Investment-grade bonds were a flop in 2006. The benchmark for Canadian government and investment-grade corporate bonds, the SC universe bond total return index, produced a 4.1% return, which amounted to the coupon — and nothing else — while Canadian bond funds generated a 2.6% average return.
Why did bonds do so poorly? The reason is simply a result of expectations that did not play out.
In February 2006, many bond fund managers believed that the U.S. Federal Reserve Board and the Bank of Canada would be dropping their interest rates as their respective countries’ economies cooled. A big drop in rates would push up prices of existing bonds; the longer the bond, the higher the potential return. The rate drop was not imminent, managers agreed, but they believed it was bound to happen some time in the second quarter.
So, bond managers got to work with their duration calculators, estimating the average weighted total returns of coupons and principal, and figured that slowing U.S. and Canadian economic engines would generate handsome gains.
However, things didn’t turn out the way they had expected. In the U.S., the Fed raised the fed funds rate — what it charges to lend required reserves on a short-term basis to banks — to 4.75% on March 28 from 4.50% on Jan. 31, then to 5% on May 10, and finally to 5.25% on June 29.
The Bank of Canada’s lending rate, which had been at 3.5% at the end of 2005, was raised in steps: to 3.75% on Jan. 24, then to 4% on March 3 and finally to 4.25% on April 26.
The central banks were not listening to bond managers. Instead, they were responding to economic growth far stronger than the pessimistic bond managers had expected.
What bond managers did not take into account is what actually happened in 2006, says Aron Gampel, Bank of Nova Scotia’s deputy chief economist: “No one expected oil prices would fall so fast. Gas at the pumps in the U.S. fell from US$3.10 at the peak in July to US$2.20 at yearend. Investors felt good with gas price pressure relieved.”
Automakers added to the feel-good atmosphere by introducing massive price discounts, especially of gas-guzzling sport utility vehicles. The discounts were unprecedented in size, Gampel adds.
Then, at Christmastime, retailers cut prices, especially on electronic goods. Mortgage rates began to come down in the U.S., to 6.25% at yearend 2006 from a 6.75% high. Then, the U.S. job market picked up.
“Put all these factors together and you get an explanation of why the Fed felt it did not have to cut,” Gampel says. “The U.S. rebound was stronger than expected.”
“Central banks don’t always do what markets expect them to do,” says Patricia Croft, chief economist at Phillips Hager & North Investment Management Ltd. in Toronto. “Last year, we had negative news from the U.S. housing market. U.S. interest rates had gone through 17 consecutive raises from their low of 1% in 2004.
“The housing-driven cut seemed due,” she continues. “After all, house prices were high and mortgages that had been taken out in early 2002, when the bank rate was at a cyclical low of 2.25%, were now being rolled over at 5%.”
Croft says she believed at that point there had to be a break. Then, the stock markets in the U.S. and Canada went into a correction in October. The case for lowering rates was fully in place.
Instead, a little girl called Goldilocks captured the attention of the stock market.
Bond markets were also keeping the yield curve flat for their own technical reasons, mainly a surge in liquidity that went into long Canada bonds.
As Tom Czitron, managing director and head of income and structured products at Sceptre Invest-ment Counsel Ltd. in Toronto, says, “There was such a demand for yield that there was a continuous bid on the long end of the yield curve. That tended to hold interest rates down on the long end of the curve.”
For instance, 10-year Canada bonds, which opened 2006 at 4.1%, also closed the year at 4.1%. Long-term bond investors got nothing other than their coupon payments.
Robert Marcus, president of Majorica Asset Management Corp. , a specialty bond manager in Toronto, is critical of the belief that central banks’ policies can be counted on to be right. “Goldilocks never works out as planned,” he says. “The usual outcome is that central banks focus more on inflation than on deteriorating growth. They are willing to err on the side of keeping monetary policy tight.”
@page_break@In Marcus’s view, the U.S. consumer will be the bellwether of that country’s interest rates and growth this year: “The cost of carrying debt is at a record high, and the biggest asset for the consumer is the cost of housing. The U.S. housing market has a value of US$23 trillion and the U.S. stock market is US$11 trillion.”
His argument is that negative wealth effects from declining house prices and rising carrying costs trump stock market gains. And Goldilocks’ fans may be shocked into recognizing that global growth is slowing and expansion of global liquidity cannot go on forever, he says.
As a result, the lessons of failed predictions in 2006 should help make forecasts for 2007 more accurate. “The lesson of 2006 is that one should not necessarily believe the consensus,” says Czitron. “It can be more profitable to trade against the consensus than with it.”
The bond market seems to think that inflation will subside, says Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver — and this usually means that one should put money on long bonds.
But that consensus is wrong, he argues, noting that profits were already taken on long bonds last year. “This year,” he says, “the money is going to be made on shorts.” IEat can we learn from it all?
Interest rate stagnation leads to unrealized expectations
Last year’s events baffled bond managers. What can we learn from it all?
- By: Andrew Allentuck
- April 3, 2007 October 31, 2019
- 11:52