The Stars Are Aligning for Higher Bond Yields

Transcription

1 SEPTEMBER 8, THE YIELD CURVE The Stars Are Aligning for Higher Bond Yields HIGHLIGHTS ff Because of an improving global economy, a number of central banks have begun to normalize their monetary policy, and others are getting ready to follow suit. Bond yields still do not reflect the situation well, and are likely to rise. ff Investors who were waiting for the Federal Reserve (Fed) to signal more hesitation about pursuing monetary firming at the September meeting have been disappointed. Not only did the Fed confirm that it would start to slowly let its balance sheet shrink as of October, but the vast majority of leaders still think that another key rate increase will be justified by year s end. ff The fact that the Fed was, until quite recently, the only advanced nation central bank to tighten its monetary policy was also an important factor in justifying ongoing very weak bond yields. However, that situation is changing fast: the (BoC) suddenly started to firm up its monetary policy this summer, and the Bank of England clearly signalled plans to do the same as of November. ff Given the lag between monetary policy decisions and their impacts on the economy, the BoC must get into position for faster future price growth as of now. Under these conditions, we can expect key rates to keep going up in the coming months, with another increase in October, and further increases in 8 and 9. CONTENTS Highlights and Editorial... Monetary Policies Federal Reserve Overseas Central Bank... 5 Bond Market United States... Provinces... 8 # BEST OVERALL FORECASTER - CANADA So far, has been marked by a fairly generalized improvement in the advanced nations economic environments and outlooks. Second-quarter results show that most of these economies recorded lively growth, with everything indicating that they will continue to do well, as consumer and business confidence indexes remain high. Despite this, and the ongoing U.S. monetary firming, long-term bond yields generally remain very low. The U.S. year yield fell back to almost % at the start of September, its lowest point since Donald Trump was elected in November. As we explained in the Economic Viewpoint published on September,, the bond market s surprising performance primarily seems to stem from the fact that many investors are still convinced that monetary policy will remain highly accommodating in the coming years. They can justify an extremely flat yield curve in the United States by arguing that monetary firming is nearly over. Inflation moderated in several countries at the end of last spring, which seemed to fuel this view, as did remarks from certain Federal Reserve (Fed) leaders, who seemed to want to wait for clearer signs that inflation was accelerating before raising key rates further. The Fed Stays on Course Investors who were waiting for the Fed to signal more hesitation about pursuing monetary firming at the September meeting have however been disappointed. Not only did the Fed confirm that it would start to slowly let its balance sheet shrink as of October (more details on page ), but the vast majority of leaders ( out of ) still think that another % key rate increase will be justified by year s end if the U.S. economy continues to perform close to expectations (graph on page ). Some leaders downgraded the long-term equilibrium rate for federal funds, Canada... 7 Tables Key Rates... 9 Fixed Income Market... 9 Schedule of Central Bank Meetings... François Dupuis, Vice-President and Chief Economist Mathieu D Anjou, Senior Economist Benoit P. Durocher, Senior Economist Francis Généreux, Senior Economist Jimmy Jean, Senior Economist Hendrix Vachon, Senior Economist Desjardins, Economic Studies: 5 8 or 8 8 7, ext. 555 desjardins.economics@desjardins.com desjardins.com/economics NOTE TO READERS: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively. IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright, Desjardins Group. All rights reserved.

