Canadian (and US) bond yields made an abrupt decline over the past few weeks. This is contrary to what experts had forecast, but it hasn’t changed their tune. In fact, Desjardins chief economist Jimmy Jean said it reinforces his belief.
In a note to clients this week, he outlined the disconnect between yields and the economy. Bond yields are falling, despite an improved macroeconomic environment. This indicates overly easy policy, which central banks have publicly expressed concerns over. If they don’t reel in the stimulus soon, they’ll be forced to make much more abrupt movements. That can trigger a more abrupt climb to mortgage rates — as early as the end of this year.
Bond Yields, Supply, and Inflation
Bond yields are based on supply and demand, like most market functions. As demand for bonds increases relative to the supply, the yield (or interest paid) falls. If everyone wants to lend you money, why on earth would you pay more interest, right?
If demand for bonds is low relative to the capital supply, the yields rise. If you lend someone cash who may not be able to pay you back, you’re going to want a risk premium. Pretty straightforward, and it’s a concept even your local loan shark gets.
Inflation is the other important thing that needs to be understood here. Inflation rises when there’s excess capital in the system, going after the same goods. Higher inflation is a sign the economy is running too hot. Low inflation is when purchasing is slow, leading to an excess supply of goods. This is typical of a recession.
There are currently two contrary market trends — low yields and high inflation. Central banks are crushing yields by flooding the bond market with cash. They have blinders on. All they can see is high unemployment and GDP below pre-pandemic levels.
Their models don’t accommodate for the fact job vacancies are in excess of job seekers. They don’t understand that people have enough money to pause and choose a new job. It isn’t built to consider GDP is lower due to restrictions on activity, not a breakdown of demand. Central banks run a very mechanical system, disconnected from reality.
Consequently, central banks have been suppressing yields. So much that mortgage rates are currently negative in real terms. Kind of like pushing a square peg into a round hole. They’ve been pumping the gas on stimulus to get unemployment to recover… but they don’t really understand what “recover” means. This has crushed yields, and caused nothing but higher inflation.
Many strategists are surprised this hasn’t ended yet. Now central banks are making subtle acknowledgments that countries may need less ease. This has made economists even more certain that higher yields are coming.
Bond Yields Have Been Falling Recently, Despite The Improved Economy
Excess ease from central banks and investors with lockdown fears pushed yields lower. Canada’s 5-year Federal Bond rate fell from 0.99% in Q1 2021, down 0.97% in the second quarter. Not a huge slip, but the US went from 1.75% in Q1 to below 1.2% in August. Some Canadians have seen this, and think it means they’ll take a dive as well. “A number of observers, ourselves included, have been surprised to see long-term bond yields continue to plunge since the start of the summer,” said Jean.
The disconnect between high inflation and low yields has the US considering a taper. In July, the Reserve adjusted its statement to recognize progress on the recovery. Desjardins points to Powell saying he wants to see employment firm before they taper QE.
Employment data in August confirmed the US job market has mostly recovered. The unemployment rate fell to 5.4% in the last report, with 10 million job vacancies. There have never been more unfilled jobs in the US, and it’s far in excess of job seekers.
“Recent events have bolstered our expectations that the [US] Fed will begin to gradually taper its quantitative easing before the end of the year and start to raise its key rates in late 2022. We still expect the first key rate increase in Canada in October 2022,” he wrote to clients. Adding, “central bankers are signaling greater concern over inflation and an eagerness to begin normalizing monetary policies.”
RBC expressed a similar sentiment a few weeks ago. They said the prospect of the US tapering ease puts Canada in a better position to ease, as well. One concern had been the loonie would become too strong, impacting exports. If the US is easing at the same time as Canada, it becomes much less of a concern. Their exchange would remain relatively balanced with both tapering ease.
Canadian Bond Yields Forecast To Fall This Quarter, Surge By Year-End
“The drop in bond yields in recent months has only exacerbated inflationary risks and could even force central banks to speed up monetary tightening to keep the economy from overheating,” said Jean.
The institution expects the current quarter (Q3) to continue its taper. By the next quarter (Q4) they see an abrupt climb in yields. The 5-year government bond is forecast to taper to 0.95% in Q3, before hitting 1.15% in Q4. By next year, they’re forecasting 1.85% yields for Q4 2022. Almost a doubling of current rates is quite the climb. It looks like they see yields rising in a bit of a rush.
Canadian 5-Year Government Bond Yield Forecast
The actual and forecast yields for the Government of Canada’s 5-year bond.
Source: Desjardins; Better Dwelling.
Important to note, most of the increases in these yields are not due to a rate hike. They don’t see the first overnight rate hike until the end of next year. However, they see bond yields climbing much faster — starting as soon as the end of this year. This is due entirely to a reduction in stimulus, and higher inflation. The former had been used to taper rates below its natural market mechanics. Tapering and eliminating the “ease” would cause rates to rise to natural levels.
“… the risk of a more abrupt adjustment to bond yields shouldn’t be overlooked,” the chief economist ends.
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