Bonds have an inverted relationship between price and yield. With interest rates and bond yields poised to
increase, bond prices will take a hit – the longer the maturity of the bond,
the larger the hit. A 10-year bond that
is subjected to a 2% increase in yield will suffer a 20% loss in value – not an
investment for the faint of heart in the current environment. Imagine if you were the manager of a major
bond fund like Pacific Investment Management Co. – arguably the world’s largest
actively managed bond fund at nearly $80 billion and over $1.4 trillion in
managed assets. What would your reaction
be to the current market conditions and the forecast of rising rates?
Inflation and interest rates are closely linked. The higher the inflation rate, the more
likely interest rates are to rise. The
U.S. Federal Reserve Bank (“the Fed”) has strongly signalled that further
multiple rate increases will be delivered this year and in 2019. Notwithstanding this clear sign and that rate
increases that have already been implemented, 10-year U.S. treasury bonds have
been volatile and have recently fallen to levels well off their February 2018
peak only to ocellate higher in April – volatility at its finest. The Fed and
bond market investors give the impression that they are at odds with their
respective views of the near term – someone appears to be wrong. It looks as though relatively lower yields in
the bond market are projecting bond investors sentiment that inflation and a
strong U.S. economy are not quite as worrisome as the Fed might have us
believe. The bond market is more than
just an economic indicator and it has been known to be dreadfully wrong – check
the 2007 – 2008 records.
Investors’ views and economic reality do not seem to be aligned at
present. Long term treasury yields are
slightly in excess of 3% and are nowhere near the Fed’s inflation target of 2%
plus the real economic growth of 2-3%.
Historically, long term interest rates tend to fluctuate around the rate
of nominal GDP growth. This rule of
thumb implies that 30-year rates should be in the 4-5% range – if inflation
were actually 2%. Sooner or later the
disconnect will align and the gap between bond yields and GDP growth will close
– either growth will weaken dramatically or interest rates will rise
significantly – place your bets.
(Norm Arychuk heads up
Avison Young’s debt capital markets group, specializing in debt placement of
all types.)
