Bonds rally as Bank of Canada cuts rates

“The long bond bull is still alive,” says Chris Kresic, senior partner and head of fixed-income for Jarislowsky Fraser Ltd. in Toronto. “The reasons are diverse: heavy debt levels for Canada, a global worry that many countries could slip into deflation, swooning Chinese stocks, falling commodity prices – especially oil – and, of course, precautionary bond-buying of debt in currencies other than the euro.”

What is separating Canadian bond moves from those in the U.S. is, of course, the widespread expectation that the Federal Reserve Board will raise its overnight rate by 25 bps in the autumn, while the BoC could cut its rate once more – down to 25 bps – before inevitably caving in and raising rates to follow the Fed.

That the BoC cut had very little effect on anything other than the exchange rate of the Canadian loonie against the U.S. greenback is beside the point, Kresic says: “If the central bank does not do something when economic news is bad, then what is the bank for? It has to act, even if its move is pointless.”

The fundamental reason that Canadian bonds have outperformed 10-year U.S. Treasury bonds is that the U.S. is far ahead of Canada in its economic recovery. For the seven months ended July 31, 30-year U.S. treasuries were down by 4.2%. In retrospect, going long on U.S. treasuries has been a losing bet, while going to a 10-year term or more on Government of Canada debt was a winning move.

Still, bond investors remain in a difficult spot. All G7 bond prices are high, as are stock prices and, for that matter, other asset classes’ prices. A Picasso painting, Les Femmes d’Alger, fetched US$179 million at a May 2015 auction at Christie’s in New York, a world-record price. That beat the previous world record for a painting sold at auction of US$142.4 million paid in 2013 for Francis Bacon’s Three Studies of Lucian Freud, also sold by Christie’s in New York.

“We have a glut of capital with fewer and fewer investments available,” says Jack Ablin, executive vice president and chief investment officer for BMO Harris Private Bank in Chicago.

This bond bull is more than money chasing duration. Rather, it is money seeking safe haven. If stock market bulls are routed and the bears win, Kresic says, then fixed-income assets will rise in value and those holding them will profit handsomely.

A deflation scenario is not a distant possibility; in fact, it is a near-term one, Kresic suggests. The U.S. consumer price index (CPI) rose by just 0.4% to July 18, while rates in other markets also are in the low single-digit range. The U.K. inflation rate is barely positive at 0.3% for the first seven months of 2015. And, in the same period, the Japanese CPI is up by a modest 0.8%. Canada’s CPI rose by 1.2% for the period, pushed a bit by rising imported product costs generated by our weak dollar. (For serious, double-digit inflation, you have to look at Venezuela, where the CPI is up by 76.4% so far this year.)

A move back to the safe haven of bonds goes along with rising T-bond rates in the U.S. Investors are taking money out of dividend exchange-traded funds (ETFs). For example, the US$20-billion Vanguard Dividend Appreciation ETF has lost US$800 million in 2015 so far, much of it headed for the 10-year U.S. T-bond that pays 2.3% as of July 22.

Uncertainty over inflation/deflation and myriad other economic problems should not disguise the reality of the bond market: where the Fed leads, the BoC will follow.

‘We are in a Poloz moment,” says Edward Jong, vice president and head of fixed-income for TriDelta Investment Counsel Inc. in Toronto. “There is a problem in that markets do not believe what he is saying.” (Stephen Poloz is governor of the BoC.)

In the end, a generally bullish stock market – admittedly with a time out in summer for consolidation – and a Canadian bond market that is not acting as though interest rates are going to soar make for the odd couple of stocks and bonds more or less moving together rather than apart.

The investor’s choice is to add stocks in a bullish market or Canadian bonds that are still rising in price on the expectation of at least one more rate cut.

“When the BoC joins the Fed and raises interest rates, Canadian bonds will decline,” Jong says. “It will be the decoupling moment when stocks and bonds move in opposite directions.”

Until that moment, the value of holding Canadian government bonds is clear.

For now, says Rod Tyler, head of the Tyler Group, a financial planning firm in Regina, a play on liquidity and yield is a winning strategy: “Put money into short governments for safety and liquidity and [into] investment-grade corporates for income.”

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