2 GRAPH GRAPH Twelve of the Federal Reserve s sixteen leaders expect key rates will have to be raised by the end of the year In the last year, economic growth in G7 nations has substantially outstripped potential growth Appropriate increase in federal funds by the end of In number of leaders. % % % Real GDP growth since mid- Potential growth*.5.5. June September Sources: Federal Reserve and Desjardins, Economic Studies taking the median forecast to.75%, but that is still much higher than the current rate. As the U.S. jobless rate could drop about.5% below its long-term equilibrium rate next year, according to Fed leaders forecasts, it makes sense that inflation slightly below target would not be enough to halt monetary firming. At the press conference, Chair Janet Yellen also took a fairly optimistic tone, noting key rate hikes in the last few quarters and the decision to start reducing the Fed s balance sheet reflected the U.S. economy s good performance. She added that all job market indicators pointed to a vast and continuing improvement in the labor market. In a speech on September, she argued that the presence of many uncertainties strengthen the case for a gradual pace of tightening, but that it would be imprudent to act too gradually or to keep the policy unchanged until inflation increased to %. Canada U.S. Germany France U.K. Japan Italy * In, according to the Organisation for Economic Co-operation and Development (OECD). already gone up nearly basis points in the last few weeks. This uptrend should persist as investors gradually revise their key rate expectations, especially for the United States. Our target for the U.S. year rate is.% at the end of, and we would not be at all surprised to see a steeper surge toward.%. François Dupuis, Vice-President and Chief Economist Mathieu D Anjou, CFA, Senior Economist and It Is No Longer Alone in Tightening Monetary Policy The fact that the Fed was, until quite recently, the only advanced nation central bank to tighten its monetary policy was also an important factor in justifying ongoing very weak bond yields. However, that situation is changing fast: the suddenly started to firm up its monetary policy this summer, and the Bank of England clearly signalled plans to do the same as of November. Facing weak inflation and strong appreciation by the euro, the is more hesitant to change its stance, but we still expect it to decrease its securities purchases next year. With strong growth in the leading economies triggering a generalized reduction in excess production capacity, because economic growth potential remains low (graph ), it is normal to see the central banks worry less about inflation that is slightly too low. Year Yields Closer to % Than % Given that the main arguments for bond yields remaining extremely low are collapsing one by one, we can only, once again, be impressed by the bond market s resilience. However, it seems increasingly vulnerable and the U.S. year yield has SEPTEMBER

3 Federal Reserve (Fed) Gradual Monetary Policy Normalization Will Continue FORECASTS A 5 basis-point key rate increase is expected for the December meeting, followed by three increases in 8. Various factors could affect those forecasts, however, including lasting, low inflation and whether Janet Yellen s mandate at the head of the Fed will be renewed. In this monetary policy normalization cycle, the Fed has already raised its key rates four times: December 5, December, March and June. The quarterly pace that began last December and continued until spring has stopped, however; at their September meeting, Janet Yellen and her colleagues chose to keep key interest rates where they were. Is that the last of the rate increases? It doesn t seem so. Inflation s weakness and the uncertainty over the hurricanes economic impact argued for caution. In fact, Fed leaders median forecast suggests another key rate increase by the end of. The Fed did not sit on its hands at the last meeting. It decided to begin another step in the process of normalizing its monetary policy. As of October, it will start downsizing its holdings of the federal and mortgage bonds bought during various quantitative easing operations. The downsizing will be very gradual, as the Fed will not directly dispose of its bonds. Instead, it will stop reinvesting all of the amounts freed up by maturities and early payments. The decrease will be limited to certain predetermined monthly thresholds (initially US$B for Treasury securities and US$B for mortgage-backed securities). The thresholds will rise every three months until they reach US$5B a month (US$B for Treasury securities and US$B for mortgage-backed securities). Since the crisis, the Fed s transactions have taken its asset holdings above US$,B. This sum could slide toward US$,5B in five years. The Fed is betting that downsizing its balance sheet will not send a shock into the financial markets. One factor that likely kept the Fed from announcing another rate increase in September is weak inflation. The annual change in the consumer price index (CPI) went from.7% in February to.9% in August. The core CPI, which excludes food and energy, dropped from.% to.7%, its lowest point since January 5 (graph ). However, many of the factors that have been making inflation weak are fading. Firstly, there is less and less excess production capacity. Real GDP should reach potential GDP shortly (graph ). Inflation is therefore expected to rise a little more quickly next year, which will allow the Fed to gradually keep increasing its key rates. For more details, see our study: Is the Period of Lacklustre U.S. Inflation Winding Down?, Desjardins, Economic Studies, Economic Viewpoint, September,, p. GRAPH GRAPH Inflation slowed since the beginning of the year The output gap is nearly closed Annual variation in % of potential GDP Gap between real GDP and potential GDP Total CPI 5 CPI excluding food and energy CPI: Consumer price index Sources: Bureau of Labor Statistics and Desjardins, Economic Studies - -7 Desjardins forecasts Sources: Bureau of Economic Analysis, Congressional Budget Office and Desjardins, Economic Studies SEPTEMBER

