As the u.s. federal reserve Board’s tapering program proceeds, forecasts that interest rates will rise and existing bonds lose value apparently have been wrong. In spite of the expectation of a broad sell-off, bond prices actually have risen. Thus, contrary to reports that bonds have gone into rigor mortis, they’re alive and well – and potentially profitable.
As of Jan. 31, U.S. Treasury 10-year bond yields plummeted to the lowest level in the previous two months as investors took shelter from turmoil in emerging markets and in the domestic U.S. equities markets. In Canada, dropping stock markets have pushed investors to shelter in bonds. The result has been a hike in the DEX universe bond index, which rose by 2.6% in January. That was the largest monthly gain in five years.
The biggest beneficiary of that change is at the long end of the yield curve, in which returns rose by 5.1% in January. Weaker home sales and the Bank of Canada’s (BoC) acknowledgment of the weak domestic economy means that low interest rates will stay in place longer, protecting bond positions.
Add in the absence of significant inflation to drive up interest rates and the short term trend is complete, says Edward Jong, vice president and head of fixed- income with TriDelta Investment Counsel Inc. in Toronto: “The much anticipated drop in bond prices – as investors dump fixed-income in preference for more risk in stocks – has not happened. Not yet, anyway.
“The BoC has been unwilling to raise interest rates,” he explains. “Its message is that rates still have to stay stimulative – that is, low.”
That talk is protecting returns for existing bond investors. The question now is whether that’s going to be a trend that lasts for a few months or reverts to the expected rise in stock returns and drop in bond returns.
For now, the movement is to take safe harbour in U.S. and Canadian bonds. Bond blogs and fixed-income chatter raise the spectre of previous defaults in Brazil in 1999, in Russia in 1998, the Thai baht collapse of 1997 and several South American bond defaults. U.S. treasuries seem the safest place in the world to hide. Add in the ascent of the greenback and the case is closed for investing in treasuries and, in Canada, federal, provincial and investment-grade corporate debt.
What, then, of tapering and its presumptive effect of allowing bond interest rates to rise? It’s already priced into bonds, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. Last year, he notes, 10-year U.S. treasuries’ yields rose to 3.03% as of Dec. 31, 2013, from a low of 1.4% earlier in the year. Since then, the rush out of emerging-markets debt and into U.S. and, to a lesser extent, Canadian bonds has driven down 10-year treasuries’ yields to a recent level of 2.7% in the U.S. and to 2.4% for federal bonds in Canada.
Where do we go from here? Bank of Nova Scotia‘s economics department predicts that the European Central Bank (ECB) won’t drop interest rates any further to achieve more economic stimulus. Thus, European sovereign bonds won’t have an incentive to rise in price. The reason is the current overnight rate of 0.25%.
The ECB has run out of room to cut its overnight rate. The eurozone’s inflation rate, which the ECB estimated to be 1.2% for 2014, dropped to 0.7% in January – well below the bank’s 2% target rate. If this rate were to drop any lower, banks in the eurozone might go into what Derek Holt, vice president of economics with Scotiabank, calls “uncharted waters of a negative interest rate policy that’s charging depositors to keep money on hold.”
This is not entirely unknown, as Switzerland’s banks have done that from time to time and still manage the feat with service charges on certain deposit accounts in excess of interest payments. Banks in Sweden and Denmark have done it as recently as 2012.
Negative interest rates on short-based bank deposits would push money out the door. Bank liquidity would dry up, commercial lending would slow to a trickle, businesses would be starved for cash and money would flee to markets in which money continues to earn positive returns in deposit accounts.
Of course, says James Hymas, president of Hymas Investment Management Inc. in Toronto: “Europe is not the tail that wags the Fed’s dog – nor the Canadian pooch, either.”
Yet, given Canada’s low rate of job creation (only 100,000 new jobs were generated in 2013) the BoC’s apparent policy to allow the loonie to decline as a means of stimulating exports, as well as the general view of the financial community that things are not so bad in Canada compared with other resources-based economies – such as Australia’s, whose dollar has done a bit worse than Canada’s – all seem to relieve the pressure on the BoC to follow the U.S. by inferring that interest rates will rise in the not so distant future.
The bottom line is that the bond market evidently doesn’t expect the BoC to raise interest rates in 2014. A flattened yield curve shows little expectation of rate growth. In this market, bonds are holding their value and delivering positive returns. There’s no rush to higher rates and no great need to flee bonds for equities – not just yet.
As for last year’s consensus that tapering would mean higher interest rates everywhere? Conventional predictions seem to be dysfunctional in a market still hanging onto fear rather than moving to greed. In that mood, the spirit is clearly cautious. And bonds, far from being orphaned by rising interest rates, continue to be prized as safe havens.
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