Well, that was fun, wasn’t it? The U.S. Federal Reserve’s announcement this past week of a quarter-percentage-point cut in its key interest rate managed to disappoint everyone: the stock market, the bond market and, of course, the twitterer-in-chief, Donald Trump.
But obsessing over one rate announcement risks obscuring the bigger question. It’s not where interest rates stand right now that really matters to Canadian and U.S. investors. It’s where rates will wind up over the next couple of years.
Some analysts now regard zero rates as a distinct possibility. Bob Michele, global head of fixed income at JPMorgan Asset Management, warned this past week in the Financial Times that yields on 10-year U.S. Treasury bonds – one of the key benchmarks in the global financial system – could be headed to zero. On Thursday, Jeremy Hale, a strategist at Citigroup, cautioned that the Fed is playing a “risky game” with interest rates and risks “chasing the market back towards the zero lower bound" if it continues to underwhelm traders’ expectations.
There are at least two good reasons to think that zero rates may be in the cards for North America.
One is the profusion of negative-yielding debt in other countries, from Germany to Japan. More than US$12-trillion worth of bonds around the world now pay their holders less than zero. By comparison, the modest but still positive rates available on U.S. and Canadian fixed-income investments look positively lush.
No wonder then that many international investors are voting with their feet. “Quite simply, the money is pouring into the U.S. bond market from overseas,” Mr. Michele writes. If this trend continues, foreign buying has the potential to drag U.S. bond yields – and probably Canadian yields, as well – down to the level of their international counterparts. (Bond yields and prices move inversely.)
A second reason to regard zero rates as a serious possibility is the growing threat of economic turbulence over the next couple of years. In a recession, central banks typically try to buffer their economies by chopping their key interest rates by four to five percentage points. Neither the Bank of Canada nor the Federal Reserve has that much room left to cut: Key rates stand at a mere 2.25 per cent in the United States and only 1.75 per cent in Canada. Even a mild downturn could force both banks to reduce their key rates to zero.
To be sure, a recession seems unlikely at the moment, especially in Canada, where the economy, if anything, appears to be picking up speed. The risks of a slowdown are real, though, especially as the trade war between the U.S. and China grows more heated by the day.
Making matters even more baffling, it’s not clear that interest rates would surge even if Washington and Beijing were to settle their differences. Inflation has been largely dormant in recent years in the developed world despite rock-bottom borrowing costs and falling unemployment. So long as inflation continues to be missing in action, it is difficult to make the case for raising interest rates.
Many money managers believe the Fed is cutting interest rates now to deliberately overheat the economy and stoke inflation. Once inflation climbs sufficiently high, it can then return to raising rates.
Maybe this strategy of short-term cuts to allow long-term hikes will work. Or maybe it won’t. Mr. Michele, for one, argues the danger is that central banks will fail to be aggressive enough. If they are too timid in chopping key rates, investors will come to expect further declines in inflation. If so, long-term yields in North America may well sink to the subzero levels common in Germany and Japan.
Not everyone agrees. Some worry the Fed has already gone too far by cutting once. Scott Minerd, the global chief investment officer at Guggenheim Partners, argues that lower interest rates can do nothing to address structural issues, such as an aging work force and lack of business investment. Cutting rates, he says, will only increase financial instability by propelling the prices of stocks, bonds and real estate to unsustainable valuations.
The debate underlines the odd situation facing Canadian investors at the moment. On the one hand, North American stock markets are hitting record highs and unemployment has fallen to its lowest level in decades. On the other hand, falling bond yields testify to creeping pessimism about the prospects for economic growth. Why are investors worldwide so willing to hold bonds that pay nothing, or next to nothing? One big reason is that these investors have misgivings about what lies ahead.
It’s not an environment suited for big one-way bets. It is an environment where investors should stay diversified and brace for the unexpected – including interest rates that could drop lower, and stay there for longer, than we ever anticipated.