The global bond market has effectively undergone a full-blown crash. How it recovers may very well shed light on the prowess of those that govern us.
Since mid-2020, the 10-year Canadian government bond has seen yields explode from 0.50 per cent to 3.31 per cent. Almost no one involved in the bond market has experienced such a dramatic rise over such a short amount of time.
Over much of that period, Canadian bond yields have risen in sync with U.S. Treasuries. But lately, that’s starting to change.
As much as Canada’s 10-year yields have increased, U.S. Treasury 10-year yields have risen even more, to 3.97 per cent. They’ve been rising at a faster pace than Canada’s ever since equity markets peaked earlier this year.
Since prices move inversely to yields, that means on the surface that investors have been losing more money with U.S. bonds than Canadian equivalents. These investors should curb their enthusiasm over Canadian outperformance – because currency movements often play a big role, too.
Often in the global bond market, the relative outperformance of one country’s bond market seems to coincide in a relative underperformance of its currency. That indeed has happened. Since mid-January, the Canadian dollar has lost more than 8 per cent of its value against the greenback, which has also outperformed the euro and the yen. Once you factor that into the equation, 10-year Canadas have actually underperformed the U.S. when currency is taken into account.
An opportunistic, but inexperienced, market participant might be tempted to just assume that they can simply hedge the currency risk if need be. The problem with this strategy is that hedging has an actual cost. This makes sense because if hedging currency risk was free, traders would merely buy higher yielding sovereign bonds, short sell lower yielding issuers and achieve a risk-free return that they could lever upon. There is no such thing as a free lunch.
Interest rate spreads and currency cross rates are related. In effect, rate spreads are to some extent influenced by the weighted average forecast that the market makes on future currency prices. In theory, the income and price performance of the bond should be offset by the change in the value of the currency. But despite the insistence of many market participants, both interest rate spreads and currency moves are notoriously difficult to forecast. Spreads can also be quite volatile.
The recent surge in the U.S. dollar against major currencies is simple to understand. Interest rates in the United States are generally higher than in Canada and Europe, and that attracts money flows to the currency. Meanwhile, given the war in Ukraine and energy supply issues in Europe, the U.S. seems to be an island of relative certainty.
But Canada may be playing a role in its currency’s underperformance versus the greenback as well. That can be partly explained by our government’s quickly deteriorating debt situation. Perhaps it might also have something to do with the loss of Canada’s reputation as a quiet, common-sense country. Consider that the trucker convoy earlier this year made headlines across the globe and sparked criticism of the Trudeau government’s handling of it.
Over the longer run, the fiscal situation of a country counts in the currency and credit markets. Sovereign bonds that are perceived as higher credit risk trade at higher relative yields, much in the same way as high yield corporate debt trades higher in yield than those of governments.
This provides a real opportunity. Traders that correctly anticipate either the deterioration of a country’s credit quality or its improvement can reap benefits. Canada is a textbook example of this. In the late 1960s, the Canadian government went on a spending spree. Eventually, in early 2002, the Canadian dollar traded as low as 62 US cents. Investors demanded higher relative yields.
Many readers will remember the early 1990s when Canada was seemingly in a debt crisis. Although it is debatable how close we were to not being able to pay our debts, international market participants were worried. I remember going to conferences and being asked about Canada’s apparent deterioration.
During that decade, Canada underwent an austerity program under then-finance-minister Paul Martin. Although the Canadian economy struggled and the real disposable income gains of Canadians lagged those of Americans, our fiscal situation improved dramatically as our debt-to-GDP ratio fell. International bond investors who were astute enough to see this shift benefited by both the loonie rising and the Canadian bond market declining in yields by more than most industrialized countries.
What can we learn from all this? First, forecasting all-in bond returns of different industrialized sovereigns is enormously difficult. Anyone can have a prediction. Few are right often enough to make consistent money on it. Two, over the long run, economic management counts. The current situation appears uncertain given the volatility of our world since early 2020. For the first time in my more than four decades of following markets, many market players are even expressing doubts about the inflation or the GDP figures provided by governments. For instance, inflation seemed to be rising much faster in real life than official government numbers tended to suggest. Methodologies behind the statistics have been questioned.
The only thing we might be able to discern from the past is that countries that get their houses in order will see their unhedged bonds outperform those that do not. Determining which countries will get this right is difficult.
The particularly worrisome part: The difference between now and the 1990s is that many countries – not just Canada – are seeing their government debt levels explode.
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.