These are times when bond investors — a conservative lot even at the most bullish moments — are turning to short-term issues, paying a lot for the security of knowing that even if the market goes into a liquidity tailspin, as it did in late 2008, their money will be safe. Short bond prices have, indeed, been rising as investors buy protection. It would appear that there is a rush to safety in a significant part of the bond market.
For financial advisors, that presents a paradox. The S&P/TSX composite index and the Dow Jones industrial average, in spite of wobbles, are both up strongly in the 12 months ended May 31. Corporate profits also have rebounded strongly from the lows of the 2008-09 collapse. Commodities prices, although volatile, remain strong. Inflation is in check and within central banks’ targets of 2% or so for the coming few years.
“One market has to be wrong,” says Chris Kresic, co-head of fixed income and partner with Jarislowsky Fraser Ltd. in Toronto, who’s betting that it’s the stock market that has misread the signs.
The stampede to safety is clear in short-term bond yields. At the beginning of June, for example, two-year Government of Canada bonds paid 1.48% annually, down from 1.69% at the end of April; and U.S. two-year bonds offered 0.48% a year, down from an only slightly less austere 0.60% at the end of April. (Two-year bond prices, notes Christine Horoyski, senior vice president for fixed-income with Aurion Capital Management Inc. in Toronto, rose by a very substantial 1% in the last week of May.)
Says Graeme Egan, financial advisor and portfolio manager with KCM Wealth Management Inc. in Vancouver: “The investors who buy two-year Canadas are parking money and getting what they regard as a good compromise between [U.S. Treasury] bills that pay virtually nothing and longer bonds that could drop in price if inflation accelerates in several years. Indeed, interest rates will eventually rise, although that expectation has been pushed back to the [autumn] and beyond.”
That is also the guidance from the Bank of Canada. The consensus of market-watchers is that the BofC will not raise interest rates until late this year or, perhaps, in 2012. That means Canada will hold its 1% overnight rate until Oct. 25 or Dec. 6. The market is betting on the latter date at the earliest, even though a June 1 statement by BofC governor Mark Carney said that modest rate rises are likely.
@page_break@The U.S. Federal Reserve Board, for its part, gives no promise that its 0.25% overnight rate will change any time soon.
As a result, a two-year payoff of 1.48% in Canadas and barely a third of that in U.S. Treasuries shows the market’s apprehension of continuing short-term economic weakness.
In this period, it’s not inflation but fear that rules. If, as the stock market has shown by its decline in early June, the faltering U.S. economic recovery needs yet another round of government money — we can call it Quantitative Easing 3 — that would depress yields further. Low yields hold out to 1.61% in five-year U.S. Treasuries. For Canadas, yields go above 2% with maturities in 2015 and beyond. That’s how long markets think the malaise will last.
At these rates, real returns are negative. Bank of Nova Scotia‘s economics department estimates that consumer prices will rise by 2.3% in Canada and by 2% in the U.S. next year. However, there is considerable reason for caution: U.S. housing prices have dropped back to their 2002 levels, and more reductions are likely; Canadian housing prices now average 5.35 times the median household income, up from the historical average of 3.5 times; and tapped-out consumers can’t help either country spend its way out of trouble.
That’s the short-term scenario. A resolution of much of the global debt crisis should take place within the two-year span of low rates. Someone has to pay for government excesses — and that, Kresic argues, is going to have to be American consumers, who will have to save to pay their bills.
“The U.S. standard of living has to go down,” Kresic says. “The bond market is betting that it will be via a deflationary scenario, perhaps after the January 2013 U.S. presidential inauguration. If that takes money out of the economy, interest rates will fall.”
Those clients positioned in the two- to five-year space will have cash for reinvestment in the most liquid part of the government bond market. Inflation, in this view, is a problem for another day.
Explains Edward Jong, head of fixed-income with TriDelta Financial Partners Inc. in To-ron-to: “Central banks do not need to be hawkish when pricing in inflation.” Translation: when rates rise, it won’t be by much.
The implication is that taking a wait-and-see position in two- to five- year bonds has a modest opportunity cost and not much risk.
Bond investors in the short-term space were rewarded in May with rising prices. Those who bet the recovery will stumble will be rewarded for their pessimism. That’s what plummeting short-term bond yields predict. There is no heroism in staying short, but there is assurance that a collapsing economic recovery will do little harm. IE