With rate hikes delayed, what’s next?

The general economic news is not good. The U.S. economy created the fewest jobs in more than five years in May, as employment in manufacturing and construction fell sharply in early June. The non-farm payroll number, a key indicator of the state of the U.S. economy, came in at 38,000 new hires – well short of the expectation that there would be 238,000 new hires, says Jack Ablin, executive vice president and chief investment officer of Chicago-based BMO Harris Bank NA, which operates as BMO Private Bank.

In the background is a startling statistic: U.S. employers hired 59,000 fewer workers in March and April than previously reported. The U.S. Federal Reserve Board’s Open Market Committee left the highly influential federal funds rate unchanged at 50 basis points in its June 15 announcement. That’s a telling move, indicating the Fed’s view is that the U.S. economy is not ready for higher rates.

“The Fed is committed to raising rates this year,” says Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. “But there is no smoking gun and the fundamentals for a rise are just not there.”

For bond investors in Canada and the U.S., the big question is not inflation; it’s corporate earnings, says Dov Zigler, financial markets economist for Bank of Nova Scotia in New York. Zigler says negative nominal short interest rates prevailing in Japan and Switzerland and experienced from time to time in Germany and parts of Scandinavia are symptomatic of the slowdown, not the cure.

To understand the market appeal of bonds with negative rates, you have to compare the collapsed inflation rates in Japan – the clearest case – with that country’s negative government bond interest yield. Given that Japan has mild disinflation and declining industrial production, the 10-year Bank of Japan issue with a minus 0.18% annualized yield produces a positive yield in real terms. Put another way, the Japanese government bond’s return is not as chancy as investing in a pure industrial output index headed relentlessly downward.

Weak economic growth numbers in the U.S. are reflected in low inflation expectations and flattening of the yield curve, notes Kresic. The all items, annualized U.S. inflation rate of 0.5% for the second quarter of 2016 does not make a case for raising interest rates.

Economic growth is weak in Europe and Japan, so any rise in U.S. interest rates would raise the value of the U.S. dollar, harming U.S. exports. If the Fed postpones raising its overnight rate to its late July meeting, to its mid-September meeting or even to November 2, that, at least, will do no immediate damage, Kresic says.

Inflation is not the issue, as prices of inflation-protected, real-return bonds (RRBs) show. For the 12 months ended May 31, 2016, RRB portfolios gained by 1.20% compared to a 1.17% return for all Canadian bonds in the period. RRBs are long bonds and, absent strong inflation expectations, they perform like conventional bonds. These almost identical returns for the period show inflation is viewed as a non-issue.

The outlook is more encouraging for conventional bonds. As of June 3, Government of Canada bonds offered 1.19% to maturity. Spreads on 10-year corporate bonds over federal bonds widened in May from 165 basis points (bps) to 187 bps.

You can buy a Government of Canada bond with a 1.07% yield to maturity or a BCE Inc. 10-year bond with a 2.94% yield. There is risk in the choice. In the event of a continuing economic slowdown, government bonds are more likely to rise in price while corporates with credit issues would decline in price.

But the yield pickup in corporates would cover a lot of price decline. For example, an Intact Financial 3.770% bond due March 2, 2026, was recently priced at $108.72 to yield 2.74% to maturity. A Loblaw 6.45% issue due Feb. 9, 2028, was recently priced at $126.88 to yield 3.51% to maturity.

The June 23 Brexit vote is a wild card. If the U.K. leaves the European Union, the U.K.’s gross domestic product would decline, according to numerous studies, thus leading to a flight to government bonds and a reshuffling of corporate bond prices depending on each issuer’s sensitivity to a decline in trade with the Continent. Disentangling the U.K. from existing trade treaties would take years. The implication: short bonds would be little affected while long corporate bonds’ prices would slump.

That situation leaves Canadian bonds mostly isolated from the Euromess.

“I see an improving economy that will be good for corporates,” says Edward Jong, vice president and head of fixed- income at TriDelta Investment Counsel Inc. in Toronto. “I’d go for corporate bonds with terms not over five years.”

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