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Business Briefing The 40-year-old virgin: When you’ve never experienced a bear market in bonds

Briefing highlights

  • Whither the bond market
  • Markets at a glance
  • What U.S. inflation could signal
  • What to expect on home prices
  • Big U.S. bank results on tap
  • IMF cuts growth forecasts
  • Housing starts slow in September

The bond sell-off

Douglas Porter warns that the long-running bull market in bonds has never been "seriously challenged" until now.

And there could be wide ripples from what Bank of Montreal's chief economist suggests may become the first bear market in almost 40 years.

FIRST, THE HISTORY

As Mr. Porter documented, yields on longer-term government bonds peaked in late September of 1981, at 15.84 per cent for the 10-year U.S Treasury and 18.14 per cent for Canadian paper of at least 10 years.

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Yields have since come down markedly, of course, moving inversely to prices. And "while it would be an exaggeration to say that the bond bull has been consistently charging through that entire period, anyone now in their 38th year would have never experienced a true bear market in bonds," Mr. Porter said.

(For the record, Mr. Porter did not reference The 40-Year-Old Virgin, the 2005 movie starring Steve Carell as that hapless fellow. He did, however, title his report “38 years old, never kissed a bond bear.”)

There have been several bouts of selling over the past few decades, with big spikes in yields.

"But the mega downtrend was never seriously challenged. Until now," Mr. Porter noted.

"It’s been highly dangerous to declare the bond bull dead for decades now, with many pundits humbled by prematurely opining on its demise," he added.

"But the sustained nature of the backup from the record lows of two years ago, and the clear risk of more, makes this episode different."

Which brings us to last week, when the yield on the 10-Treasury spiked to as high as 3.25 per cent, the steepest since around mid-2011, amid a wave of selling that drove up global yields and, thus, borrowing costs.

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As Mr. Porter noted, Canada experienced one of the steepest climbs, a move that actually began more than a week ago when trade tensions between Washington and Ottawa eased as they replaced the old North American free-trade agreement with the proposed United States-Mexico-Canada-Agreement.

(That, of course, has become known simply as the USMCA, which, since the deal was struck, has given everyone a Village People ear worm and prompted economists to have some sport with lyrics and dance moves from Y.M.C.A.)

“The USMCA deal sparked the initial selling wave – washing away the biggest source of uncertainty for Canada, and thus ramping up [Bank of Canada] tightening odds across the board – but the Treasury sell-off piled on,” Mr. Porter said.

According to John Normand, JPMorgan Chase head of cross-asset fundamental strategy, the 10-year Treasury yield now appears to be almost one-quarter of a percentage point “high relative to fair value, the largest divergence since late 2016.”

What’s happening here is what JPMorgan referred to as “the ongoing reality of U.S. exceptionalism” as the American economy forges ahead.

“There may have been some post-month-end technicalities exacerbating the impulsiveness of the U.S. rates moves mid-week ... but the ongoing grind higher in U.S. yields, absolutely and versus the rest of the world, reflects the ongoing and surprising strength of the U.S. economy, and its exceptional nature versus the rest of world,” JPMorgan global foreign exchange strategist Daniel Hui and his colleagues, Paul Meggyesi and Patrick Locke, said in a report.

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For Canada, there are additional factors, including the new trade deal, approval of a massive liquefied natural gas project on the west coast, a solid jobs market, an oil price rally, though with a gap between U.S. and Canadian benchmarks, and the first trade surplus since late 2016.

Thus, "it’s increasingly tough to justify the meaty U.S.-Canada bond yield spreads," Mr Porter said, citing the big difference between yields for longer-term paper in the two countries.

“While a better fiscal position can partly support that gap, we believe the trend will be toward a narrower spread over the next year – in other words, Canada is now looking to venture much deeper into bear country.”

NOW, THE IMPACT

We've seen the fallout from these steeper borrowing costs, notably last week's hit to stock prices and, for Canadians, the rise in mortgage rates, which are tied to the yield on five-year Canadian government bonds.

Driving home the point last week, as well, were telling comments from Federal Reserve chairman Jerome Powell, who suggested higher interest rates from the U.S. central bank.

"The sharp rise in Treasury yields in recent days therefore isn’t much of a surprise and, although the 10-year yield is now close to our end-year forecast of 3.25 per cent, it’s not inconceivable that yields rise even further in the near term," said Andrew Hunter, U.S. economist at Capital Economics.

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"But that would only reinforce our belief that the current strength of the economy won’t be sustained," he added.

"The surge in real market rates already seen is feeding through to higher borrowing costs for households and firms, and we suspect that rates aren’t as far from neutral as Jerome Powell apparently believes. We still expect that, as the boost from fiscal stimulus fades and rising borrowing costs start to weigh more heavily on rate-sensitive activity, an economic slowdown next year will force the Fed to end the current tightening cycle sooner than officials anticipate."

