A funny thing happened to Canadian bonds after Friday morning's jobs report.
Instead of catching a bid in response to the disappointing decline in employment, the Canadian bond market marched to the beat of the United States' drummer.
South of the border, the economy posted its best month of job gains since January 2012. The yield on five-year Government of Canada debt quickly rose about half as much as that of its U.S. counterpart, which spiked more than 10 basis points in the minutes following these releases.
The observation that Canadian yields follow a course charted by their American counterparts is hardly novel; however, the likely cause of today's move warrants a more detailed explanation of how and why this occurs.
Some background: there are three primary components that go into determining the yield on a government bond – inflation expectations, the estimated path of short-term policy rates set by central banks, and the term premium.
The first two factors are relatively self-explanatory, while the term premium is the extra compensation an investor demands for buying longer-dated debt. A more honest – and perhaps more accurate – definition was provided by The Economist's Greg Ip, who referred to the term premium as a "statistical junk [yard] into which economists toss stuff they can't explain with fundamentals." That is, the term premium is the 'known unknown' component of a yield that quantifies the extent to which it is higher or lower than inflation and rate expectations would suggest.
Researchers at the International Monetary Fund found the opaque realm of the term premium is the channel by which U.S. rates affect yields on other sovereign debt.
"Our analysis showed that the term premium plays a key role in the transmission of U.S. shocks to other countries," write Serkan Arslanalp and Yingyuan Chen. "We found that even if expected short rates deviated among countries because of differences in country circumstances, the term premium across countries was highly correlated."
For years, this connection has served to depress Canadian yields and effectively ease financial conditions above and beyond the stimulus provided by the Bank of Canada, which helped fuel the boom in the housing market. While Canada imported lower rates from the United States during the initial phases of the recovery from the financial crisis, growing economic traction south of the border and the initiation of a tightening phase from the Federal Reserve may see the reverse occur over the not-too-distant future.
The low interest rate environment didn't end today; far from it. Those who have claimed that central bank rate hikes are right around the corner have been found, time and time again, to share much in common with the Boy who Cried Wolf. But Canadians would do well to remember that the yields on government debt can rise absent any improvement in the nation's economic fundamentals, anticipated pick-up in inflation, or thoughts that the glide path higher for the Bank of Canada's overnight rate will be steeper or start sooner than expected.
For domestically oriented investors, the prospect of interest rate normalization in Canada driven by an improving U.S. economy is well worth keeping a close eye on. During an era in which rates are at exceptionally low levels and government bonds provide, in real terms, a paltry or negative return, investors are increasingly willing to pay a higher price for equities.
Should interest rates rise steadily, this dynamic would likely weigh on multiples for equities as investors increased their allocation to fixed income. Dividend stocks, which compete more directly with bonds, would come under particular pressure in such a scenario.
And homeowners who are scheduled to renew their mortgages might also be in for an unpleasant surprise if the yield on five-year Canadian government debt continues to rise in sympathy with the U.S. Treasury rate.