Shortly after 2 p.m. one day in September, in a men's locker room at a Bay Street gym, the half-dozen patrons in one aisle all stop towelling themselves off and stare at the TV. Are they glued to a sports channel showing highlights from last night's baseball games? A Beyoncé video? No, it's all about bonds. Some nebbishes on CNBC are jabbering excitedly about an announcement released minutes earlier by the U.S. Federal Reserve's Open Market Committee-a decision to keep its benchmark federal funds rate near historic lows of between 0% and 0.25%.
And that means bond action, baby, big time. Monthly releases of key economic statistics by government agencies, and interest rate decisions by central banks, are the lifeblood of the bond market. Those numbers give traders around the world clues about where economies and interest rates are headed. It's why they obsess about things like the "nonfarm payrolls"-the total of jobs gained or lost in nonfarm sectors of the U.S. economy, which is in the employment report released every month by the U.S. Labor Department.
Right now the stakes are higher than ever, because bonds appear to be in a bubble. After the worldwide stock market crash of 2008, investors began stampeding into bonds.
Bond prices and yields are inversely related-if investors bid up the price of a two-year bond with a 5% interest coupon from its face value of $100 to $104, its yield to maturity drops below 3% a year, because interest is paid on the face value. Bond markets are so frothy that two-year Government of Canada (GofC) bonds now yield less than 1.5%, and two-year U.S. Treasury bonds yield less than 0.5%. The mid-1950s was the last time the yields on U.S. government bonds were as low as they have been of late. Yields on corporate bonds-which are riskier than government issues-are only slightly higher.
How long will the bubble last? Jim Byrd, a managing director of RBC Capital Markets who's in charge of its team of GofC bond traders and analysts, says it could go on for quite a while, mostly because the U.S. Federal Reserve is buying huge amounts of bonds and keeping interest rates near zero. But the team can't settle in and relax for the long haul. They have to respond to shifts in prices and yields minute-by-minute.
To see how it all works, Report on Business magazine visited RBC's bond and currency traders on the morning of Oct. 19, the day of an interest rate announcement by the Bank of Canada. Here are scenes from a market near its peak.
THE PREGAME RBC's traders and analysts arrive at work each day before 7 a.m. The Bank of Canada issues rate announcements eight times a year. On those days, Mark Chandler, RBC's head of research for Canadian bonds and currency, provides instant analysis of the Bank's decision when it's released at 9. A few minutes before then on Oct. 19, he looks completely relaxed. "These guys are the rock stars," he says of the traders. "I'm just the roadie." Chandler says the traders will want him to write a report and send it to RBC's major bond clients-large pension funds, mutual funds and the like-within "about three seconds" of the announcement. "But I like to think about it for a few minutes."
Besides, like almost every other analyst and trader on Bay Street, Chandler has already predicted that the Bank will keep its benchmark overnight rate at 1% today. Analysts and traders pretty much have to call rate decisions correctly days or even weeks in advance. RBC traders say that the last time the Bank really surprised the market was August, 1998, when an unscheduled announcement jacked up rates by a percentage point amidst a global currency crisis. Frank Salmonds, an RBC managing director, quips that if the Bank raises rates this morning, "you'd find our bodies under our desks."
Everyone also knows the policy dilemmas that Bank of Canada Governor Mark Carney is facing. Like the U.S. Federal Reserve, the Bank of Canada slashed its benchmark rates to practically zero in late 2008 and early 2009 to try to help ward off a depression. But Washington and Ottawa also started running huge budget deficits, and the combination of low rates and big deficits often leads to inflation. Last spring, Carney began talking about the need to ease rates back up to contain inflationary pressures. And from June to September, he hiked the Bank's overnight rate from 0.25% to 1%.
But investors have continued to push GofC bond prices up and yields lower, figuring that economic recoveries in both the United States and Canada are sputtering, and deflation is more of a danger than inflation. Does Carney want to risk choking off a recovery with another rate hike?
PARSING CARNEY Central bankers like the Bank of Canada's Mark Carney speak their own convoluted language in official statements, because they don't want to create panic-or euphoria-in financial markets. The governor's deliberately arcane wording has to be decoded by analysts at banks and investment dealers.
