Sell-off marks end of bond bull mar­ket

Mea­gre re­turns in gov­ern­ment debt are driv­ing in­vestors into eq­ui­ties, but bonds still serve a key pur­pose for some clients

Investment Executive - - NEWS - BY AN­DREW AL­LEN­TUCK

the bond mar­ket is treat­ing the rise of in­ter­est rates in the U.S. and Canada as a trig­ger for both re-eval­u­at­ing eq­ui­ties and a mas­sive sell-off of gov­ern­ment debt. That’s driv­ing bond prices down­ward and yields up­ward — and also marks the end of the long bull mar­ket in bonds that lasted for more than 30 years.

For ex­am­ple, the bell­wether 10-year bond, the Gov­ern­ment of Canada 2% is­sue, due June 1, 2028, was re­cently priced at $96.87 to yield 2.34% to ma­tu­rity — a drop from $101.20 on Dec. 15, 2017, when it yielded 1.873% to ma­tu­rity.

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 i n 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 i n 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 al­limpor­tant 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 l ower growth i n 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.”

Newspapers in English

Newspapers from Canada

© PressReader. All rights reserved.