As 2021 opened, bond yield curves steepened — on Jan. 6, U.S. 10-year Treasury yields hit 1% for first time since March of last year. The economy may feel as if it’s beginning a cyclical recovery, but there are several key differences between a recovey and what’s unfolding now.
Ordinary consumer spending has been deferred while ultra-low interest rates have supported purchases of houses and durable goods. The unemployment rate is high (8.6% as of Dec. 31) and consumer debt has soared.
Will bond prices rise, hold or stumble in 2021?
Avery Shenfeld, chief economist with CIBC, said the outlook is grim. “Government bond yields will be low, but they will climb. Reflecting recovery, the yield curve will steepen.” He added that the Bank of Canada is likely to reduce quantitative easing.
Central banks have signalled that low interest rates will be here for at least a few years. This affects stocks in addition to bonds: low rates mean the present discounted value of future company earnings is high, which partly explains why stock prices have risen as the economy stumbled.
A common view is that a company is only worth all the money it will ever make. But future earnings are worth a great deal more when interest rates are low: $1 million of earnings in 2031 is worth about $905,000 today using a 1% discount rate. No wonder investors are willing to pay a lot for shares of the companies that generate these earnings.
The low interest rates that are good for stocks are not so good for bonds. If interest rates remain low, bond prices will reflect low cash returns. For conventional bonds, that means low prices. For investors who would like to hedge the recovery, Canadian Real Return Bonds (RRB) and U.S. Treasury Inflation Protected Securities may be appropriate: if inflation rises, these inflation-linked bonds will have handsome returns regardless of what interest rates do.
“If inflation rises faster than nominal yields, then RRBs are a good investment,” said Chris Kresic, head of fixed income and asset allocation with Jarislowsky Fraser Ltd. in Toronto. “[In 2021], we see a continued recovery and upward pressure on interest rates and inflation. So if inflation picks up ahead of interest rates, then RRB returns will beat returns of conventional bonds. If inflation lags rising interest rates, conventional bonds will turn out to be the better investment.”
Inflation is therefore the important variable. Before 1970, the value of money was attributed to the quantity of money in circulation. Prices rose in much of the industrialized world at low double-digit rates. But since the financial crisis of 2008, despite central banks creating trillions of dollars in credit, prices have seldom risen more than 2% per year in Canada, the U.S., the U.K., Japan and the EU. Vast pools of cheap labour explain some of that price stability. Low consumer prices have also kept wage-driven inflation low.
Yet the basis for concern is clear: one-fifth of all U.S. dollars in circulation were created in 2020 as part of vast stimulus programs. Those dollars could fuel a gush of spending.
Eyes are on the long end of the yield curve, where the U.S. Treasury may allow rates to rise. The word “may” matters, because a new U.S. administration may have to rein in credit, explained Romas Budd, vice-president and senior portfolio manager with 1832 Asset Management LP. “Longer term, yields will move up,” he predicted.
Structurally, that means the 10-year to 30-year spread will steepen and in turn reflect optimism for recovery, said Alfred Lee, portfolio manager and investment strategist with BMO Asset Management Inc. A recovery priced into the curve may go with rising asset prices, but for bonds, it’s a bear steepener, driving money to shorts in expectation of higher rates.
The consensus: if the recovery continues, even as central banks hold down the short end of the yield curve, long rates will rise and adept investors will shorten terms and trim back duration to cut risk. This is an interest rate strategy, not a way of harnessing inflation.
“Our outlook for the near term is reflation,” said Konstantin Boehmer, senior vice-president, portfolio manager with the fixed income team at Mackenzie Investments. But Boehmer had a warning for central banks: “The Fed can get away with deficits that no other country can handle. Countries with big current account deficits in foreign currencies — Turkey, for example — can’t be reckless with rates. Deficits will drive the prices of their sovereign bonds in major currencies. But the U.S. can begin ending [quantitative easing] and raising rates in the 10-year to 30-year space.”
All things considered, perhaps central banks will ignore price trends to favour recovery. A little bit of inflation, they may reason, won’t be a worry.