A selloff in global bond markets could have major implications for Canadian households and investors as experts say financial markets are readjusting their long-term expectations for interest rates.
Bond markets around the world surged earlier in the week, including yields on the benchmark 10-year U.S. Treasury bond, which hit a 16-year high. The S&P 500, meanwhile, sank to its lowest level in four months on Tuesday before stabilizing somewhat on Wednesday.
A similar story is playing out in Canada, with a faltering TSX matched by 16-year highs on closely watched bonds such as the five-year Government of Canada yield.
Stocks have generally struggled since the summer under the weight of soaring Treasury yields in the bond market. High yields undercut stock prices by pulling investment dollars away from stocks and into bonds. They also crimp corporate profits by making borrowing more expensive.
Bond yields help to inform borrowing rates on a number of key lending products in Canada such as mortgages and car loans. They have a close but indirect relationship with the Bank of Canada’s benchmark interest rate, and can rise and fall based on the central bank’s movements or signals for future policy directions.
Robert Kavcic, senior economist at BMO, tells Global News that one of the reasons bond yields are reaching decade-highs is an acceptance in financial markets that central bank policy rates around the world will stay higher for longer.
Annual inflation has cooled from the 40-plus-year highs seen in 2022, but remained double the Bank of Canada’s two per cent target in August. Kavcic says that with inflationary pressures sticking around, global financial markets have slashed expectations for interest rate cuts in the near future.
After already hiking its main interest rate to the highest level since 2001, the U.S. Federal Reserve has indicated it may keep rates higher next year than it had earlier expected. While the Bank of Canada has said that its future rate moves are data dependent, the central bank’s governing council was careful not to communicate hints of rate cuts in its latest decision last month.
“There’s the reality setting in that central banks are just not going to be in a position to cut rates any time soon,” Kavcic says.
Former Bank of Canada governor David Dodge told a Senate banking committee on Thursday that markets are “finally catching up with the reality of what’s going on in the world.”
Dodge said there was a “hope” that world economies would return to the pre-pandemic era of lower borrowing rates seen in the aftermath of the global financial crisis in 2008.
He argued in his testimony that the economies around the world will face “continued restriction” in global supply in the years to come, putting upward pressure on costs and requiring higher interest rates to keep prices stable in the long-term.
“We’re trying to adjust now to a world now where that is the case,” he said.
But with bond yields rising even as the Bank of Canada holds rates steady, Kavcic says the central bank might not have to hike rates further as the market itself pushes up the cost of borrowing for Canadians.
While he expects the Bank of Canada will watch for signs of easing in inflation and the labour market before making its next rate decision on Oct. 25, he says policymakers will likely be “mindful” of the bond market if it’s providing further tightening without the central bank needing to move again.
Recession warnings getting louder
Canada’s GDP growth has flattened significantly in recent months, pushing the Canadian economy closer to a recession.
A technical recession is often defined as two straight quarters of negative GDP growth.
Bond markets, too, have been signalling a recession thanks to an inverted yield curve — the point at which short-term bond yields outperform longer-term yields. The yield curve inverted more than a year ago but has recently steepened in the past week as short-term yields grow in value.
An inverted yield curve is a signal that the economy is about to slow and make way for eventual interest rate cuts, says Steve Locke, chief investment officer, fixed income and multi-asset strategies at Mackenzie Investments.
“The inverted curve is suggestive of a future environment where demand has slowed and the economy may or may not be in recession, but it’s certainly slower than it has been,” he tells Global News.
Kavcic is firmer when it comes to interpreting an inverted yield curve — the historic harbinger of a recession has never given a “false positive” before, he notes.
“You’ve never historically really got a deeply inverted yield curve and did not have a recession,” he says.
“It’s basically the market’s way of saying that central banks have tightened enough to the point where the economy is eventually going to roll over and we’re going to see rate cuts at some point down the road.”
Productive time to ‘rebalance’ a portfolio
The implications that higher interest rates could be the “new normal” for global financial markets are also weighing on stocks, Kavcic says.
Expectations for companies’ capitalizations and growth rates will have to be revised for a market that sees consumers’ spending power restrained and corporate spending power limited amid tighter borrowing conditions than they enjoyed in the past decade, he argues.
“Valuations, in a normal environment, are going to have to reset lower to account for that.”
Growth could start to return to equity markets if investors find signs of growth on the horizon, Locke says, but this can be a double-edged sword for stocks.
Global economies will need to signal a steep enough slowdown to warrant the end of the central bank tightening cycles and an eventual path to rate cuts, but simultaneously, a cooling economy could hurt the growth prospects for many of the companies trading on equity markets, he explains.
“All of this comes together to cause the stock market a little bit of uncertainty here in the last few weeks,” Locke says.
After many investors saw solid gains on equity markets for the past decade, when interest rates sat largely at historic lows, Locke says some investors might be overweighted in stocks. Now is a good time to “rebalance” portfolios with a healthier mix of stocks and bonds, he argues.
The traditional 60-40 split of stocks to bonds is “actually quite appropriate for many investors,” Locke says, pointing to opportunities in some corporate bonds on the market today that are providing highs not seen on the bond market for more than a decade.
“We think that there’s good opportunity around in the bond market today and investors would be well-suited to think about, if they haven’t rebalanced in a while, those areas and reintroducing or adding a little bit of exposure there,” he says.
— with files from the Associated Press