If the rapid recovery in the world’s largest bond markets this week is any indication, an economy recovering from the COVID-19 shock and surging inflation is a thing of the past.
The price of US 10-year Treasuries has risen, causing yields to fall 8 basis points on Tuesday, the second largest daily decline in 2021. On Wednesday, the rally escalated, with rates falling to just under 1.3 percent, their lowest level in almost four months.
Canadian bond yields have dropped to a comparable low, while German Bund yields have dropped to -0.3 percent from above 0 percent in May.
Several factors have been proposed, including a squeeze on investors who had gambled on rising yields, softer-than-expected economic statistics, and concerns about COVID variations.
When you get past the noise, the true message from sovereign bond markets, which are carefully studied by policymakers and investors as a crucial indication of economic trends, is clear: economic growth, albeit firmer, appears to have peaked, and any increase in inflation will most likely be temporary.
“Markets have shifted from believing that growth is strong and inflation is possible to believing that growth has peaked and inflation is fleeting,” said Guy Miller, chief market strategist at Zurich Insurance Group.
The bond market’s turnaround may contradict the message from the US Federal Reserve, which has recently turned to a hawkish stance and accelerated its rate hiking schedule.
According to the minutes of the Federal Reserve’s June policy meeting, which were released on Wednesday, officials felt that significant further progress on the economic recovery “was largely assessed as not having yet been realized” last month. They did agree, however, that they needed to be ready to respond if inflation or other hazards arose.
“Various participants” at the June 15-16 meeting felt requirements for decreasing the central bank’s asset purchases would be “met somewhat earlier than they had anticipated,” according to minutes that revealed a divided Fed grappling with the arrival of inflation and financial stability worries.
Others, however, saw a less obvious message in the statistics, warning that reopening the economy after a pandemic created an exceptional level of uncertainty, necessitating a “patient” approach to any policy shift.
Despite the Fed’s broad change, it does not anticipate to begin raising rates until 2023, and, like other major central banks, it has stated that it will ignore any short-term rise in price pressures.
“You have to adjust your thinking given the realities,” Pictet Wealth Management strategist Frederik Ducrozet said. “Economic growth is not steady, inflation is not about to skyrocket.”
The return to bonds comes as evidence supports the notion that economic growth has reached a nadir.
On Tuesday, data revealed that service sector activity in the United States expanded at a moderate pace in June, while a carefully monitored barometer of German investor mood declined more than predicted in July.
Many traders holding “short” Treasury positions – effectively bets that yields would climb in tandem with a rebounding economy – would have lost money as a result of the bond rally, prompting many to liquidate their positions, pushing yields even lower.
Many investors have been pessimistic on Treasuries, including the world’s largest asset management, BlackRock. On Wednesday, BlackRock restated its pessimistic position. Yields, on the other hand, have been steadily declining by 50 basis points since March.
Some mention demand from Europe and Japan, where central banks are staunchly dovish, as an explanation for the slide. Others point to the influx of liquidity into the US financial system as the Treasury spends its cash balance and the Federal Reserve buys $120 billion in Treasuries each month.
However, despite the apparent strength of the economy, bond markets may have had reservations about the forecast; yield drops are being led by “real” or inflation-adjusted borrowing rates, according to ING Bank analysts.
Ten-year real yields in the United States have fallen to minus 1%, the lowest level since February, while German real yields have fallen to three-month lows.
According to Mike Sewell, a portfolio manager at T.Rowe Price, the 1.77 percent U.S. 10-year nominal yield reached in March may stay this year’s high as further “reflation” bets are forced to unwind.
“There’s still a chance that trade will reengage, but it’s more likely in the third or fourth quarter.” The reflation trade is currently not dead, but it is in hibernation, according to Sewell.
First, China, the world’s second largest economy, revealed statistics this week suggesting that growth in the services sector has slowed to a 14-month low. Some observers feel that this is a pattern for how industrialized economies will fare in the future.
Second, COVID-19 caseloads are increasing in many countries, notably China, and concerns are mounting about new, potentially more contagious variations.
The Delta variation of the coronavirus, which is currently prevalent in many nations, including the United States, is easier to spread than earlier variants of the virus.
“Markets’ muscle memory is that if instances rise, governments will clamp down again, resulting in slower development and a vicious cycle,” said Charles Diebel, head of fixed income at Mediolanum International Funds.
Why are bonds falling in value?
- Bonds are generally advertised as being less risky than stocks, which they are for the most part, but that doesn’t mean you can’t lose money if you purchase them.
- When interest rates rise, the issuer experiences a negative credit event, or market liquidity dries up, bond prices fall.
- Bond gains can also be eroded by inflation, taxes, and regulatory changes.
- Bond mutual funds can help diversify a portfolio, but they have their own set of risks, costs, and issues.
Why are Canadian bonds falling in value?
