The great reversion: Betting on inflation

U.S. 10-year treasury bonds’ yield reached 2.48% on Jan. 20, up from 2.27% at the end of 2015. The 10-year yield had shrivelled by 0.9% between the end of 2015 and the record low of 1.37% in early July 2016. But the yield climbed by 0.84% between October and December 2016, the largest quarterly jump since 1994.

The upward trend of rates is clear. Yet, the 10-year treasuries’ yield still is much below the 4.76% that prevailed on Jan. 1, 2007 – the last full year before the global financial crisis began in 2008, and a world of chaos and pain away from its historical peak of 15.82%, set on Sept. 30, 1981.

According to Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto, if this world continues, 10-year U.S. treasuries will pay 3% a year and rise to 5% within 10 years. There could be a boost of 75 basis points to 5.75% or 6% for 30-year bonds. The yields for provincials and corporate bonds will be boosted even more – by as much as 3% or 4% – before quality heads below investment-grade.

We also are moving into the great unwinding. If global fears of economic collapse declines sufficiently, then so will hoarding of money in short sovereign bonds. Liquidity should return to the corporate bond market if the new U.S. administration weakens capital requirements for these bonds. (These requirements have discouraged banks from holding bonds in inventory.)

That’s the outline, but there is far more to the story. In a reviving world, the yield curve should steepen. Rising inflation and the expectation of more inflation to come will steepen the curve.However, as the U.S. yield curve steepens, the Canadian curve is likely to be flatter, reflecting lower growth and inflation expectations north of the border.

Does all this mean there could be a rush to sovereigns again? Yes, if growth disappoints or if there are economic shocks. Among the potential drags on growth are slowing productivity and declining population growth as a result of U.S. checks on immigration. That drop could continue for decades, as fewer people in their 20s and 30s (a common age for immigration) have children, buy homes and cars, and increase their spending in general.

A big stock market swoon also would prompt more bond buying – and see stock market multiples tumble. The cyclically adjusted price/earnings ratio, a.k.a. the CAPE index, reached 28.3 in late December, far above the normal or long-run average of 16.65.

“Crystal-balling” what should be a sedate government bond market that is heading back to traditional yields is perilous. Higher interest rates would curb corporate profits. That would tend to limit companies’ growth and expansion and, ultimately, the demand for loanable funds. And if there are cybersecurity events, such as a gaming of bank data leading to accounts that cannot be recovered, that also could raise risk and draw money back to bonds. Even to paper bonds, assuming you remember a time when there were such things.

There will be risks in the process of bond market normalization, although they will be more than compensated for by rising interest rates, Jong says. “But if central banks are successful in maintaining inflation below 3%, then there would be an upper bound on mid- to long rates,” he explains. “If that is the case, then the 30-year rates would not go over 4% and the 10-year would level off at 3.25%.”

There is a wild card in the prediction: the course of U.S. policy is unclear – to say the least. For skeptics, that means a rise in market risk, potentially lower returns and a resulting decline in bond yields, explains Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “If the administration [of U.S. President Donald Trump] does not generate the economic growth it has promised, then bond yields would not rise and Canadian yields could stay fairly steady,” he suggests.

Canada’s economy remains vulnerable, particularly in residential mortgage spending. That’s a reason that the Bank of Canada (BoC) may not raise rates in the near future, Kresic notes.

Nevertheless, Europe is moving away from forceful bond yield suppression by central banks. As a result, the long-term outlook for European bond yields is for them to rise, Kresic acknowledges. With quantitative easing (QE) off the table, the pressure to hold rates down has eased. The new course is upward, but not quickly.

Investors will also have to accept that rates will not move past the mid-single digits for long bonds, Jong says. Investors approaching retirement will not see a move back to the double-digit rates of the early 1980s, a level that many still think of as”normal.”

The core question: How high will rates rise during the normalization process?” U.S. treasury bond yields will rise within the bounds of increasing demand for loanable funds and the inflation-fighting influence of the U.S. Federal Reserve Board. The BoC eventually will follow the Fed, with the timing in Canada dependent on our growth and inflation rates.

Corporate bond yields reflect both central banks’ influence and the robustness of the economy. With the improvement of corporate fundamentals and expectations of lower taxes, U.S. junk bonds returned 17% in 2016.

That was accompanied by a healthy 4.3% return for Treasury inflation-protected securities (TIPS) in 2016.

In corporate bonds, a key indicator, the S&P 500 earnings yield, (the reciprocal of the price/earnings ratio), remains just over 1% higher than the 10-year, BBB-rated bond yield. These ratios have moved in tandem for decades.

The earnings yield, having fallen from a mean of 6% in the 2002-13 period to a bottom of 5% in early to mid- 2016, are now headed up. That upturn predicts a return to the pre-QE 5% yield of BBB bonds.

Then there is the debt issue to consider. If U.S. infrastructure spending rises – as Trump has promised -and U.S. corporate and personal income tax rates decline – as he has urged – then the U.S. government debt outstanding will soar, as will yields on treasury debt.

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