The north american bond markets have gone into a tailspin, generating large losses for bond traders as a massive sell-off in June left fixed-income investors gasping. But for financial advisors of “buy and hold” fixed-income investors, the reality is quite different: not only was the reaction premature, rising yields mean that bonds can start to cover inflation.
Here is what happened: from the end of May to the end of June, interest rates rose across the yield curve, which steepened. U.S. Federal Reserve Board (the Fed) Chairman Ben Bernanke suggested in a June 19 speech that there would be a decline in the U.S. unemployment rate to 7% by the end of the year from 7.5% at the time, as well as a rise in inflation and a resulting opportunity for the Fed to stop its quantitative easing (a.k.a. QE III) program.
The Fed has been buying US$85 billion of U.S. government bonds each month. But with that price support gone, there are expectations that bond prices will collapse. The idea that the Fed might be serious about withdrawing bond market price supports struck a chord with both bond and equities markets – and the rush for the exits began.
The results show the carnage: the 10-year Government of Canada bond recently posted a yield of 2.55%, up from 1.87% at the end of March. The 10-year U.S. treasury bond recently yielded 2.74%, up from 1.85% at the end of March. And panicked sellers drove down not just bond prices but equities prices in U.S. and other markets as well.
A flight from bonds presumably would boost stocks. Yet, in the period from May 22 to June 26, other bond and equities markets around the globe swooned in sympathy with those in the U.S.
The question is: what comes next? It’s possible to see the bond sell-off in June as a tantrum, but a return to normalized interest rates has to happen someday. But, at the moment, the economic recovery is more tentative than certain.
After Bernanke’s June remarks seemed to pop the bond bubble, Bill Gross, founder, managing director and co-chief investment officer of Newport Beach, Calif.-based Pacific Investment Management Co. LLC, said he thought the chances were slim that U.S. inflation, now running at an annual rate of 1.4%, would tick upward to the Fed’s target of 2% or that the U.S.’s gross domestic product (GDP) growth, now running at an annual rate of 1.6%, would rise to 3% by yearend.
Gross’s implication is that the Fed may have to stick with its QE III program. That would mean the same traders who rushed for the exits will have to rush back in. If history is a guide, they will overpay to get in, producing profits for the clients who bought when prices collapsed in June.
And there is irony in Bernanke’s remarks: if interest rates are driven up to pre-intervention levels of 2008, the Fed would have to re-enter the market to buy bonds once more to push down the cost of money.
Anticipation of this happening already is moving the market. Says Rémi Roger, vice president and head of-fixed income at Seamark Asset Management Ltd. in Halifax: “I would be surprised if there is not a bond price rebound.”
Yet, the bond market inevitably will normalize and we will see: three-month U.S. and Canadian federal bonds pay 3%, 200 basis points more than today; five-year bonds pay 4% compared with 2.25% today; 10-year federal bonds pay 5%, twice today’s rates; and 30-year bonds reach toward 6% from the recently quoted 2.86%.
Thus, the rush for the exits in June can be read as a practice scrimmage, in which central bank suppression of the yield curve ends. If bond traders anticipate the end of the party, they will leave.
That’s because higher interest rates mean higher financing costs and, thus, lower profits.
As an example of what is to come, real estate investment trust (REIT) prices fell dramatically in June, notes Barry Gordon, president and CEO of Toronto-based First Asset Capital Corp. Yet, the drop in prices was premature, he says: “In the early stages of a rising interest rate cycle, REITs get whacked. Then, inflation kicks in, rents go up and the REIT units recover.”
This same philosophy, he adds, applies to the dividend-rich bank and utility stocks beaten down in the rush for the exits. Borrowing costs could rise, but better conditions ultimately boost earnings.
What happens next depends on the U.S. economic recovery, which is modest at best. If institutional money managers keep selling bonds, then total returns, which are heavily dependent on price moves in a low interest rate environment, will continue to drop. Continued flight from the bond market will cause prices to drop further, push up yields and possibly force the Fed and other central banks to provide support for bond prices.
The bond market slump has given traders a sense of what’s to come, but it has come too soon, says Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: “Fundamentals rule. If the market sell-off continues and interest rates go to 4% with core inflation in both Canada and the U.S. running at about 1%, real yields would be 3% against a long-term average of 2.5%. That implies interest rates would have to come down.”
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