When the Bank of Canada issued its interest rate announcement at 9 a.m. on Oct. 19-keeping its benchmark overnight rate at 1%- RBC research point man Mark Chandler wrote and issued a report to RBC's traders and major clients within 20 minutes. Here's how it went.
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WHAT THE BANK OF CANADA SAID |
HOW RBC INTERPRETED IT |
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"The global economic recovery is entering a new phase. In advanced economies, temporary factors supporting growth in 2010-such as the inventory cycle and pent-up demand-have largely run their course and fiscal stimulus will shift to fiscal consolidation." |
"We would characterize today's statement as considerably dovish in tone compared to the previous one in September," said RBC's Chandler. The tone of the statement is as important as the Bank's actual rate decision. In September (when the Bank raised interest rates a quarter point), it said an economic recovery was proceeding and that financial conditions remain "exceptionally stimulative." To Chandler, that was a sign of a "tightening bias," meaning that the Bank was ready to keep raising rates to choke off potential inflation. October's statement dwells more on signs of economic weakness. |
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"A weaker-than-projected recovery in the United States.…Heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery." |
"As expected, there was some concern expressed at both the strength of the Canadian dollar and the expected uneven growth in the U.S. economy," said Chandler. The upshot: Canadian exports could suffer because of weak U.S. demand and a strong loonie, while other countries try to devalue their currencies to make their exports cheaper." |
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"The Bank expects…growth of 3.0% in 2010, 2.3% in 2011 and 2.6% in 2012." |
"The statement captures downward revisions to the Bank's growth forecast from the last official release [in July]" noted Chandler. And they're hefty reductions. |
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"The Bank judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012, rather than the beginning of that year." |
"Importantly, [the statement]also pushes the expected time until the economy reaches full capacity out to 'the end of 2012' from an earlier estimate of 'the end of 2011,'" Chandler wrote in boldface type. This was the big news of the day: the persistence of what economists call the output gap-the difference between what Canada's economy would produce at full capacity, and what it's producing now. If the gap lasts until the end of 2012, there's less risk of inflation until then. |
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"This leaves considerable monetary stimulus in place, consistent with achieving the 2% inflation target." |
"It is possible that a resumption of tightening in March is still in the cards, but the data would have to convince the Bank of Canada to upgrade current forecasts," said Chandler. The Bank is keeping rates low to stimulate the economy, and there's little risk this will heat up the economy enough to raise core inflation to 2%. |
WHAT'S A YIELD CURVE Traders and analysts talk a lot about bond yield curves. So do economists and policy makers, who like their yield curves "upward-sloping"-a sign of a healthy economy. An "inverted yield curve" is scary-it usually means a recession is coming.
A yield curve is a chart of bond yields, with the bonds of shortest duration on the left, and the longest on the right. A full Government of Canada bond curve starts with issues due to mature within 30, 60 and 90 days, all the way out to 30-year bonds on the right. Traders and investors will also compare the GofC bond yield curve with those for U.S. Treasuries and corporate bond indexes.
In normal times, you'd expect short-term yields to be lower than long-term ones. If investors are going to hold a bond for 20 years, they'll want a higher yield than for a one-year bond, to compensate them for greater uncertainty and possible inflation. That's why yield curves tend to slope up to the right.
Interest rate decisions by central banks affect the yield curve, but the impact tends to be greater at the short end (five-year bonds or less) than the long end, which is guided more by investors' assumptions about long-term economic growth and inflation.
One risk Bank of Canada Governor Mark Carney faced before the Bank of Canada's Oct. 19 rate decision is that, if he kept increasing rates in a weak economy, he could eventually invert the yield curve-yank up short-term rates higher than long-term ones-and choke off borrowing and spending by consumers and businesses.
