Financial advisors need a new tool kit to deal with interest rate divergence in bonds caused by rising interest rates in the U.S. while Canada’s and other G7 nations’ interest rates remain on hold. The best move for this stagnation and future interest rate increases is a barbell strategy that keeps some money invested in short-term bonds and some in long bonds. With the right balance, accounts can stay with index’s average duration and be ready to capture rising interest rates when they happen.
For now, interest rates are headed in different directions depending upon the country. The Bank of Canada (BoC) has given no indication as yet of a plan to follow the U.S. in increasing interest rates, while the European Central Bank (ECB) is considered to be on the verge of launching new stimulative measures. The ECB’s actions may involve interest rate cuts or other moves to drive short-term rates down into negative territory – at which time bonds, at redemption, will fetch less than when sold by central banks.
The U.S. is alone in raising interest rates; as a result, a flood of foreign cash is already headed into U.S. fixed-income markets.
This means that foreign cash inflows will lift the U.S. dollar (US$) in relation to other currencies. That is already happening. On Nov. 27, the Wall Street Journal’s dollar index, which tracks the value of the greenback against 16 currencies, hit a 13-year high. On that day, a euro bought US$1.0594, a 12% drop in its year-to-date value. The loonie has moved roughly in sync with other global currencies (other than the US$); US$1 cost C$1.17 on Jan. 2 and C$1.33 for the same trade on Nov. 27, based on BoC data.
As other currencies depreciate in relation to the US$, that will set up a cascade effect in the U.S., says James Hymas, president of Hymas Investment Management Inc. in Toronto: “There has already been a good deal of currency adjustment in the rise of the US$ against the Canadian dollar [C$} and the euro. A certain amount of the Fed’s desire to raise [interest] rates is exploratory – to see what happens. Increases in the value of the US$ in relation to other currencies will shift the terms of trade in the U.S. to favour imports and discourage exports. And that would add to the restraint that the Fed wants.”
In the U.S. bond market, if more foreign money moves to 10-year and longer rates, that will drive up bond prices and drive down yields. If the Fed is successful in anticipating and controlling inflation, then inflationary expectations would be modest and the long end of the yield curve would not rise by much. That could mean a flattening of the curve, which is exactly the opposite of what monetary policy should favour in a recovery, Hymas says. Hence the irony and delicacy of the Fed’s position.
Part of the problem of where bond yields are headed is macroeconomic – recovery in the U.S., but stagnation or slow growth in the rest of the world. The other part is structural, for, as Chris Kresic, head of fixed-income and senior partner with Jarislowsky Fraser Ltd. in Toronto, points out, quantitative easing by central banks in Europe and elsewhere has soaked up bonds, driven down yields – as intended – and made the steepening of the yield curve that much harder to achieve through interest rate increases alone.
The Fed’s interest rate increases will make the U.S. the only G7 country actively raising interest paid on short-term central government bonds. Yet, global dislocation in debt and currency markets is not likely to be a major concern for the Fed, says Jack Ablin, executive vice president and chief investment officer at BMO Harris Bank N.A. in Chicago. “The Fed’s mandate is the U.S., although [the central bank] has to be cognizant of what happens in the rest of the world.”
Bond market interest rate divergence means that what’s good for the U.S. is not helpful to the rest of the world. For Canada, there is a pull to follow the U.S. Canada being out of sync with U.S. monetary policy for extended periods is unlikely, Kresic adds.
In anticipation of U.S. interest rate increases, there is downward pressure on the C$, observes Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto: “I have been looking at a flattening curve for weaker global economies.”
Currently, Canada’s federal bond yield curve has an average duration of eight years. To be close to index-neutral, you can use a barbell strategy that amounts to playing both ends of the curve. Investments at either end of the curve create an average duration of 7.5 years. Thus, you can go 50/50 with two-year and 14-year duration government bonds as an alternative to the straight eight-year duration bond. The two-year Government of Canada bond would pay 0.60% to maturity and the 14-year duration pays 2.33% to maturity, so the barbell strategy averages 1.46% to maturity.
Compared with an eight-year duration Canada bond that pays 1.6% to maturity, you lose yield – that’s the negative carry, or the relationship of time invested to return – but you gain the tactical advantage of being able to roll the front end at maturity, Kresic notes.
The interest rate disparity between U.S. fixed-income markets and those of the rest of the world is likely to grow in coming months. As Aron Gampel, vice president and deputy chief economist with Bank of Nova Scotia in Toronto, explains: “The U.S. economy is moving gradually to a higher and more sustainable growth trajectory that’s driven by domestic demand. In contrast, much of the rest of the world’s economies are moving to lower and less sustainable growth trajectories.”IE
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