The bond market is having a hissy fit. Investors – even those who don’t own any bonds – should pay attention.
The abrupt rise in recent days in short-term bond yields signals the belief in some quarters that central banks are suddenly waking up to inflationary dangers and trying to walk back a policy mistake. If so, interest rates could be headed up faster than thought, with dismal consequences for stock prices and real estate speculators.
To be sure, this is far from a done deal, but it is easy to see why people are worried.
Policy makers had insisted for months that inflationary pressures were transitory and would soon fade. Steady as she goes was the boring but reassuring message from central banks.
But, ahem, that was then. This is now.
Tiff Macklem, the usually predictable governor of the Bank of Canada, gave the markets a pre-Halloween shock last week when he abruptly ended the central bank’s massive bond-buying program. He also signalled interest rates could start to tick up sooner than expected to help contain inflation.
The Reserve Bank of Australia, that country’s central bank, added to the ghoulish fun when it suddenly ended its efforts to target short-term bond yields. Yields soared on Friday in response.
“As November dawns, markets know for sure that central banks have capitulated to a rise in prices and are poised to abandon the ‘flexible average inflation targeting’ regimes that were adopted last year,” Karl Schamotta, chief market strategist at Cambridge Global Payments, writes in a research note.
Proponents of flexible average inflation targeting – or FAIT – promised to tolerate short-term surges of inflation during economic recoveries. But inflation rates north of 4 per cent in Canada and the United States have twisted FAIT to the breaking point.
Exactly how tough policy makers are prepared to get will become clearer when decision makers at the U.S. Federal Reserve meet on Wednesday. The world’s most powerful central bank will offer clues about the timing of future interest rate hikes and the schedule for tapering its own bond-buying program. Much depends on precisely what it says.
“Economic recoveries are faltering and asset prices across the globe have become underpinned by the expectation that real interest rates will remain low,” Neil Shearing, chief economist at Capital Economics, writes. “If that expectation shifts suddenly, it could trigger a dramatic repricing in asset markets that leads to renewed economic stress or even threatens financial stability.”
Any sudden rise in interest rates would put a dent in today’s richly priced stock market by making bonds a more attractive alternative to equities. Higher rates would also undermine borrowers’ ability to service the staggering levels of debt they have accumulated during the pandemic.
The most likely outcome is still for inflation to drop back next year, to around 3 per cent in the U.S., Mr. Shearing says. This would allow central banks to gradually withdraw their emergency support measures with no great harm done.
In contrast, “the stuff of nightmares” for central banks would be a scenario where inflation continues to tickle 5 per cent. If so, central banks would feel pressure to boost rates, a move that could hammer stock and bond prices and dislocate debt markets.
So far, stock markets are taking the dangers in stride. Credit that to a strong earnings season and strong household balance sheets as well as the simple reality that so long as bond yields remain as dismally low as they are now, investors have few alternatives to stocks.
The yield on a Government of Canada two-year bond has doubled over the past month and was trading around 1.07 per cent on Monday, but is still considerably below the 2.5-per-cent dividend yield on the S&P/TSX 60 Index. The 10-year Canada bond yield has also climbed but, at 1.74 per cent, is also below dividend levels.
Not everyone is convinced the rising rate trend has a lot of gas left in it. David Rosenberg of Rosenberg Research points out that Canada’s gross domestic product (GDP) advanced at only 0.4 per cent, month-over-month, in August, well below expectations. He estimates that third-quarter GDP figures will show an annualized rise of only 2.0 per cent, far below the 5.5-per-cent forecast of the Bank of Canada.
A crawling GDP recovery is not the usual backdrop against which to hike interest rates. The Bank of Canada’s sudden turn toward a harder, more hawkish tone appears to assume that slack in the economy will be absorbed faster than previously thought. However, slowing growth and persistent supply chain problems call that assumption into question. “The [Bank of Canada] may have jumped the gun on this pivot,” Mr. Rosenberg writes.
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