Andrew Pyle
August 18, 2023
Yield Spike Creates Value in Bonds
A couple of weeks ago, I discussed how stocks were becoming overvalued on a number of fronts, including the gap between dividend yields and higher yields on bonds. Despite the fact that there has been a chorus of economists proclaiming victory on inflation after a couple of reports, the reality is that central banks are not budging on their mission to wrestle it down to target. Add in some additional signs that consumers are also not budging from their spending ways and you have a recipe for even higher yields. Not only are short-dated government bond yields approaching their recent highs, but long-term yields have blown through even the highs from last fall.
South of the border, the 2yr treasury yield has pushed back up towards the 5% level after a brief rally at the start of the month. As of Thursday’s close, we were just a tenth of a percentage point from the 5.07% high in early March. The benchmark long bond has sold for six straight sessions and crossed 4.40% on an intraday basis Thursday – the first time we have been here since 2011. It closed at 4.3877%, a hair above the closing high back last October. This time last year, the 30yr was trading at just over 3.09% and at the start of the pandemic we were down close to 1%.
The Government of Canada bond market has deteriorated in sympathy with the U.S., though the 2yr yield has been capped at around 4.80% for the time being. And, while the 30yr eased back slightly on Thursday, it had just tested above 3.60% for the first time since last November. Last October’s peak of 3.70% was also the highest since 2011.
Investors are to be excused if they feel a little bewildered here. After all, if there has been so much progress in bringing inflation down, why then are bond yields rising? The problem is that the North American economy has not fallen into the recession that many forecasters predicted as we came into 2023. In January, the consensus real GDP growth forecast for 2023, tabulated by Bloomberg, was just 0.2%. This month, the consensus has moved up to 1.6%. For Canada, the 2023 consensus call on GDP has also risen from about half a percent in January to 1.5%. These predictions are definitely not reflective of a booming economy, but they also don’t suggest enough slowing to permit inflation to keep dropping at the pace we have seen so far this year.
Without continued progress, central banks are committed to keeping official rates higher for longer. If rates stay high and the economy is buoyant, then investors are going to demand additional risk premium for holding a longer-term bond. This is more true today after the world has witnessed what can happen if you don’t match an appropriate risk premium to a longer-dated maturity. Recall the events from the Spring when a few U.S. banks experienced balance sheet implosion from the acute correction in long bonds that took place in 2022.
Some have gone so far as to say that we will never go back to the ultra-low yields of just a couple of years ago and that we should instead get used to long bond yields that are up in the 5% area. This is based on the view that inflation is going to have an upward bias that we haven’t seen for a while and that expanded debt levels will create a supply-demand imbalance in bonds. I would agree with the first point over the near-term, though we have learned to be careful about saying some things will “never” happen again. I do disagree with the second point though, as this assumes that we do not see a breakdown in economic activity, that pulls inflation lower and thus leads to official rates being brought down. The fact that we haven’t seen this breakdown yet doesn’t mean it isn’t in the works, as I discussed with respect to the consumer in last week’s newsletter – in particular, the greater than 50% growth in Canadian interest paid by households on debt.
The U.S. is in a slightly better position, mainly because homeowners were able to lock in very low mortgage rates for periods as long as 30 years; however, with the 30yr bullet mortgage rate now back to the 7.16% high we saw last year (which was the highest since 2001), pressure on homeowners is not insignificant by a long shot. The U.S. Mortgage Bankers Association publishes results from its loan application survey on a weekly basis, and the Purchase Index last week showed a further decline – approaching the low we saw at the end of February (144.8). We would have to go back to 1995 to find a lower level. And why would expect anything different? If you are sitting at home with a comfortably low mortgage rate, why go buy another house and lock in at a less comfortable one? This doesn’t necessarily imply that traditional housing indicators, like sales and prices, are going to experience a sharp drop, but for all the ancillary sectors that feed off of housing stock rotation, there are going to be some tough times ahead.
There is also likely to be a psychological effect from what is happening to rates. When things feel good and borrowing costs are low, individuals are going to more likely to take risk. That might mean risk in a portfolio, or simply the risk from making large-scale purchases. When the environment looks shaky and debt costs are running sharply higher, the reverse is true. People can become more defensive on both fronts and may even look to “risk” capital as a source of funds to reduce debt. Even at the margin, where someone may not feel compelled to liquidate investment or physical assets, they may choose to shift that capital into assets deemed safer, like bonds.
This is why we view these rebounds in bond yields as buying opportunities. The forces that some believe will propel yields even higher will eventually run into the opposing forces of risk reduction and economic slowdown (which itself can be a by-product of risk reduction as spending is curtailed in favour of reducing leverage). As clients know, we have slowly started to shift the fixed income portfolio away from an overweight position in corporate bonds and loans to Canadian government bonds. In so doing, we can also extend duration in the portfolio (move to a longer average maturity), based on these sharply higher long yields. Remember that when rates go up, longer-dated government bonds will lose more value than short-term ones, and vice versa.
The shift to Canadian government bonds, rather than U.S. treasuries is based on the fact that we see stiffer economic headwinds here than south of the border and, therefore, have greater confidence that bond prices can rise. You see, the pundits that claim there is ton of resilience among U.S. households aren’t wrong on a comparative basis. The above chart shows ratios of household debt to disposable income for both the U.S. and Canada. As you can see, the U.S. ratio has actually been declining since 2022, resuming the downward trend that started in the financial crisis. Even with a modest pullback in recent quarters, Canadian household debt is still more than 180% of disposable income, compared with less than 100% in the U.S. This would suggest that the economic pinch from higher rates will likely be more painful here than in the U.S., and require a faster pivot to rate cuts by the Bank of Canada. That should provide relatively better conditions for a bond rebound in Canada.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.