You occasionally hear people talk about interest rates back in, say, 1965, and compare them with recent rates in years.

The comparison is always a bad one, I believe. There is a basic reason for this:
before 1981, the primary trend in interest rates was upward and the trend in bond prices was downward. Since 1981, the primary trend has been the reverse: interest rates have been dropping and bond prices rising (the bond bull market).

What made sense when yields were rising may not make equal sense when the primary trend of yields is downward. Fighting the primary trend in a market is always a mistake. However well you may play the counter-trend, you always have the risk the primary trend will reassert itself at an inconvenient time for you.

Which brings us to the question of the moment: what is the primary trend? Is it still a bond bull market, and are yields still headed downward?

Longest-term Canadian government bonds
have indicated recently the bond bull market continues. Their yields dropped to new post-1981 lows (see table).

Bond bull markets and bear markets differ
from the stock market because they last so long.

There is another difference. Yields and interest rates oscillate, usually making only two or three highs and lows in a century. At times, yields drop almost to zero. In fact, Canadian treasury bills provided a negative return at times during the Second World War. The highs, as history tells us, sometimes have ranged up to 20% or so.

Although both long-term bond yields and short-term interest rates move together in the long haul, they often step to different rhythms.

Short-term yields are much more volatile; they dance around a primary trend. Their gyrations often lead investors astray, but they can also lead the way.

Short-term rates are currently marching higher to the beat of the U.S. Federal Reserve Board drum. But, to the consternation of many investors, long-term bond yields have not also done so. In fact,
they have been dropping.

This illustrates the limit of the central bank’s influence on interest rates. Central banks hold sway over the shortest-term yields, but the bond market has no ruler. Long-term yields rise and fall based on investors’ anticipation of future rates of inflation.

So the Fed has been fighting inflation by raising short-term rates, but the bond market sees the battle against inflation as won.

The accuracy of the contrasting views
depends on whether the primary trend is still upward for bond prices (downward for yields), or whether the bond bull market has ended and interest rates are starting a long, long rise.

It depends on whether bond yields are continuing to drop. The market for Government of Canada long-bonds says they are. The midweek average yield on Canada bonds maturing in more than 10 years dropped as low as 4.53% in February, a new low since 1981. The 10-year bond has done the same, dropping to 4.11%.

This would be an emphatic affirmation that the bond bull market lives, except for one thing. In the world’s primary bond market — the market for U.S. treasuries — long-term yields remain above their lows. If and when they drop to new lows, there will be absolute confirmation that yields — low as they are compared with 1981 — will continue to drop.

How low is low? At the end of the last two bond bull markets, in the 1940s and 1890s, long-maturity U.S. issue yields were as low as 2.5% — even high-quality corporates were in that range.

The significance of a continuing bond bull market centres on inflation. Bond yields drop when inflation expectations drop. And why would inflation drop? When the supply of goods and services is abundant, and demand insufficient to give sellers pricing power. And when might this occur? In a severe business slowdown or — to mention the unmentionable — a period of deflation.

That is the urgent question that the bond market may answer in the next few months.
If more bond yields go to new lows, the bond bull market will live. But should yields reverse upward and surpass recent highs, it would be fairly conclusive that the tide has turned.

In addition, the spread between long-term yields and short-term interest rates provides economic forecasts. The differing patterns have already indicated slowing business activity, perhaps as early as this year, because the spread has been narrowing.