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Monday, May 7, 2018

Is the complacency in the bond market really over?

By Norm Arychuk (Toronto, Debt Capital Markets Group)

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.)

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