U.S. “fiscal cliff” will hit bond market

The U.S. Federal Reserve Board’s twist is due to expire on Dec. 31. And lack of action to reflate the economy could push stock investors into despair, says Rémi Roger, vice president and head of fixed-income at Seamark Asset Management Ltd. in Halifax: “A comparison to the 1930s is not wrong. The period of the 1930s was about deleveraging. That is what is going on now. The stock market has not discounted a great deal of uncertainty. If stock prices fall, money could move to bonds, further depressing yields.”

If the Fed tries to compensate for what the U.S. Congress and the administration fail to do, that would probably reduce interest rates yet again – although with near-zero short-term rates and historically low long-term rates, the Fed’s room to manoeuvre is small. Any decline in long-term interest rates could generate capital gains for mid- to long-term bonds. But if interest rates rise, losses on long bonds would be massive.

Canada’s close financial relationship with the U.S. implies that what happens there happens here. The International Monetary Fund has cut its 2013 growth forecast to a 1.9% rise in gross domestic product (GDP) for Canada and to 2% for the U.S. Scheduled spending cuts in the U.S. would cut 4% out of its GDP, leading to much the same for Canada – which would result in GDP growth of minus 2% for both the U.S. and Canada, resulting in a surefire cocktail for recession.

An economic slowdown would tend to flatten the yield curve, says Chris Kresic, partner and co-head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. A flatter yield curve would reduce the premium for going long and tend to push money toward the belly of the curve. That would mean lower interest rates at the long end and profits for those holding long bonds. However, going long on the speculation that the U.S. government will fail to act is a risky move.

Says John Carswell, president of Canso Investment Counsel Ltd. in Richmond Hill, Ont.: “The yield curve is now a construct of the Fed. Our view is that from a long-term perspective, U.S. Treasury bills should be 2% over inflation. If you think inflation is 2%, then the T-bill rate should be 4%. Yield normalization, which is inevitable, will add 2% all along the curve.”

That’s a warning to avoid getting steamrollered by the inevitable, eventual rise in interest rates, which can be countered by a move to the short end of the yield curve, Carswell adds.

Predicting how the U.S. government will cope with its fiscal cliff is, at best, short-term speculation, says Hubert Marleau, chairman of Palos Management Inc. in Montreal: “At the end of the day, mean reversion takes hold. That would force yields up all along the curve, perhaps beginning in 2014. The Fed has made a commitment to keep rates low until 2015, but the market could anticipate that and start a bond sell-off. So, I would be a seller of long bonds. Moreover, even the Fed’s board members say that the suppression of interest rates has to stop.”

But holding your breath for the inevitable can be an expensive process. “You are not being paid to wait in government bonds with negative real yields,” Carswell says. “Not much has to go right for the bond market to react. A 1% rise in long Treasury yields would result in a 14% capital loss. Moving up by 2% to normalized levels would inflict a 25% capital loss, far from offset by the current meagre 3% yield.”

It’s likely that despite whomever wins the U.S. election, which occurred just after Investment Executive went to press, the Bush-era tax cuts are likely to be extended and discretionary federal spending maintained for at least another year. That would favour stocks and pull money out of bonds – another reason to be very cautious in buying or holding long government debt issues. Moreover, if the recovery strengthens and inflation worries resurface, bond prices will fall further.

History is on the side of normalized yields, even if there is a short-term gain from money fleeing stocks for bonds. For safety, it’s best to go with short-term bonds, Carswell says: “In our market, caution will pay. Our portfolios remain investment-grade and relatively short.”IE

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