Even investors who shun fixed-income securities should pay attention to recent upheavals in the bond market.
Bond yields remain low by historical standards but have rocketed higher in recent weeks. Those higher yields carry a mixed message. On the one hand, they warn of higher inflation ahead. On the other hand, they suggest economic growth may prove considerably stronger than expected.
Why should most investors care? Higher yields could cool off Canada’s red-hot real estate market, knock down gold prices and rattle today’s exuberant stock markets.
Much depends, though, on whether investors choose to view recent developments as a negative or a positive. For now, many tend toward the darker view.
A CNBC survey of more than 100 chief investment officers, equity strategists and similar institutional heavyweights conducted at the end of March showed nearly half of respondents – 47 per cent, to be precise – regarded rising interest rates as the biggest threat to the stock market.
More than 60 per cent of those surveyed said the yield on the benchmark 10-year U.S. Treasury bond will finish this year above 2 per cent. That would be more than double the level at which it started 2021 and considerably higher than the 1.7 per cent level around which it is now trading.
If investors begin to see fresh appeal in bonds as yields rise, stocks could take a hit. For most of the past year, the dismal yields on bonds have left many people with no perceived alternative other than to buy stocks. But as bonds begin to offer a more reasonable payoff, many of the folks who have loaded up on stocks might choose to shift back toward fixed-income securities.
To be sure, there are other ways to view this situation. What rising bond yields also seem to be telling us is that optimism about the North American recovery is bounding ahead – something that would ordinarily be good for stocks. The rapid deployment of vaccines and the massive stimulus package unveiled by U.S. President Joe Biden have combined to overhaul economic expectations in the matter of a few weeks.
One gauge of the rosier mood is the JP Morgan Forecast Revision Index, which measures how much U.S. economic forecasts have shifted over the course of a three-month period. It just recorded its biggest upward bounce on record. “In other words, the economic outlook improved at a historic pace this quarter,” Joe Weisenthal of Bloomberg wrote.
The Canadian outlook is brightening in tandem. Gross domestic product rose 0.7 per cent in January, well in advance of both previous estimates and market expectations, according to numbers published this week. As a result of the improving trend, investors have been voting with their feet, moving away from bonds and into areas that can benefit from stronger economic growth. As bond prices fall, yields go up.
Consider the yield on the 10-year Government of Canada bond, a key benchmark for Canadian markets. It has tripled from below 0.5 per cent last August to 1.5 per cent on Thursday. Much of that improvement has taken place since early February.
Capital Economics sees more increases ahead. It predicts the yield on the U.S. 10-year Treasury will hit 2.25 per cent by yearend and 2.5 per cent by the end of 2022.
Canadian markets will follow a similar trajectory, but at a lower altitude, according to the forecaster. The 10-year yield in Canada will rise, but only to 2 per cent by the end of 2022, it says.
Exactly how those rising yields affect markets will hinge on how much they reflect fears of rising inflation and how much they reflect hopes for persistently higher real growth. Break-even rates, one measure of expected inflation, have surged in recent weeks. They now suggest investors are braced for U.S. inflation of about 2.5 per cent a year over the next five years.
Those expectations are still largely in line with the Federal Reserve’s long-term goal of pinning inflation around 2 per cent, notes Roberto Perli, head of global policy at Cornerstone Macro in New York. He sees limited room for further moves upward in Treasury yields unless inflation shows signs of spiralling out of control or growth expectations get revised higher.
The former seems unlikely for now, but the latter is a growing possibility. If growth expectations do get revised higher, “Treasury rates could climb significantly more from here,” Mr. Perli wrote.
An upward surge in yields, driven by higher growth expectations, would be bad news for gold, which does not typically thrive when real interest rates are rising. Higher rates would also be a challenge for real estate markets and for stocks, especially high-flying sectors such as tech stocks that benefit from low interest rates. Investors should keep a close eye on this unfolding bond market story.
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Ian McGugan