Rising Rates Spell Trouble for Government Bonds

Featuring

Patrick O’Toole

From

Related Article

Text transcript

Patrick O’Toole, vice-president global fixed income, CIBC Asset Management.

Inflation certainly has been attacking the bond market of late, and a lot of folks have been, to a certain extent, shocked that we’re not seeing longer term bond yields, like 10-year and 30-year bond yields, rise meaningfully. And in the U.S. in particular, the 10-year Treasury yield still remains below the highs we saw earlier this year in March and October of 2021. So what we’re seeing is elevated inflation, and there’s been this sort of tug of war between those who think it’s transitory, as the central banks have been talking about, and those who think that it’s more persistent. And we did see the central banks shift gears a little bit in the recent months, the Fed and Bank of Canada both shifted towards the end of September. Whereas the Fed came out, and said it to a certain extent spooked the market. They announced late September that they were going to taper their bond purchase program, which is known as quantitative easing.

They were going to reduce the amount of bond they were buying each month, starting in November. And they were going to wind that program up by the middle of 2022. And that latter part that wind up by the middle of next year, that was what kind of spooked investors a little bit. They thought the Fed would probably go a little slower in winding down that bond purchase program. And that opens the door when the Feds has also said in the past, “we won’t hike interest rates until we’re done tapering the bond purchase program.” So that opens the door to them hiking rates as soon as the third quarter of next year, given they said they were going to be done by the middle of 2022. And that’s faster than the consensus had expected. Similarly, in Canada, the Bank of Canada talked about the output gap closing in the second quarter of 2022 and saying it could hike rates in the middle quarters of next year, meaning they could hike in April. Again, sooner than the market had expected whereas they had previously been saying, it wouldn’t hike until perhaps the second half of next year.

So what we saw is futures markets move very, very quickly, arguably too quickly to price in rate hikes next year. Otherwise, we’re sitting here today, the futures market sees about this late November. The futures market sees about four to five Bank of Canada hikes in the next 12 months and two to three hikes in the U.S. Fed funds rate. And that seems pretty aggressive, particularly for Canada. Let’s remember the futures markets, they’ve notoriously been wrong and too aggressive in expecting rate hikes. And our view has been the central banks are going to try to be more stubborn and go slower in hiking rates. Given that both the Bank of Canada, the Federal Reserve have put a greater focus on achieving full employment before hiking rates.

And when they talk about full employment, they mean for all parts of the workforce. In the past, the Fed has actually hiked rates before they’ve seen a recovery in the employment rate for the less advantageous groups in the workforce. And in Canada, the Bank of Canada deputy governor said recently that the bank wants to see full employment for all groups. So we think they don’t plan hiking rates until they see a full recovery for those groups. And while they have that plan to slowly raise rates, when they’ve seen a recovery and employment for all groups, there may come what I call a Mike Tyson moment. And Mike Tyson’s famous for saying, “Everyone has a plan until they get punched in the mouth.” The central banks have their plan, but the bond market may provide that blow that derails their plans. And that blow would be longer term bond yields spiking higher, but so far longer term bond yields aren’t concerned that inflation is enough of an issue that they’re demanding a higher, longer term bond yield to compensate for that. And we haven’t seen those yields moving materially higher.

So while Canada’s 10-year yields at a one-year-high, U.S. 10-year yields are still a bit below the March and October highs of 2021. And that surprised many who think longer term Bond Yields should be higher. So to a certain extent you could argue it’s a stamp of approval from the bond market that agrees with the Federal Reserve and the Bank of Canada, that inflation is actually going to be falling next year and will get closer to that 2% target both central banks have sometime by late 2022. It also could reflect concerns that the central banks will be too aggressive in raising rates next year, thereby resulting in the economy slowing faster than some think. In other words, tightening monetary policies too soon and too fast.

Having said that, bond yield or longer term interest rates should still move up a bit next year, but nothing too excessive. Why should they move up? Well, we see GDP slowing next year in both Canada and the U.S. but it’s still going to be pretty healthy growth levels of around 3% real GDP. And inflation’s slowing to the low twos next year. So the growth rate is still pretty good. So that should justify bond yield, moving up a little bit, particularly as we do expect central banks to be hiking rates some point next year, maybe just perhaps not as soon as the market’s currently expecting. So a lot has to go right for those rate hikes to happen and things like more Covid problems, low recovery and wages, inflation moving lower, faster than expected or oil price continuing to move down. Any year all of these could take the heat off the central banks, hiking rates next year.

So investors should expect some mild increases in bond yield next year. That means returns aren’t necessarily all that outstanding the usual type of bond funds. So investors should look to funds or products that offer diversification away from typical government of Canada bonds, and typical investment grade corporate bonds, and look to products that include high-yield bonds and emerging market bonds, private debt, and other things to enhance returns. We think some of those alternatives will provide better returns than domestic bonds.