COVID19 is a real-world bond fund test (Falato, Goldstein, and Hortaçsu 2020). Concerns about the pandemic’s economic impact sent global markets into a tailspin in March 2020. The value of bond fund holdings fell as spreads on Canadian corporate bonds increased dramatically. A big number of investors reacted by withdrawing money from these funds in order to raise cash. In March, net redemptions were $14 billion, or around 4.5 percent of assets under management (Bank of Canada 2020).
Despite their magnitude, these redemptions were far lower than those indicated by a model simulation based on credit spreads in March (see Figure 1 for a summary of the model simulation compared with what happened in March).
The disparity between expected and actual redemptions in March can be explained, at least in part. The Bank of Canada’s liquidity and asset purchase facilities, we believe, contributed to market stability and reduced investor redemptions. Fund managers also helped to minimize massive redemptions by stepping up their efforts to build relationships with investors (i.e., they had regular conversations about investment decisions). Investors who left the fund were also paid increased fees by some fund managers. Because the cost of providing liquidity in this market increased dramatically in March, the additional fees were judged justified.
Most fund managers, according to evidence, satisfied redemption demand with cash and other liquid assets. Securities authorities also granted fund managers more leeway in using borrowing to control redemption demand. According to available data, bond funds’ cash holdings decreased from 4.2 to 3 percent of assets under management in the quarter ended in March.
Overall, the joint actions of fund managers and regulators helped prevent funds from selling bonds in a market that was experiencing severe liquidity stresses, which would have exacerbated the market’s poor liquidity conditions (see Gravelle 2020 for an explanation of market liquidity and how conditions evolved during the crisis). Bond funds may be more vulnerable if there is another wave of huge redemptions because they have already depleted their cash reserves. Bond funds can assist minimize future forced sales of less liquid assets by swiftly restoring those buffers. The Bank will keep an eye on these funds to see how they affect fixed-income market liquidity.
Is it wise to invest in Canadian bonds?
Bonds issued by the Government of Canada offer significant returns and are backed by the federal government. They come in periods ranging from one to thirty years and, like T-Bills, are almost risk-free if held until maturity. With a period of more than one year, they are regarded the safest Canadian investment available. Until maturity, when the whole face value is repaid, they pay a guaranteed, fixed rate of interest. No matter how much you invest, the Government of Canada guarantees every penny of principal and interest. Even if you usually hold your assets until they mature, it’s comforting to know that Government of Canada Bonds are fully marketable and can be sold at any time for market value. Both U.S. and Canadian dollars can be used to buy Government of Canada Bonds, and both are considered Canadian content in your RSP/RRIF.
Key Benefits
- Regardless of the size of the investment, the safest Canadian investments are available in Canada.
- For RSP purposes, investments denominated in US dollars are considered Canadian content.
Are Canadian bonds increasing in value?
As the epidemic creates a “new market regime,” Canadian investors could expect a second year of equities gains and negative bond returns, according to a report from the BlackRock Investment Institute.
According to the institute’s 2022 view, while the Bank of Canada is set up to raise rates sooner than other central banks, Canada is not alone in the new system. For the second year in a row, BlackRock anticipates worldwide stock gains and negative bond returns, which hasn’t happened since data was first gathered in 1977.
Are bonds safe in the event of a market crash?
Down markets provide an opportunity for investors to investigate an area that newcomers may overlook: bond investing.
Government bonds are often regarded as the safest investment, despite the fact that they are unappealing and typically give low returns when compared to equities and even other bonds. Nonetheless, given their track record of perfect repayment, holding certain government bonds can help you sleep better at night during times of uncertainty.
Government bonds must typically be purchased through a broker, which can be costly and confusing for many private investors. Many retirement and investment accounts, on the other hand, offer bond funds that include a variety of government bond denominations.
However, don’t assume that all bond funds are invested in secure government bonds. Corporate bonds, which are riskier, are also included in some.
Is today a good time to invest in 2022 bonds?
If you know interest rates are going up, buying bonds after they go up is a good idea. You buy a 2.8 percent-yielding bond to prevent the -5.2 percent loss. In 2022, the Federal Reserve is expected to raise interest rates three to four times, totaling up to 1%. The Fed, on the other hand, can have a direct impact on these bonds through bond transactions.
Is the Bank of Canada investing in bonds?
In March 2020, the Bank of Canada launched an asset buy program to enhance market functioning in the Government of Canada (GoC) bond market, in response to unruly market conditions. The Bank agreed to the following in the Government of Canada Bond Purchase Program (GBPP), which was announced on March 27, 2020:
GBPP purchased all maturities throughout the yield curve to meet their commitments.
The GBPP’s focus shifted from restoring market functioning to delivering additional monetary stimulus through a quantitative easing (QE) program in July 2020. (see Bank of Canada 2020a). It’s crucial to assess the impact of this massive and unprecedented quantity of purchases (about $307 billion as of August 31, 2021) on GoC bond yields, especially given it was the first time the Bank deployed a QE program as part of its extended monetary policy toolkit in Canada.
