While U.S. stock markets soar to record highs after the passing of the Trump administration’s Tax Cuts and Jobs Act, bonds face a rough ride.
A perfect storm is building for higher interest rates. How fast rates rise and if they rise for the right reasons—strong economic growth and the accompanying inflation—are key questions for financial markets. The implications are far-reaching—from threatening U.S. stock markets to the Canadian economy and its highly leveraged borrowers.
Interest rates in advanced economies are being pushed higher by strengthening global growth, prospects for higher inflation, and less bond buying by central banks. The United States has the additional dynamic of a ballooning deficit to fund $1.5 trillion in tax cuts, which may double its supply of bonds in 2018.
“The dramatic increase in U.S. fixed-income supply in 2018 is a significant risk to markets,” said Deutsche Bank chief international economist Torsten Slok in an email to clients.
The U.S. 10-year bond yield is hitting levels it hasn’t since the fall of 2014. The 2.60 percent yield level has been breached and the direction it’s headed unquestionably seems higher. The Canadian 10-year bond yield has followed suit, albeit in reference to a 2.20 percent yield.
“They’re a material driver, particularly for [Canadian] 10-year bonds,” said Andrew Kelvin about U.S. Treasury bonds in a phone interview. Kelvin, senior Canada rates strategist at TD Securities, added, “The five-year sector is still impacted certainly by U.S. Treasury yields.”
With Canadians owing on average about $1.70 in debt for every dollar of disposable income, the Bank of Canada remains cautious on future rate hikes. But mortgage rates follow Canadian bond yields, which move without caution, as U.S bond yields drag them higher.
Slok says that if demand for U.S. bonds doesn’t double, then rates will move higher, the additional cost for companies to borrow (credit spreads) will increase, the U.S. dollar will weaken, and stocks will likely fall as foreigners move out of depreciating U.S. assets—all while U.S. economic fundamentals remain strong.
More Buyers Needed
The U.S. Joint Committee on Taxation estimates that the new tax cuts will add $135 billion to the deficit in fiscal year 2018 and $280 billion in 2019.
TD Securities estimates the U.S Federal Reserve’s reduced bond buying will add $230 billion to the deficit in 2018. This will need to be funded by Treasury issuance, which TD Securities expects to be concentrated in maturities below five years.
As the supply of bonds increase, the amount of additional yield investors require to own the bonds generally increases.
What’s important for the health of the stock market is that credit spreads remain stable.
“A rapid increase in rates (roughly 100 basis points [1 percent]) would hit spread markets, delivering moderately wider spreads as opposed to the tightening that has often historically occurred when rates rise gently,” said Jeffrey Rosenberg, Blackrock’s chief fixed-income strategist in his January commentary.
Blackrock’s global chief investment strategist, Richard Turnill, says rising global inflation expectations are already fuelling higher bond yields.
“Markets are growing more confident that global inflation has finally hit bottom,” said Turnill in his Jan. 22 weekly commentary.
He points to the recent move higher in U.S. 10-year yields as being mainly driven by the market’s expectation for higher inflation—at their highest in three years.
The International Monetary Fund just upgraded its global growth forecast to 3.9 percent in 2018 and 2019—up by 0.2 percent from October. A key part of this is the bigger boost forecast for U.S. growth in 2018 of 2.7 percent—up by 0.4 percent from October.
The Fed penciled in three rate hikes for 2018 in its December forecast. Accordingly, the U.S. 2-year yield recently moved above 2 percent for the first time since the fall of 2008 and now is slightly higher than the S&P 500 dividend yield.
Slok says the supply of U.S. government bonds will almost double to $1 trillion in 2018. BMO deputy chief economist Michael Gregory says the U.S. Treasury has to find buyers for more than $500 billion of debt.
“Investors should spend less time looking at U.S. economic fundamentals and more time on where a doubling in demand for U.S. fixed income can come from,” Slok said.
The U.S. bond market is getting nailed at both ends. While a rapid rise in rates is unlikely, a gradual increase certainly appears to be.
“We’ve seen fairly modest increases in yields in the U.S., all things equal,” Kelvin said. He doesn’t think the Bank of Canada is expecting a very large increase in rates, say 1 percent, as a likely scenario, but it’s a risk at this stage.
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