June 14, 2021

Declining Bond Yields Herald a Growth Comeback       

Global equities made gains with the old winning ways making a comeback. Falling bond yields gave the growth trade a boost; the health care and information technology sectors performed well, as did the typical interest rate sensitive areas of utilities and real estate. On the flip side, falling yields and a flattening yield curve hit the financials sector, a key component of the value trade. The S&P 500 Growth Index rose 1.4% against a 0.6% decline for the Value Index. An upgraded demand outlook from the International Energy Agency lifted oil prices. Offering some salve for Canada’s energy sector as TC Energy Corp officially terminated the Keystone XL pipeline. 

US and Canadian 10-year bond yields both slumped to a more than 3-month low. The sideways action for bond yields since early March, has in the last two weeks, morphed into a decidedly downward trend. However, something is awry when copper and oil prices are headed higher, US inflation hits 5%, while bond yields are trending lower. Either the bond market is sniffing out trouble, or there are other factors at play. We believe the culprit is a series of other factors, including:

• correcting the yield overshoot from Q1
• the ‘inflation will be transitory’ narrative is believed by many
• the combination of foreign flows, bond-buying programs, and bursting cash balances all providing ample demand for bonds

The speed and magnitude of the move up for bond yields in Q1 were simply too far, too fast in pricing in a full recovery. Positioning in the bond market had turned very bearish. The current downtrend in yields is consolidating the move and unwinding some of that bearishness.

Even amid mounting production bottlenecks, soaring commodity prices, and worker shortages, the consensus view is that inflation will be largely transitory. This is a story the market both wants to believe and is currently supported by a fair degree of evidence. Of course, there is concern that inflation won’t be transitory, but for now, those fears are being kept at bay. Notably, the European Central Bank (ECB) and Bank of Canada emphatically echoed the Fed’s ‘transitory’ message in their recent meetings.

Last but importantly, bond buying from a variety of corners is providing robust demand. The Fed and ECB are still executing quantitative easing (QE) measures at full throttle. The Bank of Canada has pulled back some but is maintaining its $3 billion weekly QE. Further demand for safe assets sits in huge cash balances. US bank deposits sit at US$17 trillion and have grown at a 20% annualized pace through the last 14 months versus their 20-year average growth rate of ~7%. Flows into US money-market funds have surged with total assets of US$4.6 trillion, just shy of the record set in May 2020. Enticed by falling hedging costs, foreign investors upped their holdings of longer-maturity US government bonds in March. The strong move higher for global stock markets also prompts rebalancing, and asset-liability immunization flows from pensions and other institutional investors.

We still believe that yields will trend higher as more and more of the global economy picks up steam. In the first quarter, Canadian 10-year yields rose 88 bps, resulting in a painful 5% decline for the FTSE Canada Universe Bond Index. The good news for bond investors is that we don’t envision a repeat of this magnitude or speed. A smaller and slower move is easier to digest, but the headwinds remain; a move to a 2% 10-year yield by year-end is still higher by 63 bps but over six-plus months.

The week ahead

• Canadian, Eurozone, and Japanese inflation data
• Canadian and US housing data
• US Federal Reserve monetary policy meeting
• US, Japanese and Chinese industrial production data
• US, UK, and Chinese retail sales data
• Eurozone trade data
• Chinese fixed asset investment data