When we examine the influence of the GBPP announcement in March 2020 on GoC bond yields, we find that:
However, determining the actual impact of the GBPP is challenging because numerous factors influence GoC bond yields. The GBPP, for example, occurred at a time when gross GoC bond issuance tripled. To put it another way, we can’t see or estimate what the level of GoC bond yields would have been if the GBPP hadn’t existed.
Furthermore, because it only measures the surprise component of the GBPP announcement, the yield impact of the initial announcement likely underestimates the impact of the GBPP. The GBPP’s entire impact is anticipated to be greater, given that market participants:
- Because of the initial announcement, you might have been expecting the Bank to announce an asset purchase program.
- the market dysfunction seen in the GoC (see Fontaine, Ford and Walton 2020)
- Market expectations that the Bank would cut the policy interest rate to its effective lower bound of 0.25 percent were also altered.
- They most certainly boosted their estimates of the program’s total expected size later, especially as it transitioned from an instrument aimed primarily at restoring market functioning to one used to deliver further monetary policy stimulus1.
We also look at how GoC bond rates react to the Bank’s daily GBPP bond purchases. D’Amico and King (2013) coined the term “flow effect” to describe this response. On GoC bond yields, we detect a minor and transient flow effect that tends to reverse in the four days following the GBPP operation.
With efficient markets, a little flow effect is expected. That is, the GBPP’s price/yield impacts should reflect new knowledge and altered expectations regarding the volume and type of securities to be purchased over the duration of the program. These expectations may shift over time, although they do not always vary on operating days. As a result, the operations themselves are consistent with a tiny flow effect. These operations give very little new material information that could affect security prices beyond what markets already know from earlier announcements and operations.
Why are bond yields in Canada rising?
Many individuals are unaware of the tight link between fixed mortgage rates and bond yields issued by the Bank of Canada.
Both rates can fluctuate on a daily basis, but they pose different concerns, as they are on opposite extremes of the spectrum. Banks view fixed mortgages as ‘riskier’ assets, whilst government bonds are regarded as’safer,’ if not risk-free. Why?
Mortgages are not 100% guaranteed to be paid back, unlike government bonds. Mortgages have a higher risk of failure or early repayment, which could cause the projected return on investment to be disrupted. As a result, banks raise mortgage rates to compensate for the increased risk.
Fixed mortgage rates are influenced by a variety of factors. Government of Canada bond yields, however, are the single most important influence. Banks actually base their fixed mortgage rates on the 5-year bond yield market, using the expected earnings from bond investments to offset the costs and any losses suffered in the mortgage market.
How much higher are mortgage rates priced over bond rates?
The growth in capital costs squeezes lenders as the 5-year bond yield rises. They will eventually be unable to absorb the increase and will pass it on to the borrower by increasing fixed mortgage rates (variable rates are unaffected because they are related to the prime rate).
The average’spread,’ or markup, of fixed mortgage rates over secured government bonds in a normal market is around 100 to 200 basis points, or 1 percent to 2 percent. The spread relationship, or markup, will widen and contract in reaction to a variety of market factors, including the danger of rising inflation, investor appetites, product supply, and competition from alternative investment options, such as corporate bonds or equity markets.
This spread can widen during times of financial turmoil. For example, when the COVID-19 epidemic threw the Canadian markets for a loop in 2020, certain mortgage rates were temporarily elevated despite falling bond yields.
It’s not a given that banks will hike fixed mortgage rates in response to rising bond yields. However, with the economy attempting to recover and housing markets cooling, if bond yields rise, fixed rates are expected to rise as well.
What options does the Bank of Canada have for expanding the money supply?
The Bank of Canada (BOC), Canada’s central bank, can increase monetary supply by purchasing assets such as government and corporate bonds. Financial organizations also produce money by lending to businesses and consumers.
Is it wise to invest in bonds in 2021?
Because the Federal Reserve reduced interest rates in reaction to the 2020 economic crisis and the following recession, bond interest rates were extremely low in 2021. If investors expect interest rates will climb in the next several years, they may choose to invest in bonds with short maturities.
A two-year Treasury bill, for example, pays a set interest rate and returns the principle invested in two years. If interest rates rise in 2023, the investor could reinvest the principle in a higher-rate bond at that time. If the same investor bought a 10-year Treasury note in 2021 and interest rates rose in the following years, the investor would miss out on the higher interest rates since they would be trapped with the lower-rate Treasury note. Investors can always sell a Treasury bond before it matures; however, there may be a gain or loss, meaning you may not receive your entire initial investment back.
Also, think about your risk tolerance. Investors frequently purchase Treasury bonds, notes, and shorter-term Treasury bills for their safety. If you believe that the broader markets are too hazardous and that your goal is to safeguard your wealth, despite the current low interest rates, you can choose a Treasury security. Treasury yields have been declining for several months, as shown in the graph below.
Bond investments, despite their low returns, can provide stability in the face of a turbulent equity portfolio. Whether or not you should buy a Treasury security is primarily determined by your risk appetite, time horizon, and financial objectives. When deciding whether to buy a bond or other investments, please seek the advice of a financial counselor or financial planner.