The long, painful legacy of interest rate distortion

Article content

Once upon a time, investors considered bonds to be safe, at least when compared with equities. Not anymore. As rates have risen and inflation got sticky, bond markets have taken a beating, and long bonds in particular have fallen out of investor favour.

In their Canso Market Observer for October 2023, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. looks at why the legacy of a decade of loose monetary policy has proven so painful for bond investors, and then asks a provocative question: after double-digit declines, are long bonds finally cheap enough to tempt investors to get back in? 

For the full October 2023 Canso Market Observer Newsletter, click here.

A decade-long binge, a bad hangover

Whatever happened to “safe” bonds? That’s the question the Canso team asked as it looked at the roller-coaster ride fixed income has been on lately. Yields are rising and falling on “the smallest change in economic statistics and utterances from anyone at the Federal Reserve,” they wrote. The bond yield curve is inverted – but where is the recession that this inversion was supposed to prognosticate? Inflation, which investors readily assumed would respond quickly to higher interest rates, is still kicking. And economic growth is robust, thumbing its collective nose at central banks that are doggedly determined to crush demand and contain inflation.

The trouble, the Canso Market Observer argued, is humans – the “investment lemmings” who have developed an out-of-touch sense of what “normal” is. Between 2011 and 2021, investors got used to the idea that ultra-low interest rates were not only necessary (given lacklustre economic growth), but inevitable. It was a world view propagated by central bankers who embraced the command-and-control belief that “Money Doesn’t Matter.” (So, they created lots of it.) “Convincing arguments,” the Canso team wrote, “seep into the mainstream and become unassailable truths that a consensus forms around.”

But just because everyone thinks something is true does not make it true. Or, as the Canso team put it, “the aggregated behaviour of fickle humans is not an impartial arbiter of investment value.” Markets are too often victims of herd mentality – and the bond market is really paying the price for it today.

What went wrong?

The beginning of the end for the secular bond bull market came, fittingly enough, during the pandemic, when central banks indulged in an exuberant fit of money creation that made the previous decade of loose policy look downright prudent. Consumers had lots of cash and less to spend it on, owing to the supply chain constraints of the pandemic era. “Nobody should be surprised that this resulted in the highest inflation since the 1970s,” the Canso team wrote.

All that cash not only distorted prices, but also investor behaviour. Meme stocks and NFTs took off, as “zero and negative cost of capital caused investors to enter into a senseless and success-drunk speculative frenzy,” the newsletter noted. “Any thought of efficient capital allocation became a quaint historical relic.” Meanwhile, central bankers forgot a basic reality of what an economy’s financial system is supposed to do: allocate capital efficiently.

Bond investors ended up hopelessly confused and downtrodden. The newsletter pointed out that in the span of four years, the Government of Canada bond yield curve went from flat (in 2019) to “normal” (in 2020 and 2021) to inverted, when monetary tightening began in 2022. As the Canso team pointed out, the inversion suggested that investors believed higher rates (that is, above zero) would crush inflation sooner rather than later, so they were positioning themselves for falling rates. “When the inevitable rally in bonds came,” the newsletter wrote, “they didn’t want to be left behind.”

The rally hasn’t come. The slowing of inflation has been anything but quick. And yet the yield curve is still inverted. Investors are still waiting for a return to “normal.” That might take a while.

Are long bonds a bargain?

The trouble, according to Canso, is that investors underestimated the severity and impact of interest rate distortions. To illustrate the overvaluation of long government bonds during the pandemic money-creation spree, the team recalled the 2020 issuance of 30-year U.S. Treasuries and the 2021 issuance of Canada bonds that were offering yields of just over 1 per cent. At the time, Canso warned that such bonds were “vastly overvalued” from a historical perspective – yields that low were not even seen during the Great Depression. Yet investors bought them, and now they are paying the price. Long Treasury prices have dropped by as much as 50 per cent. Some long Canada bonds, the newsletter pointed out, are down more modestly – about 30 per cent!

That debacle – a rarity in bond markets – has captured a lot of media attention lately, and the Canso team noted that investor “consensus seems to be moving decidedly against bonds, and especially longer-term bonds.” The consensus, of course, has ultimately proven wrong before. The flight from long bonds may be a sign that investors have capitulated to the inevitability of higher rates for longer. But what if they are as wrong now as they were in 2020?

When the herd is moving in one direction, there could be opportunities elsewhere. Yes, inflation is still above central bank targets, but yields have risen to give more reasonable compensation for risk. The question the Canso team asked is, is it enough to get investors interested in long bonds again?

Maybe not. The Market Observer pointed out that the real yield (net of inflation) for Canadian long bonds remains well below the post-1980 average of 3.2 per cent. The latest inflation read of 4 per cent implies a fair value for long yields of 7.2 per cent; if inflation got back to the Bank of Canada’s 2 per cent target, that would imply a fair-value yield of 5.2 per cent. Either way, Canada long bonds do not look cheap at a 3.7 per cent yield. And there’s no guarantee inflation will get back to “normal” anytime soon. Canadian M2 money supply has continued to grow, the Canso team noted, and recent union wage settlements hearken back to the high-inflation 1970s.

By contrast, money supply in the U.S. been declining since the middle of last year – perhaps making the prospects for long Treasuries better. “Our evidence of the relative attractiveness of Canada bonds and U.S. Treasuries is not conclusive,” the Canso team wrote, “but … our gut reaction is that longer-term Canadas are expensive relative to U.S. Treasuries.” That could leave Canada bonds vulnerable to a correction down the road. As it stands, “long bonds are not cheap,” the newsletter concluded. “The bond market has been waiting to return to ‘normal’ for a long time. Given that their sense of normal was developed in the most bizarre period of monetary policy in history, we fear they might be waiting for a long time.”

Where’s there’s smoke…

For now, the Canso team wrote, caution remains the byword. Given that long bonds are still priced above historical norms, they favour the shorter end of the yield curve, which is offering better return for inflation risk. With the outlook still cloudy, the team prefers a “Batten Down the Hatches” stance, protecting portfolios and avoiding undercompensated risk. “A monetary tightening doesn’t end well for risky financial assets, and this time will probably be no different,” they added.

In short, while the bond “herd” is slowly realizing the vulnerabilities that became entrenched in the market after years of interest rate distortion, the real Great Awakening might be yet to come.

The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd, which is a member and content provider of this publication.