When GDP and inflation perk up, so will bond interest rates. For now, getting paid little is the cost of prudence

By Andrew Allentuck | Mid-October 2014

The most pressing and most unavoidable question in the bond market: when will interest rates rise?

The U.S. Federal Reserve Board has hinted that it will not raise interest rates soon. The Bank of Canada (BoC) asserts it will have a monetary policy of its own, yet it also is in no hurry to raise interest rates. Europe is experiencing malaise, with Germany's short-term interest rates below zero and possibly headed lower.

So, what's a sensible fixed- income investor to expect?

The Fed and the BoC persist in keeping short rates at or near zero as a policy commitment to economic stimulus. But those central banks are going against the tide of history. Interest rates averaged 3%-5% for much of the period from the end of the Second World War to the end of the 20th century. And there were times that the U.S. kept rates low by administrative fiat to hold down inflation, for that was what the monetary policy of the day required.

For example, the Fed's Regulation Q put a limit on what commercial banks could pay depositors from 1933 to 1986. In the 1970s and 1980s, that limit was 4.5% even as inflation soared into double digits. Now, interest rates are being held down again, but it's the lack of inflation behind the Fed's measures - such as quantitative easing, which have been used to suppress any moves to higher interest rates - this time.

Today, the demand for loanable funds, an important interest rate driver for corporate bonds, is weak. U.S. retail sales growth is feeble. Canadian household debt, for its part, is at about 1.6 to 1.7 times annual gross household income, which implies that consumers are tapped out in paying their mortgages and credit card bills. Thus, they cannot borrow much more.

Despite the widespread belief that interest rates should rise to their historical norm eventually, that's not happening. One school of thought is that 1%-2% is the "new normal" and, absent a strong economic recovery, that's where rates will stay. In this view, lenders can be content to stay with low rates.

"The only thing that will push interest rates up is inflation," says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago. "Bank lending is increasing slowly. Bond rates, relative to nominal [gross domestic product (GDP)], have been a good proxy for interest rates. Today, nominal GDP is 4.2%, so the 10-year rate should be at least 3.5%. In fact, it's 2.59%. It's a great environment for borrowers, but not for lenders."

There are new metrics in the bond market - and they're not macroeconomic. The new rule appears to be that bonds are for precautionary balances and rebalancing equities holdings when investors take stock profits. Says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto: "Up until a month ago, I thought that North American [interest] rates would be dictated by central bank policies."

However, he suggests, now it's market forces more than the policies of the BoC and other central banks that are making Canadian and U.S. bonds must-have products for which price and yield matter relatively little in comparison with sheer commodities-type pricing by supply and demand.

In global markets, money is moving from Europe, where sentiment indicates a weakening of the euro, and into the U.S., Canada and Australia in search of liquidity and security. In Germany, for example, the Deutsche Bundesbank's overnight deposit rate is minus 0.20%; its 10-year rate is 1%. From that perspective, North American interest rates look downright attractive.

The bond market has been expecting a BoC tightening of as much as 75 basis points in short-term rates by late 2015. The latest version of what the future holds has the loonie losing value slowly as the market watches sagging economic growth that could make the BoC wait yet another year - perhaps until 2016 - to raise short-term interest rates.

The current interest rate level in the U.S. and Canada makes sense if bonds are viewed as being must-have commodities and investors are prepared to pay whatever it takes to own them. Another force that makes bonds worth having, even though those bonds pay little to nothing, is banking regulations, which force lenders to keep more government bonds on their books. This satisfies the lenders' reserve requirements and allows them to make more loans. The profits from increased lending compensate for low yields on government bonds.

There are other reasons for increased demand for low-yield government debt. For example, new rules for U.S. money market funds will force them to disclose daily net asset values. The bookkeeping practice that has allowed U.S. money market funds to keep their unit values steady at $1 will require these funds to hold more government bonds and fewer at-risk assets.

Corporations have been buying back their stock at the expense of their balance sheets, which now show increased bond debt. But with interest rates at historical lows, the interest cost of financing buybacks is low. Investors are pleased.

None of this is really about calibrating interest rates. That's an afterthought in this market.

So, how long can the price of money hover in the low single digits?

"Yields at present are not sustainable, for real rates are below the replacement cost of capital," says James Hymas, president of Hymas Investment Management Inc. in Toronto. "However, if we get into deflation, then the negative real interest rates prevailing now will turn positive. For now, investor sentiment does not show deflationary expectations, but there are many tripwires in the Middle East, Ukraine, and in the Baltic republics."

Still, a return to normalcy may come one day. Says Chris Kresic, co-head of fixed-income and senior partner with Jarislowsky Fraser Ltd. in Toronto: "Macroeconomic forces will return to rule markets. Weak global recovery underlies historically low returns, but normal growth and normal inflation will bring interest rates back to the historical norm."

In other words, when GDP and inflation perk up, so will bond interest rates. For now, though, getting paid little is the cost of prudence and price of security.

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