A widely used market indicator is underscoring the potential for sharply higher Canadian bond yields in what would be positive news for bank stocks but a major headwind for utilities.
The copper-to-gold ratio – the price per tonne of copper divided by the bullion price – is a way to measure the balance between optimistic and pessimistic investors. Copper is a proxy for global manufacturing activity and the price reflects expectations for future economic growth to some extent. Gold is insurance well suited to pessimists, a hedge against currency devaluation or financial system calamity.
The copper/gold ratio has been highly correlated to domestic bond yields over time, as the first accompanying chart highlights. As the copper price rises against gold, this indicates a growing economy and an increase in inflation expectations that pushes longer-term bond yields higher.
Canada 10Y bond yield (%)
Copper-to-gold ratio (right scale)
3.0%
6.0
5.5
2.5
5.0
2.0
4.5
1.5
4.0
1.0
3.5
0.5
3.0
0
2.5
2017
2019
2016
2018
2020
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW;
BLOOMBERG
Canada 10Y bond yield (%)
Copper-to-gold ratio (right scale)
3.0%
6.0
5.5
2.5
5.0
2.0
4.5
1.5
4.0
1.0
3.5
0.5
3.0
0
2.5
2017
2019
2016
2018
2020
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
Copper-to-gold ratio (right scale)
Canada 10Y bond yield (%)
3.0%
6.0
5.5
2.5
5.0
2.0
4.5
1.5
4.0
1.0
3.5
0.5
3.0
0
2.5
2017
2019
2016
2018
2020
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
The copper/gold ratio signals that bond yields should be much higher, roughly double the current 0.75 per cent for the 10-year government of Canada bond. It is important, however, to recognize that the divergence on the chart can correct in two ways – the copper/gold ratio can fall or bond yields can climb.
The way in which the two lines on the chart narrow their current gap has important implications for equity returns. To illustrate, I’ll outline the likely sector implications for the scenario where bond yields rise.
The two major S&P/TSX Composite sectors with the closest connection to bond yields (according to correlation calculations) are banks and utilities.
The second chart compares the S&P/TSX Banks Index with the 10-year government of Canada bond yield. Bank stocks have tracked the bond yield relatively closely in the past five years with the notable exception of the 14 months leading up to the pandemic.
Canada 10Y bond yield (%)
S&P/TSX Banks Index (right scale)
3.0%
3,800
3,600
2.5
3,400
2.0
3,200
3,000
1.5
2,800
1.0
2,600
2,400
0.5
2,200
0
2,000
2017
2018
2019
2020
2016
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW;
BLOOMBERG
Canada 10Y bond yield (%)
S&P/TSX Banks Index (right scale)
3.0%
3,800
3,600
2.5
3,400
2.0
3,200
3,000
1.5
2,800
1.0
2,600
2,400
0.5
2,200
0
2,000
2017
2018
2019
2020
2016
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
S&P/TSX Banks Index (right scale)
Canada 10Y bond yield (%)
3.0%
3,800
3,600
2.5
3,400
2.0
3,200
3,000
1.5
2,800
1.0
2,600
2,400
0.5
2,200
0
2,000
2017
2018
2019
2020
2016
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
Lenders benefit from higher long term bond yields because they indicate a steeper yield curve (the difference between two-year and 10-year yields). A steeper curve increases profitability for banks, which borrow funds at short-term yields and charge clients higher, longer-term borrowing rates.
Interestingly, bank stocks appear to have priced in rising bond yields, climbing despite persistently low yields.
The third chart shows that while banks have a positive correlation to bond yields, utility stocks move in the opposite direction of rates. This is particularly evident during the two-year period after May, 2017. The S&P/TSX Utilities Index dropped and then staged a recovery while bond yields did exactly the reverse – rising and then falling.
The inverse correlation between utilities stocks and bond yields is easily explained. As risk-free bond yields climb, they become more attractive to investors relative to dividend-paying equity sectors.
Canada 10Y bond yield (%)
S&P/TSX Utilities Index (right scale)
3.0%
2,900
2,700
2.5
2,500
2.0
2,300
1.5
2,100
1.0
1,900
0.5
1,700
0
1,500
2018
2019
2020
2016
2017
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW;
BLOOMBERG
Canada 10Y bond yield (%)
S&P/TSX Utilities Index (right scale)
3.0%
2,900
2,700
2.5
2,500
2.0
2,300
1.5
2,100
1.0
1,900
0.5
1,700
0
1,500
2018
2019
2020
2016
2017
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
S&P/TSX Utilities Index (right scale)
Canada 10Y bond yield (%)
3.0%
2,900
2,700
2.5
2,500
2.0
2,300
1.5
2,100
1.0
1,900
0.5
1,700
0
1,500
2018
2019
2020
2016
2017
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
The new waves of the coronavirus in the Western world makes the copper/gold ratio even more important to follow in the weeks ahead. Weaker economic data, such as Thursday’s U.S. jobless claims that showed a greater-than-expected 853,000 in new applications, suggest a drop in copper prices, continued low bond yields and solid returns from utilities stocks. If, on the other hand, markets continue to focus on the postvaccine economic recovery, this means a higher copper/gold ratio and yields, benefiting banks.
My personal suspicion is that yields won’t spike for at least a few more months yet, as investors digest what will likely be some very soft economic data.
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Scott Barlow