The past month has been a tough one for bond investors. Signs that inflation is likely to linger for some time has sent the 10-year Government of Canada bond yield back to near its highest levels of the past 12 months. Since bond prices move inversely to yields, fixed-income investors believing losses were behind them after a disastrous 2022 have been taken by surprise.
But are yields set to reverse once more, making this an opportune time to buy bonds?
The yield curve inversion tells us that the market thinks it is, signalling that rates should soon resume their downtrend.
Yield curve inversions – the rather unnatural state when shorter-term bonds yield higher than longer-term ones – have historically been followed by significant bond rallies. This is especially true when an inversion is preceded by a significant increase in rates, just as it has this time around.
A yield curve inversion occurs as bond market participants collectively bet that longer-term rates will eventually decline to below present short-term rates. However, two significant factors are troubling.
One is that core inflation is not coming down as quickly or by as big a magnitude as many had hoped. The market is betting inflation will decline to levels still above the central bank target rate of 2 per cent, but this might not occur as quickly as hoped. The entire 1970s was characterized as a period where, after every economic downturn, inflation declined but to higher lows than expected.
Second, the economy is not yet imploding and the stock market is hanging tough. The flight from stocks to more conservative bonds has yet to occur.
Some historical context is needed. From early in the 1980s to 2008, bond yields were generously above levels of inflation at the time, yet inflation was slowing and we had solid economic growth. High spreads between bond yields and inflation did not appear to impede economic growth, contradicting the economic orthodoxy that existed in the 1960s until well into the 1980s. In fact, compared with our present circumstances, the 1982-to-2008 period seems like an economic golden era.
The spread between 10-year U.S. Treasuries and inflation peaked at almost 10 percentage points in 1982. This peak coincided with the long-term bull market we experienced until 2020. Between 1984 and 2000, the spread averaged about four percentage points. From 2000 to the financial crisis of 2008-09, this spread entered a range averaging about 2.5 percentage points. After that period, bond yields only averaged about a half-a-percentage-point spread until the COVID-19 lockdowns.
Bondholders seem to be less and less compensated for their interest rate risk after each economic downturn. This has benefited debtors, however, especially governments and large corporations, and caused soaring government debts. Corporations saw their effective cost of capital decline, which led an explosion of zombie companies – companies that aren’t earning enough to cover their expenses over an extended period.
Since 2019, we have been in a period where yields on bonds are below inflation, even after a savage bond bear market.
Given current yields, an inverted yield curve and declining inflation, the one- to two-year outlook for bonds is positive and presents a buying opportunity, especially if an overvalued stock market incurs a setback. However, longer term, the outlook may be less rosy. Government debt has exploded in many nations to the point that the stimulating effects of government debt and spending is losing effectiveness.
When debtors get into trouble they typically default, restructure or in the case of the government, allow inflation to eat away the real value of their debt. This is effectively what happened after the Second World War in the United States. From July, 1946, to the end of 1948, consumer prices rose by one-third while interest rates averaged about 1 per cent. Economic growth eventually soared and people accepted the loss of the value of their bonds since it was seen as a small price to win the war.
Ultimately, the question is whether interest rates will be kept at or below inflation by central banks. The purposeful setting of interest rates low relative to inflation is sometimes called financial repression. It is effectively the confiscation of the capital of savers over time in a manner that financial officials hope is unnoticed. Working in favour of the long-term bond investor is the fact that debts are so high, governments may be forced to pay investors higher rates as fundholders, pension funds and crucially, foreign investors and governments grow tired of earning low returns on depreciating currencies.
The long-term outlook for bonds will depend on the interest rate relative to inflation. Bonds will return to being solid, albeit unspectacular, investments if finance officials and central bankers begin displaying economic statesmanship. There is no guaranty of that but investors have time to observe and decide.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.
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