Where bond prices and yields will go in 2020 depends on a balance of market expectations and political events. The year 2019 was a remarkable year of dropping rates that drove up Canadian bond returns by 6.87% on the FTSE-TMX Canada universe bond index and by 8.72% according to the Bloomberg Barclays aggregate index for all U.S. bonds.
Dropping rates also pushed some long European and Japanese senior bonds further into negative yield territory. In a general sense, a Niagara of money to be lent met feeble demand for loanable funds. Dropping interest rates in senior markets around the world was the well-known outcome. That’s over. The scenario for 2020 is likely to be rate stability.
The year 2020 looks like a period in which bond markets catch their breath. On Jan. 22, the Bank of Canada announced it would keep its overnight rate at 1.75%. The U.S. Federal Reserve Board, for its part, is widely viewed as ready to stand pat — subject, of course, to events. This year could turn out to be a year in which bonds are tortoises rather than hares. But much depends on risks and how markets view them.
Benjamin Tal, deputy chief economist with Canadian Imperial Bank of Commerce in Toronto, discounts politics. “Fundamentals are unchanged,” he says. The market will not speculate on politics, he adds, but will seek certainty in systemic trends, including energy prices in Canada, trade fundamentals and labour costs in the U.S. and Canada.
Bonds — which encapsulate interest rate trends in government bonds and earnings fundamentals in corporate bond issues — remain the alternative to stocks. Price to earnings (P/E) ratios have risen because of elevated prices rather than because of higher earnings, Tal notes. The trend toward higher P/E ratios in the U.S. helped to drive money into bonds for speculative reasons rather than income, and those moves were rewarded with exceptional gains.
In spite of geopolitical turbulence, investment markets appear to be valuing fundamentals rather than speculating on geopolitical events. That is only sensible, says Sal Guatieri, director and senior economist with Bank of Montreal in Toronto.
“Our outlook for interest rates is for calm in the year ahead,” Guatieri says. “Neither the Bank of Canada nor the Fed will change policy rates this year. They are likely to hold at 1.75% in each country and if there is a cut, it is more likely to be done by the Bank of Canada because our economy has underperformed in the past year.”
Moreover, Guatieri adds, lowering the Canadian policy rate would mitigate pressure to push up the foreign exchange value of the loonie.
A move toward lower rates also would be a tonic for Canada’s lagging economy. “Rather than going from strength to strength, Canada’s economy has been moving from weakness to weakness,” states a Jan. 7 release from Montreal-based National Bank of Canada. “The Citi economic surprise index for Canada has been in free fall, trudging around the lowest levels seen since the [2008-09] global financial crisis.”
A bias toward lower interest rates is reinforced by high debt levels that are inhibiting spending by consumers. That’s economic drag. Rising oil prices also tend to slow the economy: although there are benefits to energy firms, the wider economy is hindered.
Anish Chopra, partner with Portfolio Management Corp. in Toronto, sums up the problem: “The global economy is slowing. In Canada, consumer debt levels are high. The U.S. dollar is losing value against the Canadian dollar. If that trend continues, the Bank of Canada will look at cutting rates for trade reasons.”
On the buy side, individual fixed-income investors are in a dilemma. Government bonds are fine for speculation if you think interest rates may drop, but those bonds will pay few of your bills, given coupon rates in low single digits. And the dichotomy is likely to get worse, says Chris Kresic, head of fixed-income and asset allocation with Jarislowsky Fraser Ltd. in Toronto.
“The old idea was that you would save in your working years and then retire and spend what you saved,” Kresic says. “Now it turns out that bonds do not pay enough, so people have been saving more. That has taken away from the stimulative value of policy rate cuts. The dilemma will persist until the older population starts to spend more.”
Households desperate to build their accounts with seemingly safe fixed-income investments face a hard choice. Short bonds or cash equivalents pay, at best, a fraction of 1%. Long bonds have strong appreciation potential if rates drop and a matched potential for loss if rates rise. That’s the risk embedded in long bonds — and what any conscientious financial advisor can tell a concerned client.
If the demand for loanable funds increases and interest rates rise, bond losses will be inevitable. That is the risk for individual investors. You may want to tell your clients that 2020 is a year not to overweight mid- to long-term bonds.