Longer-term bond yields have been trending higher since mid-September, a development that may be surprising some investors given that both the U.S. Federal Reserve and the Bank of Canada have cut their key interest rates by half a percentage point during that period.
Since bond yields and prices move inversely, prices for many bonds have been falling, dampening expectations for a sustainable new bond bull market.
Don’t be fooled by this short-term move. Investors should feel comfortable with exposure to bonds – particularly long-term ones. Inflation is declining and the economy in the industrialized world outside the United States does not look great. These are good conditions for fixed income. Bonds will not likely yield outsized returns, but they remain a steady, low-risk investment.
The Bank of Canada’s lowering of its benchmark policy rate by a half-percentage point to 3.75 per cent last week was largely expected and had little discernible effect on mid- and long-term bond prices. Ten-year Government of Canada bond yields had fallen from almost 4 per cent in late April to just under 3 per cent in mid-September. Since then, yields have ticked up slightly to 3.25 per cent.
The Bank of Canada’s move came after the Federal Reserve cut its key rate by half a percentage point on Sept. 18. The Fed was seen by some to have changed policy and is now prioritizing fears of economic weakness over inflation concerns.
U.S. inflation, as defined by the CPI, has come down to 2.4 per cent as of September. For the present, the battle against inflation has been won. U.S. M2 money supply – a measure of the total supply of cash in circulation and other liquid assets – has only grown by 2.6 per cent over the past 12 months, which is well below historic norms. Consequently, I do not see a resurgence in price pressures any time soon.
Although I am an inflation hawk by nature, having begun my career in the 1980s when rates soared into the double digits, I must concede that a Fed funds rate that remains around 5 per cent in an economy that has inflation heading toward 2 per cent and an unemployment rate of 4.1 per cent is too restrictive.
I expect U.S. 10-year Treasury yields to remain in their 3.5-per-cent to 5-per-cent trading range for some time, with a higher probability of breaking below 3.5 per cent than breaching 5 per cent.
The Canadian 10-year bond yield is about a full percentage point below the U.S. 10-year, although this spread is about a quarter of a percentage point less than it was in early September. Canadian bonds have outperformed in price, but this has been offset by the decline in the Canadian dollar against its U.S. counterpart. U.S. Treasuries to my eyes right now represent better value, even though as Canadians we must be attuned to currency fluctuations.
The outlook for bond returns must always be assessed against potential equity returns. Equities usually outperform bonds and the performance of the S&P 500 index over the past 12 months has been nothing short of outstanding, rising by almost 40 per cent. However, this return has been fuelled by speculation more than earnings growth.
My two favourite long-term equity valuation indicators – the Buffett Indicator and the Shiller cyclically adjusted price-to-earnings ratio – are indicating a strongly overvalued U.S. equity market. (The first indicator takes total market capitalization divided by total GDP, while the second uses the 10-year moving average of earnings per share to give a clearer picture of how expensive stock prices are.)
This does not mean a bear market is assured but is far more probable than when these indicators show undervaluation or fair valuation. These are not timing tools. However, they are at levels that have only been higher before the dot-com crash at the turn of the century. These indicators, in the past, have always preceded a multiyear period of poor real equity returns. I doubt if it will be any different this time.
The solid but boring returns promised by bonds over the longer term are therefore looking all the more attractive given the overpriced equity markets. If there is a major selloff in stocks, there will be a flight to quality investments in favour of long-term bonds.
That’s not to say bond markets don’t face some serious headwinds of their own. Although growth in the U.S. has been strong, federal deficits in the past few years have been at levels only previously seen during recessions. The U.S. federal debt-to-GDP ratio has ballooned to 120 per cent and shows no sign of reversing, let alone stabilizing. Interest payments have increased substantially owing to higher rates, and military spending will likely increase given the dangerous state of the world. Neither presidential candidate has indicated any concern about the debt in their campaigns.
Investors, especially foreign investors, may become reluctant to finance America’s ever-increasing debt. The so-called BRICS countries are looking for alternatives to the U.S. dollar as the U.S. government, regardless of which party is in power, has weaponized the currency and used it to punish those nations, institutions and individuals who fail to comply with the U.S.
This strategy of financial warfare is risky and only time will tell what the eventual results will be. One day, the U.S. may have a failed bond auction – whereby the Treasury doesn’t have enough bidders to take all the debt it is trying to sell – which will panic the market as investors tire of financing an ever-increasing U.S. debt burden.
Nevertheless, long-term government bonds are good value despite the risks. Just don’t expect double-digit returns and keep your eye on the uncertain international political situation. I also suggest underweighting corporate bonds in your portfolio, as the spreads on U.S. corporates – the extra yield investors are compensated with relative to safer government issues – are at 17-year lows.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.