Citigroup, in turn, suggested something different, with the impact spreading beyond the U.S.

"We have long argued that the U.S. economy does not appear particularly sensitive to higher interest rates from a real economy and debt sustainability perspective," Citi analysts said. "But higher U.S. real rates may still aggravate financial fragilities in the more vulnerable parts of the world economy."

As for stocks, remember that analysts have been questioning the high prices, regardless. What this does is add some fuel to that.

"Indeed, the spread between the forward earnings yield on the S&P 500 and the 10-year Treasury yield has now compressed to the lowest level since we were emerging from the financial crisis, and more than a full percentage point below the five-year average," said BMO senior economist Robert Kavcic.

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"On the surface, that argues for some caution as stocks become more expensive relative to their risk-free alternative. However, a few factors could ease the concern."

For one thing, expectations for corporate earnings have surged, which "has helped limit the deterioration in relative valuations that we would otherwise see with yields jumping 100 basis points in a year," Mr. Kavcic said.

Remember, too, that markets are following "very favourable" stock valuations since the recession, he added.

“Finally, although most stand-alone equity valuation metrics are stretched, this could as much reflect what’s happening on the yield side of the equation – that is, Treasuries becoming less overvalued as monetary policy normalizes.”

While we wait and watch for where stocks head, there's also the impact on Canada's fragile housing markets to consider.

Juggling the costs of owning a home is already a huge issue, while most markets are climbing out of a slump sparked by new mortgage-qualification rules and measures to cool inflated prices in British Columbia and Ontario.

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And now the rise in yields.

As columnist Robert McLister reports, many lenders raised their rates, though not the major Canadian banks.

Source: Capital Economics

"Unfortunately, those moves could have negative consequences for the housing market," said Stephen Brown, senior Canada economist at Capital Economics.

"Mortgage rates are determined in large part by broader financial conditions, so if the recent rises in bond yields are sustained then mortgage rates will probably head higher, too."

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Markets at a glance

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Aurora to list on NYSE

With just over a week to go before marijuana becomes legal in Canada, Aurora Cannabis Inc. is heading for the New York Stock Exchange.

Aurora filed for a listing, it said today, and expects to begin trading by the end of the month.

Aurora’s move is the latest as the industry grows.

“Through our NYSE listing, Aurora joins an established group of mature global brands with improved access and exposure to an engaged international institutional audience,” chief executive officer Terry Booth said in a statement.

What to watch for this week

Markets will be watching for the latest inflation report from the U.S., especially after the rise in bond yields.

"So far, the move higher has been largely in real yields," said Citigroup strategist Andrew Hollenhorst.

Which makes Thursday's report on September inflation "particularly important, as an upside surprise could move yields higher by driving up inflation expectations," he added.

An upside surprise would mean something hotter than what economists expect the report to show, that consumer prices rose 0.2 per cent from August, with annual inflation easing to 2.4 per cent.

"Although growth indicators continue to suggest another hot quarter, underlying inflationary pressures still appear relatively contained and shouldn’t lead the Fed to accelerate its rate-hiking cycle," said Katherine Judge of CIBC World Markets.

Here's what else to watch for this week:

WEDNESDAY

Watch for the second construction report of the week, when Statistics Canada releases a report expected to show the value of building permits rose 2 per cent in August from July.

THURSDAY

Watch for China's September trade numbers. That's what President Donald Trump will be doing.

"Trade figures for September are due toward the end of the week, and the September hits will inform reactions to tariffs, though it may still be early to expect such influences given supply chain lags," said Derek Holt, Bank of Nova Scotia's head of capital markets economics.

FRIDAY

A big day, this, as major U.S. banks begin reporting quarterly results, with Citigroup Inc., JPMorgan Chase and Wells Fargo & Co. on tap.

Those results will be "teasers to the following week’s earnings deluge," Mr. Holt said.

"If the usual pattern whereby earnings wind up beating expectations holds, then perhaps that will drive renewed [market] stability as the full season is being digested," he added.

The Teranet-National Bank home price index reading for September will also be released, and could mark something of a milestone, according to Mr. Brown at Capital Economics.

He expects the report to show Canadian home prices gained 2.5 per cent from a year earlier, showing that home price inflation rose for the first time in 15 months.

But "it seems unlikely that that will mark the start of a sustained pickup in house price inflation," Mr. Brown said.

"While home sales have stabilized in Toronto, they continue to fall sharply in Vancouver," he added.

"As a result, the sales-to-new listing ratio now points to outright declines in Vancouver house prices ... That is likely to offset moderately positive house price inflation in the larger Toronto market."

And with just a few days to go before marijuana becomes legal in Canada, watch for quarterly results from Aphria Inc.

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