Algonquin Capital: "Rates They Are A-Changin"

~ Bob Dylan

As the world tries to figure out what to expect from a Trump presidency, it appears the market has reached its conclusion. With US 10y bond yields up 0.60% in November, the expectation is for stronger growth and higher rates.

Investors, shocked with losses of 2% in their fixed income portfolios, have been wondering what happened and what’s next?

To answer these questions let us begin by looking in the rear view mirror. Historically, government debt has yielded 1% to 2% above inflation. When US 10 year notes traded at 1.75%, one could assume that people expected changes in consumer prices to be roughly zero for a decade. This seemingly bold bet suddenly appeared to be a silly one, prompting people to hit the sell button.

What drove the panic selling?

The anticipation of a substantial supply of new bonds and inflation.

As the Dylan song goes, “Come senators, congressmen, please heed the call.” With Republican’s in full control of US policy, the door is open to significant tax cuts and infrastructure spending. Since such policies would need to be financed with an abundance of debt, investors are rightfully demanding a higher return as compensation.

Donald and friends have also raised the inflation spectre. With US unemployment at 4.9% and a tough stance on illegal immigrants, there may be a limited amount of labour to meet the demand created by fiscal stimulus. This could lead to a substantial rise in wages to attract employees.

Further stoking the inflationary flames is the potential for a trade war. There have been forecasts showing that the imposition of 15% tariffs on Mexico and China could add 1% to US consumer prices.

This combination of rising wages and prices would push the Federal Reserve to steadily hike rates through 2017, forcing bond prices lower. As long as the promise of fiscal stimulus remains, US yields will likely remain under upward pressure. The path won’t necessarily be a straight one; however, it does seem that the ‘bottom’ is in.

What about O Canada, our home and native land?

Unlike the Federal Reserve, we expect the Bank of Canada to remain on the sidelines for the foreseeable future. This will keep short end rates anchored, but longer-dated yields have to adjust higher in sympathy with the US in order to entice global investors.

So how much higher will Canadian interest rates go?

To answer this, we revert back to our trusty rear view mirror. The Bank of Canada has successfully managed to keep inflation at roughly 2% for the last 25 years. Assuming history is a reasonable guide and rates normalize, one can expect 5 and 10 year yields to reach somewhere between 2.5% and 4%. These levels are more than double today’s yields, meaning more losses from traditional fixed income could be on the way.

How long will it take for rates to reach these levels?

‘The answer, my friend, is blowin’ in the wind.
The answer is blowin’ in the wind.’