bonds-high-yield

What a difference a year makes.

Not long ago, investors were asking how low rates could go. Now, with most central banks in neutral or tightening mode, investors are asking the opposite.

Despite action from central banks, long-term bond yields are so far unimpressive.

“The significant change in tone by several central banks has had little impact on the financial markets,” says senior economist Mathieu D’Anjou in a Desjardins economics report. “Even in the United States, where the Fed raised its key rates by 1%, the 10-year yield is staying near 2%.”

The problem is real yields are low, with the real 10-year yield “hovering at around 0.50%, which is a far cry from the yields of 2% or higher commonly seen in the early 2000s,” says the report. “After rebounding into positive territory in late 2013, real 10-year yields have not shown an upward trend since the Fed began its key rate hikes in December 2015.”

As short-term yields rise, however, long-term yields should eventually follow suite.

“It would not be logical for lenders to accept a lower real yield on 10-year bonds than on one-year bonds, unless they are counting on an imminent recession,” says the report.

Over the past year, the yield curve flattened significantly — an unsustainable trend, particularly since the supply of U.S. bonds is abundant.

“In addition, the Fed’s estimates show that the term premium on a 10‐year bond, which reflects the part of the bond yield that cannot be explained by anticipations over short-term rates, is already negative, and an additional drop would be surprising,” says the report.

Read: Interest rate sensitives that still make sense

Monetary policy outlook

To assess the future of monetary policy, the report discusses the theoretical concept of the neutral rate, defined as the rate that maintains an economy operating at its full capacity, as well as maintains inflation at the level targeted by the central bank once cyclical influences have dissipated.

The neutral rate thus indicates when central banks should end monetary tightening.

While there’s uncertainty surrounding the exact value of neutral rates, “the weight of evidence suggests that they are at least 2.5% in nominal terms,” says the report.

At that value, assuming economic growth and inflation both rise as expected, the Fed and BoC can “continue to gradually raise their key rates in the coming quarters without worrying about implementing a contractionary monetary policy.”

Read: What Canada’s hot streak means for interest rates

That means “a significant increase in long‐term bond yields in the next few quarters.”

Read the full Desjardins report.

Also read:

Get choosy with U.S. consumer stocks

Rate hikes don’t demand fixed-rate mortgages

Originally published on Advisor.ca
Add a comment

Have your say on this topic! Comments are moderated and may be edited or removed by
site admin as per our Comment Policy. Thanks!