THE EXTREMELY HIGH-TECH/ODDLY ARCHAIC BUSINESS OF BOND TRADING There's no shortage of gadgets on a bond trader's desk. RBC's Jim Byrd and his traders each have five computer screens. Two of Byrd's screens display data from Canadian and U.S. bond brokers. One has current prices for all outstanding Government of Canada issues. One has numerical spreads that Byrd likes to follow-differences between, say, two-, five- and 10-year GofCs, comparisons with U.S. Treasuries, and so on. The fifth is a screen with a feed from Bloomberg financial news. Byrd also has a speaker with links to four inter-dealer trading services for Canadian bonds. A voice reads out prices continuously, like a taxi dispatcher.
Despite all that computer firepower, bond markets are archaic compared to those for currency and stocks. There is still no real central and transparent electronic bond market in Canada for retail customers. Until the 1990s, bonds were traded almost exclusively by phone-investors who wanted to buy or sell might call three or four dealers to get price quotes. In 2001, Canada's major investment dealers created CanDeal, an electronic market for GofC bonds and other securities, and the TMX Group now has a stake. But Byrd estimates that about half of all bond trading is still done by phone.
Because all bids, offers and executed trades aren't fed into a central market immediately, trading bonds can be more difficult than trading stocks or currencies. A typical GofC bond order for an institution would be, say, $30 million. On Bank of Canada rate announcement days, big dealers often lay in inventories of billions of dollars worth of GofCs, as RBC did on the morning of Oct. 19.
But if prices and yields are moving fast, it can be hard to get a handle on what's going on. Oct. 19 begins pretty much as predicted. Investors start buying GofC bonds right after the rate announcement at 9 a.m., and yields dip across the yield curve (see "What's a yield curve?" page 53). But shortly after 10, yields start going back up. The curve is also behaving oddly: The initial dip in five-year GofCs was bigger than that for two-years and three-years. Normally, you'd expect the shorter the duration, the bigger the drop.
Traders are fuming. Some (as shocking as this may sound) are using four-letter words. "Won't someone buy my bonds?" moans Byrd, his face flushing. Much of the wailing is just kidding around-a way for the traders to blow off steam. But some of it's genuine.
What next? Will the market resume pushing yields lower? Should RBC do some buying to try to get some momentum going? Traders yell across the aisle to RBC's institutional sales reps for bonds, who are on their phones to clients. Byrd blurts out things like, "If the fives are down to 38, we'll take 10 there."
By 11 a.m., yields across the GofC curve have resumed drifting down, and they finish modestly lower at the close of the trading day at 5:25 p.m. In a market that's often opaque from minute to minute, the RBC traders' instincts have turned out to be correct. Most of the market action is over by lunchtime. "Volumes were light at about $5.5 billion," says Byrd. "We were actually busier the day before and traded around $7 billion."
A Bank of Canada interest rate announcement isn't as big a deal in the corporate bond market as it is in the Government of Canada bond market. Before the 9 a.m. announcement on Oct. 19, Steve Thom, RBC's managing director in charge of Canadian corporate bond trading, says that 10% of what will happen to Canadian corporate issues that day will be a response to the rate decision, "and 90% will depend on other stuff"-U.S. stock and bond markets, central bank moves in other major countries, and so on.
The overriding issue in corporate markets is credit quality. Bond investors must constantly assess the creditworthiness of companies. True, they also monitor the spread between corporate bond yields and the typically lower yields on government bonds of the same durations. Over the past year or so, investor demand for even junk bonds (ones graded very low by bond rating agencies) has pushed yields on them down to within a few percentage points of yields on government bonds.
On the morning of Oct. 19, Bank of America and other large U.S. banks post stronger-than-expected third-quarter earnings. Early that morning, however, there is a surprise quarter-point interest-rate increase by the Bank of China. Stocks open sharply lower in New York because of fears that China may trigger a global economic downturn. Yet, Thom says, U.S. corporate bonds "are doing okay." When stocks slide, investors often look to quality short-term corporate bonds instead.
The Bank of Canada's decision to not increase rates also helps Canadian companies. Any firm thinking of issuing bonds won't have to offer investors very high yields. On the morning of Oct. 19, there are rumours in the market that a major Canadian bank is about to issue bonds. The rumours by themselves cool demand for GofC bonds, because investors in search of a slightly higher yield may buy bank bonds instead. As things turn out, CIBC issues $1.5 billion worth of bonds the following day, which also sees issues from Brookfield Asset Management ($350 million) and First Capital Realty ($50 million). Thanks for that, Mr. Carney.
