What Goes Down Must Go Up

by The Algonquin Team, Algonquin Capital

“For every action, there is an equal and opposite reaction."
Sir Isaac Newton

The big, and perhaps most perplexing, question in fixed income land is: When will interest rates rise?

Unfortunately, we broke our crystal ball a few months back and will have to rely on economic theory and a bit of physics to unwrap the problem.

Theoretically speaking, rates should rise when the risk of lending money rises.  When dealing with governments, the risk of default is typically assumed to be negligible (not a good assumption across the board – think Greece or Argentina).  Accordingly, the focus tends to be on inflation.  As such, prior to the economic meltdown of 2008, government yields generally traded one to two percent higher than expected inflation.

But over the past eight years this relationship has broken down.  Today, government securities return less (sometimes far less) than inflation.  One could argue that investors are so risk averse that they would rather lose purchasing power slowly than face potential capital losses in riskier assets.  Others claim that we are in the grips of deflation and that bonds actually offer good value.  Try telling that to anyone buying a home in Vancouver or Toronto, or to those who pay attention to their household bills.

So to answer the big question we must first ask, what’s keeping interest rates so low?