Interest rates are testing ever lower thresholds. As rates drop, prices of existing government bonds soar. The question is: how will bond returns behave as nominal rates head toward zero and perhaps go negative?
With overnight nominal rates of 2.25% in the U.S. and 1.75% in Canada – and negative rates in Germany, much of the Euro area, Switzerland and Japan – investors are wondering if North American rates will begin to show minus signs.
There are rate inversions already. For example, as of Aug. 15, the Bank of Canada’s (BoC) overnight target rate of 1.75% exceeds the 1.30% yield on 30-year Government of Canada bonds.
Likewise, in the U.S., the Federal Reserve Board’s target rate of 2.25%, set on July 31, is higher than the 30-year treasury bond yield of 1.98%. Inversions predicting recession are evident. But will they drive bellwether government debt’s nominal interest rates below zero?
“Negative rates in North America are not unthinkable,” says Benjamin Tal, deputy chief economist with CIBC World Markets Inc. in Toronto. Banks in Germany are lending at negative rates, he says. About US$15 trillion of global debt outstanding now bears negative rates.
In practical terms, that means commercial banks may deposit regulatory capital with the pertinent central bank and get less for it than they might if they invested the money in the open market and paid a tiny premium – i.e., reverse interest from the central bank. This concept enshrines the abstract idea of paying back a little less than one owes. You could say that “less less” is more; thus, the logic of buying negative-pay bonds.
First, some good sense. “Long rates are not negative,” Tal says. Even if the short rates set by central banks do go negative, he says, the yield curves as a whole will remain in positive territory. Moreover, the odds of negative nominal rates happening are low. Canada and the U.S. are not eurozone basket cases such as Italy, which has a 9.7% unemployment rate, or Spain or Greece, with unemployment rates of 14% and 17.5%, respectively.
Still, lower interest rates for Canada and the U.S. are foreseeable. The BoC may have to follow the latest Fed cut by perhaps a quarter of a point. But the amount of easing of monetary policy that’s in sight won’t drive rates negative, insists Josh Nye, senior economist with Royal Bank of Canada in Toronto.
“At this point, we think rates will remain positive in both Canada and the U.S.,” Nye says.
The BoC and the Fed both have higher policy rates than the European Central Bank (ECB). The ECB’s rates could go lower, but the economic outlook in the U.S. does not indicate that the Fed has to use policy to provide more accommodation. The implication is that there is a lot of distance between the 2.25% front-end rate in the U.S. and negative rates. The same goes for Canada, even though the baseline rate here is 50 basis points (bps) lower.
Rate prediction should be apolitical, but, realistically, global debt markets are watching the U.S. for indications of what happens next. The global economy is hardly robust, given political problems interfering with central banks and debt management in China, and with Europe edging closer to recession (pushed, perhaps, by Brexit).
Rate cuts drive money out of countries and push their currency downward. If all countries cut rates, the effects of those cuts would cancel each other out.
But a major central bank acting for all its members, such as the ECB, can have significant effect. As of Aug. 12, the ECB has a -0.40% overnight rate. And rates appear to be headed lower.
As of the same date, German two-year federal bunds yield -0.89%; 10-year bunds, -0.59%; and 30-year bunds, -0.10%.
The longer you go, the less you lose. The 79-bps difference between two- and 30-year bond yields is the tightest since 2008.
What to do? There is a divide between being a purist and being a practical investor. A purist may be dazed by negative nominal interest rates and a bond market that assures negative real yields while prices of existing bonds rise – as has happened. The practical investor takes it in stride, recognizing that nominal interest rates below former norms, and real rates in negative territory, are a fact of life. At that point, the practical investor buys more bonds on the theory that if rates fall further, bond prices will rise.
Charles Marleau, president of Montreal-based Palos Management Inc., is a practical investor. He’s cutting risk: “I am selling long-duration bonds and moving to shorter durations between one and seven years. More cuts will drive the shorter bonds more than the longer bonds, especially if long-bond rates are inverted. The yield curve will steepen. It has to happen.”
Yield curves are positively sloped for the range of five to 30 years in Canada and for two to 30 years in the U.S. For corporate bonds, all rates are positive. In the U.S., bellwether single-A bonds make up one-third of all outstanding corporate bonds.
Prices of those single-A bonds will rise, says John Lonski, managing director and chief economist with Moody’s Analytics Inc. in New York. Like Tal, Lonski believes the yield curve outlook for U.S. and Canadian investment-grade bonds is positive.
The consensus: government bond yields will be positive and corporate debt will be priced with customarily higher yields.