy rate, resumes its strategy to normalize this rate? The Fed is in a position to consider this, as the U.S. economy is in far better shape than that of Europe and Japan.

McHugh: If the Fed raises the federal funds rate, the impact on the bond market could be fairly contained. This is because, prior to raising its rate, the Fed would likely telegraph that its rate hike is imminent and the market would price this in. Also, the weak global economic backdrop and the prevalence of negative interest- rate policies and asset purchases in other jurisdictions, such as the European Union, will likely constrain any domestically related rise in U.S. bond yields.

Gregoris: The Fed would like to raise rates at a rapid pace. It is involved in a chess game, where it is trying to think two or three steps ahead. We are seven years into a U.S. recovery, U.S. unemployment rates are low and this should lead to some inflationary pressure on wages, which will be seen as a positive. Although there was some talk about this September, I think that the Fed will likely have the opportunity to raise rates in December. It is looking to build up an interest rate that is high enough that in the next recession, monetary policy will be effective in stimulating the economy. The current federal funds target rate is 25 to 50 basis points (100 basis points equals 1%). If the rate is 50 basis points, going to zero in a recession does not do much.

Stonehouse: The Fed remains a little ebullient about the prospective pace of its rate hikes and the degree to which it can raise rates. Each year, the Fed goes into the year thinking that it might be able to do up to four increases a year, and each year its hopes are dashed. That will continue to be the case. In our view, the Fed is unlikely to be able to get above 1% in this economic cycle, before recession potentially looms.

Q: The Bank of Canada recently maintained its policy rate, its overnight target rate, at 50 basis points, despite the weaker Canadian economy.

McHugh: Canada’s central bank is reluctant to lower its overnight rate, because it is concerned about exacerbating the already strong house price appreciation in key markets. The high levels of personal debt linked to the Canadian housing market is a serious challenge.

Gregoris: The Bank of Canada is waiting for the Fed to move. It is saving this 50- basis-point ammunition for later. If the Fed increases short-term interest rates in December, that should ease the Canadian dollar. The decline in the Canadian dollar versus the U.S. dollar has given the Bank of Canada a lot of policy relief in the last couple of years. Bank of Canada governor Stephen Poloz would like the currency to continue to decline.