Sell-off marks end of bond bull market

In a parallel move, the U.S. Treasury 10-year bond, due Aug. 1, 2028, was recently priced at US$123 to yield 2.929% to maturity – a drop from US$129.39, yielding 2.36% to maturity on Dec. 15.

Behind the plunge in bond prices is central bank policy. The Bank of Canada (BoC) raised its overnight interest rate target to 1.25% on Jan. 17. That was the BoC’s third increase since last summer, after increases of 25 basis points (bps) each in July and September. The increase in January was accompanied by precautionary statements that “some continued monetary policy accommodation” is likely to be needed to keep the economy as robust as can be expected.

There are perils. U.S. President Donald Trump has expressed displeasure with the North American Free Trade Agreement. Fear of higher trade barriers to Canadian products and lower U.S. taxes on corporate and other sources of income have weighed on Canadian capital markets. The implication for Canada is slower economic growth and lower demand for loanable funds.

Moreover, the Jan. 17 BoC statement notes that lower corporate taxes in the U.S. and what the statement referred to as “trade policy uncertainty” would reduce money flowing into investment in Canada by as much as 2% by the end of 2019.

Monetary policy is divided at the 49th parallel. The U.S. Federal Reserve Board is committed to raising interest rates quickly, while the BoC is taking a more cautious approach. In the U.S., the 10-year treasury bond yield is expected to climb to 3.5% by the end of 2018, according to a prediction in a Goldman Sachs Group Inc. report published on Feb. 12.

The three anticipated interest rate increases by the Fed already are baked into bond prices. In addition, economists with several large investment banks are discussing the possibility of a fourth rise in rates. In Canada, the 10-year rate is likely to rise, but at a slower pace than U.S. rates, says Andrew Grantham, senior economist with Canadian Imperial Bank of Commerce in Toronto: “Our view is that we are going to remain in a lower-growth environment.”

The driving forces behind U.S. interest rate increases are that U.S. unemployment is dropping – giving rise to fears of higher inflation – and that the US$1-trillion deficit predicted in the U.S. federal budget released in the second week of February will have to be financed along the treasury bond’s yield curve.

The foundation underlying Canadian interest rate policy will not be just a reaction to U.S. monetary policy moves, but also to the reality that resources prices, especially energy prices, and those of other commodities are weak.

“The outlook for the Canadian [bond] yield curve remains positive,” Grantham says, noting that the 57-bps spread in interest rates between two- and 10-year Canada bonds – 1.77% and 2.34%, respectively – is fairly wide, a positive for the economy. He adds that the curve is flattening in the stretch from 10 to 30 years, given the long bond’s yield of 2.48%. (Flattening is the precursor to inversion, an all-important prediction of a recession to come. Narrowing spreads are intrinsically pessimistic.)

“The BoC cannot be too aggressive to signal more [interest] rate rises,” says Charles Marleau, president and senior portfolio manager with Palos Management Inc. in Montreal.

Marleau’s implication is that the U.S. yield curve can rise aggressively while the yield curve in Canada remains flatter. That would reflect lower growth in Canada – unless commodities pick up and U.S. trade policy cools.

Market reaction to central bank interest rate increases has been by the book: lower bond prices and a shift of money into equities. Those changes should continue because the real rate of interest for 10-year bonds, which is the bond coupon rate minus the consumer price index (CPI) – the CPI is at 2.1% in the U.S. and at 1.9% in Canada – is at a meagre 0.83% annually in the U.S. and 0.44% annually in Canada. That’s a reason to shift money out of bonds and into equities, the latter of which have higher returns baked in with their combination of dividends and anticipated growth.

The outlook for bonds is negative for now. Stocks may wobble, but anticipated tax benefits and predictable stock buybacks and dividend increases are bullish. On the other hand, rising interest rates and low real returns will continue to undermine bond prices.

There’s a long-term argument for what seems to be a bond market falling off the ledge of hope. Aging populations in Canada and the rest of the developed world, together with longer life expectancies and the vast number of people in China entering a high consumption economy with a reported savings rate of 40% of earned income, suggests that there will be a lot of cash seeking a home.

Bonds, with their stipulated maturities, are the natural home of money slated to fund retirement. So, bonds shouldn’t be counted out. Stocks rallied strongly following the 2016 U.S. presidential election, but, as Edward Jong, vice president, fixed-income, with TriDelta Investment Counsel Inc. in Toronto, says: “The pressures that support bubbles don’t endure. In capital markets, fizzles are seldom far away.”