Strategists offer dismal outlook for bond markets

(January 27, 2005) Now is probably not a good time to be in bonds. While economists may disagree on the direction of Canada’s monetary policy, either way, the prognosis is dim for fixed-income investors getting into the market today.

Marc Levesque, chief strategist at TD Securities, was the more upbeat presenter at a lunch meeting of the Toronto CFA Society yesterday. He told delegates there is still room for Canadian interest rates to go up, and painted a picture of robust health for the U.S. economy, calling conditions there “mega-stimulative.”

“We’ve never seen a situation where the environment has been this stimulative and the U.S. economy has faltered,” he says. “This has never failed to kick-start the economy in the past.”

South of the border, he expects rates will continue to rise, and the Bank of Canada will follow suit in the second half of 2005. His prediction puts U.S. rates at 3.25% by the end of the year.

But where Levesque is positive on the health of the economy and the efforts of the Federal Reserve, Peter Gibson, head of portfolio strategy and quantitative research at Desjardins Securities, is worried rates will continue trending downwards, and deflation will again rear its head in the next two or three years.

He says that when a country has the level of debt and other deflationary risks as the U.S. has, nothing short of cold fusion or some comparable breakthrough in productivity growth will do the trick of correcting the problem. “It needs to be massive.” For comparative purposes, he points out that neither the telephone nor the light bulb was able to reverse disinflation trends in the past.

Likening the situation in the United States to the problems experienced in the United Kingdom in the 1930s when the government defaulted on its gold-backed currency, Gibson suggested the U.S. dollar still needs to devalue another 20%. Bond yields will sink in 2006 and 2007, and the price of oil will settle to $43 by the end of the year.

Levesque also says the U.S. dollar still needs a substantial correction, but he suggests a relatively moderate 6-10% is more likely. The corresponding appreciation in the Canadian dollar, is very similar to currency movements in early 2003. Following the last aggressive appreciation, exports flattened out, he says, and there is some risk it could happen again.

Overall though, Levesque says the Canadian economy is proving to be extremely resilient, and business investment remains strong. Because Canadian companies are somewhat cash-heavy, and the Canadian corporate sector has never been in such a strong net-lending position, the corporate spread could get narrower still.

“There’s a lot of talk that corporate spreads have hit bottom,” he says. “I’m not 100% convinced that you’ll see spreads widening.”

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com