The trend in interest rates does not paint a pretty picture as 2019 gets underway. The reason is that short-term interest rates, which are set by central banks, are trending higher than long-term interest rates set by inflation expectations. This scenario is the first step toward an inversion of the yield curve, which has an uncanny way of predicting future business conditions for just about everybody.
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The Bank of Canada is in the process of “normalizing” – that is, raising – short-term interest rates. Adding to that restraint, sagging oil prices, the announced closing of General Motors of Canada Co.’s assembly plant in Oshawa, Ont., and Canada’s tariff war with the U.S. have taken the wind out of the economy’s sails. In turn, this is resulting in lower growth expectations and subsequent flattening of the yield curve.
The curve is pretty flat already. As of Jan. 3, 2019, two-year Government of Canada bonds yielded 1.77% and five-year Canada bonds yielded 1.76%. At the long end of the curve, 30-year Canada bonds yielded 2.07%, down from 2.55% at the beginning of November. That drop of 48 basis points is a sign of slowing future economic growth.
A flat yield curve – or, worse, an inverted yield curve – makes business for banks, life insurance companies and utilities (all of which have hefty debt on their books) more difficult. Each of these industries has its distinctive exposure to the flattening yield curve and each is led by the trendsetting government-bond interest rate. In sum, 2019 is not looking good.
For banks and other companies with extensive credit structures, the effects of the yield curve’s flattening are stark, says Chris Kresic, head of fixed income and asset allocation and portfolio manager with Jarislowsky Fraser Ltd. in Toronto: “When short-term financing costs go up, as they are doing, the biggest debt issuers – that is, the banks, which roll their debt constantly – find their financing costs up.”
Higher rollover financing costs mean banks, telecommunications companies and big utilities firms that rely on short-term financing are finding that the costs of their commercial paper programs are increasing. In turn, those higher costs work to discount the profitability of debt-financed operations, especially mergers and acquisitions.
There may be worse to come as the flattening of the yield curve leads to inversion. The yield curve on U.S. treasuries inverted for the first time in a decade on Dec. 3, 2018, when the difference between the yields for three- and five-year U.S. treasuries, which is a bellwether for inversions, dropped below zero.
Looking ahead into 2019 on an industry basis, the sinking yield curve will have a detrimental impact on the housing market, says Charles Marleau, co-founder and chief investment officer with Palos Management Inc. in Montreal: “Mortgages, which are long-term commitments by lenders, will pay less if the yield curve inverts. That means raising new money for housing will be harder, [resulting in] less construction and [lower] profits.”
The message is that you should anticipate downturns in housing starts in 2019. And down the supply chain, there will be reduced spending on residential and commercial construction – all financed with less rewarding long-term loans.
That means renting to tenants will be less profitable, says Geoff Castle, portfolio manager with Vancouver-based PenderFund Capital Management Ltd.’s $575-million Pender Corporate Bond Fund: “Rental rates in major markets return just 1% of capital.” That’s not much return for the risk. If capital is harder to get, there will be less housing started in 2019, he suggests.
Meanwhile, life insurers have significant exposure to long-term bonds to cover their payout risk, says Stewart McIlwraith, senior vice president and head of insurance with DBRS Ltd. in Toronto. So, if long bonds pay less, then the policies life insurers underwrite will be less rewarding to the insured and, thus, less attractive. In turn, consumers of life insurance will be more inclined to put their money into shorter-term investments that pay more.
The situation is much the same for other long-term borrowers, such as utilities and telecommunications companies. Many of these companies are regulated and able to adjust prices of services to costs. However, a lower return for long-term investment in equipment, which is supported by long-term business expectations, means that less investment gets done.
The writing is on the wall, and 2019 is shaping up to be a year that many will want to forget, Kresic says: “Full inversion of the curve has not happened yet. But with absolute yield going down and short-term borrowing costs trending higher than long-term [borrowing] costs, expansion plans and investment plans [will] get put on hold.”