Bond yields could double, economists warn
Spiking from historic lows
Time to strap on your seat belt. The yield on the U.S. 10-year will shoot up to 3% by the end of this year, nearly twice this year’s lows, says Royal Bank of Canada’s chief U.S. economist.
“We do not expect that process will be linear, however,” cautioned Tom Porcini, in a note to clients.
That may be an understatement.
Over the past few days the yield on the benchmark 10-year bond has staged one of the biggest moves since the financial crisis in 2009. Since Tuesday it’s jumped nearly 40 basis points.
Said Mr. Porcini: “Remember, while the Fed may no longer represent a significant impediment to higher yields, the fate of rates is multifaceted: European stress, EM growth concerns, and our own homegrown issues will all ultimately dictate the direction and speed with which we get to 3% — or, even if we get to 3%.”
Translation: The U.S. central bank along with its peers around the world is about to back away from quantitative easing programs that artificially pumped up liquidity and cushioned against market turmoil. Get ready for the full impact of the storm that is raging in global markets.
News of the central bank action sent markets plummeting last week and the trend continued on Monday, with the TSX down 102 points, or 0.8%, by mid-afternoon, while the Dow Jones was down 43 points, or 0.3%, and the S&P 500 was down about 8 points, or 0.5%.
While the pullback in equities appears to be losing momentum, analysts expressed worry that markets are not behaving as they should. In a normal world, a rise in bond yields is a signal that the economy is growing stronger and capital is flowing back into equity markets, but this time the opposite is happening.
“It seems everything is kind of counter-intuitive at this stage,” said one analyst. “It’s a question of shoot first, ask questions later.”
As a minor player in the global scheme of things, Canada is mostly on for the ride, but gyrations in the bond market have already had a real impact here, with mortgage rates at all the major banks already on the way up.
The rock-bottom interest rate environment that has prevailed since the financial crisis has dramatically reduced the cost of mortgages, which in turn helped to push up home prices.
But that trend is reversing in a hurry.
Banks fund their mortgages the same way governments do, by issuing bonds. When the cost of borrowing rises for the U.S., the same goes for banks. Over the past week all the major lenders have hiked mortgage rates, with Bank of Nova Scotia unveiling its latest rise Monday.
Borrowers whose mortgages are up for renewal could be facing a tougher new reality, but a lot depends on the details, said Peter Routledge, an analyst at National Bank Financial. “If you’re renewing a variable mortgage, you could have a higher cost of borrowing, but if you have a fixed loan that you took out five years ago, you will likely pay less.”
The real question is where rates go from here. Michael Gregory, a senior economist at Bank of Montreal, is calling for continued volatility but does not believe that rates will continue to escalate steadily.
“Probably in the weeks and months ahead the yield [on the U.S. 10-year] will go to 3%, if only temporarily,” Mr. Gregory said.
But it may well fall after that as markets come to grips with the fact that while the Fed has signalled it plans to crank back on stimulus as early as the middle of 2014, that’s still a year away and there’s plenty of time to prepare.
One reason the market reacted so violently to the comments from the Fed on Tuesday was that it was at last signalling an end to quantitative easing programs that have so far buffered markets from the impact of problems such as the European debt crisis and the still grinding U.S. economy. The end of quantitative easing means “a return to volatility,” said Mr. Gregory.