Are we there yet?

by The Algonquin Team, Algonquin Capital

If you don’t know where you’re going, you’ll end up someplace else.
Yogi Berra

With the kids out of school, families across the country are packing up their cars and embarking on summer road trips. Journeys filled with bad dad jokes, frequent pee stops, and that oh too familiar backseat chorus.

‘Are we there yet?’

After years of wondering when interest rates will rise, the 0.45% increase in the Canadian 5 year yield in June has many bond investors asking the very same question. While the markets have cried wolf before only to see rates back down a month or two later, there is the nagging feeling that this time is different.

Previously, rising yields were met with central bankers steadfastly beating the drum of deflationary concern. No amount of economic data could shake their belief that the abyss of deflation lurked around the corner. As a result, they implemented and maintained the extraordinary measures of negative real (and nominal) rates and quantitative easing to stimulate economic growth.

Although lacking hard evidence that inflation is rising, policymakers have begun to change their tune. The Federal Reserve has laid out how it will begin its tapering process. The ECB has started to mull an exit from quantitative easing and negative rates. And even the Bank of Canada publicly stated that the economy had recovered from the shock of plunging oil prices.

The abrupt change of heart by the Bank of Canada caught many flat-footed. Despite the domestic economy performing better than predicted, CPI has not been particularly strong. And since economic growth hasn’t led to rising inflation in the G7, concerns around the perils of excessively low rates had faded.

Nonetheless, those driving the car have determined that deflation risks have considerably diminished and that reflationary forces now have the upper hand. As a result, they seem to be quite willing to remove the ‘emergency’ or ‘insurance’ stimulus that they have been relying on since the ‘Great Recession.’

Based on the data this may seem premature. But CPI tends to lag GDP growth, and changes to monetary policy can take several months to have an impact. Thus central bankers have to make decisions based on forecasts and often act before the economic numbers exhibit significant change.

So while we might not be there yet, it appears we are finishing the long stretch of the deflationary highway and moving onto the side roads. And like kids waking up when the car changes speed on the off-ramp, the Canadian market is now preparing for an interest rate hike tomorrow, the first in seven years.

Over the balance of the year, we expect to see a modest rise in yields, particularly once central banks commence the tapering process. But as is so often the case after a long road trip, the visibility on the side roads can be poor, and we can expect a bumpy and unpredictable ride en route to our final destination.

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