A woman walks past the Bank of Canada headquarters in Ottawa, June 1, 2022. Yields on long-term Canadian and U.S. government bonds hit 16-year highs on Tuesday, before falling slightly on Wednesday.Adrian Wyld/The Canadian Press
The months-long rout in global bond markets reached a fever pitch this week, as investors increased their bets that the world economy is entering a new era of stubborn inflation and persistently hawkish central banks.
Yields on long-term Canadian and U.S. government bonds hit 16-year highs on Tuesday, before falling slightly on Wednesday. Bond yields rise when prices fall.
Longer-term rates have been pressing higher for months in response to stronger-than-expected economic data, particularly in the United States. That’s increased the odds that inflation will remain above the U.S. Federal Reserve’s target and force it to keep its benchmark interest rate higher for longer than previously anticipated.
Ten-year U.S. Treasury yields have risen to 4.74 per cent from 3.3 per cent six months earlier, while yields on 10-year Government of Canada bonds are up to 4.15 per cent from 2.75 per cent over the same period.
The sharp repricing in bond markets has been supercharged by several factors impacting bond supply and demand, including a spike in U.S. government bond issuance and a pullback in demand for U.S. debt from Japanese investors. Canadian long-term bonds tend to move alongside U.S. bonds.
“That’s probably the story of why the moves have been so violent: It’s that technical trade on top of the growing question around what is fair value in long-term yields, when inflation is the risk not deflation,” said Brian D’Costa, founding partner and president of Algonquin Capital.
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The rise in yields has clouded the economic outlook. On the one hand, long-term interest rates are rising because bond investors are betting on relatively strong economic growth and stubborn inflation. At the same time, the spike in long-term borrowing costs and heightened market volatility could reduce the likelihood of a soft-landing, where inflation comes down without a significant recession or jump in unemployment.
Homeowners, for one, face increasingly large payment shocks the more long-term interest rates rise. Meanwhile, government debt-servicing costs are marching higher, leaving Ottawa and the provinces with less fiscal room for other priorities.
Abrupt moves in bond markets can also trigger financial stability concerns. This happened in Britain last year when a swing in government bond prices squeezed poorly hedged pension funds and nearly sparked a fire sale in the gilt market.
Analysts are still debating why interest rates have risen so abruptly, with the arguments falling into two camps: macroeconomic and technical.
Strong U.S. economic growth and labour-market data in the face of 11 consecutive rate hikes by the Fed, has led many bond traders to discount the likelihood of a recession, and price in fewer rate cuts over the next few years.
Federal Reserve officials essentially ratified this view with a new forecast two weeks ago that showed two fewer rate cuts next year than previously expected. Bank of Canada officials, for their part, paused rate hikes last month, but said they could raise rates again. They said they have not even begun considering rate cuts.
There’s also a growing belief that inflation will prove more stubborn going forward than in the past 15 years, because of structural changes in the economy, including aging populations and fracturing global trade networks.
“Our view is we’re probably back to the world that we saw from between 1993 to 2007, where when the Bank of Canada or the Fed cut rates, they cut rates to 3 per cent, when they hiked rates, they hiked them up to somewhere between 5 and 6 per cent,” Mr. D’Costa said.
There may be more immediate reasons for bond-market gyrations. For one, the U.S. government recently ramped up bond issuance to finance its gaping budget deficits. That means more U.S. bonds entering the market, putting downward pressure on prices.
There’s also been a pullback in Japanese demand for U.S. debt, as the Bank of Japan has begun allowing domestic bond yields to move higher, having an effect on foreign-exchange rates and encouraging investors to buy locally.
Then there’s the question of market timing, said Chris Whelan, senior Canada rates strategist at Toronto Dominion Bank. Many investors appear unwilling to buy bonds, despite their higher rates, until there’s a better sense that yields aren’t moving higher. That assurance can only be provided by weaker economic data, which would reinforce the case that the Fed and the Bank of Canada are done hiking interest rates.
“You don’t end up having a lot of participants having tremendous courage to buy a market that’s trending higher in yields. And then each day when the weaker macro data hasn’t come … the more complacent the market gets with yields staying here for longer,” Mr. Whelan said.
In this environment, every piece of economic data has an oversized effect on market moves. This dynamic was apparent on Tuesday and Wednesday, when U.S. yields shot higher after strong job-vacancy data, then fell in response to relatively weak hiring data the next day.
The next key risk comes on Friday, when both the U.S. and Canada will publish employment numbers.
“Everyone is so on edge right now, that I think it’s basically whichever way the data moves, we’re just going to have an amplified move in that direction,” said Taylor Schleich, director of economics and strategy at National Bank Financial.
“If [the jobs data on Friday] is much stronger than expected, you could very well see this sell-off continue. And vice versa, if it comes in weaker, then perhaps you get a pretty big move lower [in yields] and everyone starts to say, ‘Okay, maybe we overreacted a little bit.’ ”