A BOND FOR EVERY SEASON
RSP Season: January to March Banks, investment dealers and mutual funds get huge inflows of cash in the run-up to the annual March 1 tax deadline for RSP contributions. They usually park that money in Treasury bills (30, 90, 180 or 360 days) and bonds with relatively short durations (one, two or five years). Those issues offer safety and a small return while money managers decide where to invest more permanently.
Mortgage Season: late March to early July Home sales tend to peak near the end of the school year. Banks typically give prospective homebuyers a 120-day commitment for a maximum mortgage size and an interest rate. To cover part of those commitments, banks will often sell five-year GofC bonds. This generates cash that they can lend. The bulk of mortgage loans have five-year terms. When the actual loans come on the banks' balance sheets (remembering that loans are assets for a bank), they have essentially traded one asset with a five-year term for another that they expect will earn a higher return.
Rollover Days: June 1 and Dec. 1 About 80% of GofC bond issues currently outstanding pay interest on June 1 or Dec. 1 each year, and they will mature on one of these dates. Investors typically use the cash they receive to buy more bonds. About $6.5 billion worth of coupons will come due this Dec. 1 and next June 1, and the value of bonds maturing will be $7.3 billion on Dec. 1 and $15.8 billion on June 1. But it's hard for traders to predict where the rollover money will go-investors don't necessarily buy bonds of the same duration as the ones they had.
BUT WHAT ABOUT THE DOLLAR? If foreigners buy Government of Canada bonds denominated in Canadian dollars, any swings in the value of the dollar will directly affect their returns. This is one of many reasons why the Bank of Canada is concerned about the dollar when it makes interest rate decisions. But currency markets are huge and trade electronically 24 hours a day around the globe, so the dollar can get knocked around by a lot of other influences besides the Bank's decisions.
Oct. 19 provides a good example: The Bank of China's surprise decision to raise its rates by a quarter-point comes at 7 a.m. Eastern time; the euro and the U.S. dollar jump immediately. Analysts and traders take the hike as a sign that China might relent in its strategy of keeping the value of the yuan low, which has helped it rack up huge trade surpluses with the United States and the European Union.
The Canadian dollar is hammered quickly, too. By 9 a.m., when the Bank of Canada announces its decision to stand pat on interest rates, the dollar is down more than a cent and a half relative to the greenback. But only about a third of that decline comes immediately after the Bank of Canada news; the rest is China's work. Wayne Baker, RBC's global head of trading the Canadian dollar, figures the market absorbed that decision in about two minutes. "Not even that," he says with a grin. "Probably two seconds."
HOW LONG CAN THE BOND BUBBLE LAST? The short answer is: as long as the U.S. Federal Reserve can keep printing money. On Nov. 3, the Fed announced that it will spend $600 billion (about $75 million a month) over the next eight months to buy long-term U.S. Treasury bonds. It's called "quantitative easing," a practice central banks occasionally use to pump-prime a stalled economy. The Fed buys the bonds from commercial banks, thereby filling the banks' coffers with cash. The idea is that they'll lend out that money at low interest rates, and that will give the U.S. economy a lift. The Fed has already spent $1.75 trillion buying Treasuries and government-backed mortgage bonds since early 2009, a tsunami of cash that's helped to push down bond yields worldwide.
Do bond traders worry that the bubble will burst? Stealing a bon mot from Alan Greenspan: yes and no. "Too much cash in the system before 2000 contributed to the run-up and crash of the tech market in 2000, and interest rates held too low for too long were a factor in the credit crisis [of 2007-'08]" says RBC's Byrd. But Fed chairman Ben Bernanke is worried about a double-dip recession. "It's a bubble that's here to stay in the short-to-medium term," says Byrd. "Does it change our day-to-day activities? No, but it's something to be cognizant of at all times." U.S. Treasury yields remain near historic lows. When the Fed does start to pull back, that will be a dramatic day on world bond markets indeed.