4 (BoC) Key Rates Should Continue to Rise Slowly FORECASTS Given the lag between monetary policy decisions and their impacts on the economy, the BoC must get into position for faster future price growth as of now. Under these conditions, we can expect key rates to keep going up in the coming months, with another increase in October, and further increases in 8 and 9. Canada s economy maintained a very high cruising speed in the second quarter, with real GDP growth of.5%. This increase follows first-quarter growth of.7%, and takes the total gain from the start of the year to.% (annualized). We have not seen this lively a beginning to a year since (graph 5). Among other things, consumer spending is up sharply, stimulated by a solid labour market performance, increased household income and fairly high consumer confidence. stay above growth potential in and 8, which will help generate a positive output gap (graph ). The real GDP growth is well above its growth potential, which the BoC puts at.% to.% for. As a result, excess capacity was quickly absorbed and the output gap is nearly closed. This can be seen in the unemployment rate, among other things. At just.% in August, it is below equilibrium, which the Organisation for Economic Co-operation and Development (OECD) estimates is.7% for. Note that the equilibrium rate (NAIRU) is the unemployment rate below which some inflationary pressure begins to emerge. On the other hand, as excess production capacity is absorbed and slight shortages emerge in certain sectors, upside pressure on prices could eventually intensify. Under these conditions, the total annual inflation rate should rise to around the midpoint target in the second half of 8. The total annual inflation rate went from.% in July to.% in August. With the lagged impact of excess capacity seen in recent years, we can expect total inflation s rise to remain subdued in the coming months. That should keep the total annual inflation rate below the midpoint target (%) for several more months. The effects of the gradual rise by key interest rates and slowing housing market should, however, help curb Canadian domestic demand growth in the coming quarters. In the near term, base effects will still favour ongoing sustained economic growth in the third quarter of. After that, real GDP growth should converge on a pace that is more sustainable over the medium range, i.e. around %. This means that real GDP growth will GRAPH 5 GRAPH Canada s economy has shown vigorous growth since the start of Canada s output gap should be in positive territory as of now Total growth* in the year s first two quarters Output gap * Annualized. Sources: Statistics Canada and Desjardins, Economic Studies Desjardins forecasts Average 8 Integrated framework 8 Extended multivariate filter Sources: Statistics Canada, and Desjardins, Economic Studies SEPTEMBER

5 Overseas Central Bank The Bank of England Opens the Door to a Rate Increase Despite Brexit BANK OF ENGLAND (BoE) In the summer of, after the Brexit vote, the BoE had increased its asset holdings and cut its key rate by a quarter of a point. These interventions were aimed at helping Britain s economy get through a period of probable turbulence. More than a year later, Britain s economy is doing relatively well, with excess production capacity still declining and inflationary pressure becoming a growing threat. Inflation has been around the % mark for some time now (graph 7). The pound s prior depreciation no longer seems to be the only explanation for the high inflation and the BoE is now opening the door to interest rate increases. Our forecasts now include a quarter point increase before year s end. After that, the British economy could slow enough to discourage the BoE from continuing with monetary firming in 8. EUROPEAN CENTRAL BANK (ECB) The euro s appreciation adds to the uncertainty; the ECB is indicating that it will keep a close eye on the situation. The euro s strength also influences inflation, justifying a downgrade to the forecasts for 8 and 9, despite a more robust economy (graph 8). The inflation forecasts were also trimmed in June. The ECB refrained from rushing to make a September announcement about a potential reduction to its securities purchases. However, we are expecting such an announcement by the end of the year, probably in October. Stronger euro appreciation could prompt the ECB to wait a little longer or opt for a more gradual approach. Interest rate increases seem quite distant still; they will probably not come before the end of 8. GRAPH 7 Inflation is around % in the United Kingdom Inflation rate Total CPI CPI excluding food and energy CPI: Consumer price index GRAPH 8 The ECB trimmed its inflation outlooks for 8 and 9 a little Euro zone Inflation rate ECB forecasts for total CPI Total CPI March forecasts 5 9 CPI excluding food and energy June forecasts ECB: ; CPI: Consumer price index BANK OF JAPAN (BoJ) Like most of the advanced economies, Japan s economy recently picked up the pace (graph 9). However, inflation remains weak, at around.5%, and the BoJ is not giving any clues about removing monetary stimulus soon. It seems to want to wait for inflation to anchor in at around % before it takes the foot off the gas. The pace of securities purchases is still being guided by a target of about % for the year bond yield. The BoJ may have to accelerate its purchases if the global trend for bond yields heads upward again. GRAPH 9 Japan s economy has accelerated Real GDP Quarterly annualized variation Annual variation Sources: Cabinet Office and Desjardins, Economic Studies SEPTEMBER 5

6 Bond Market Despite Monetary Policy Normalization, Markets Remain in Post-Crisis Mode FORECASTS Because of an improving global economy, a number of central banks have begun to normalize their monetary policy, and others are getting ready to follow suit. Bond yields still do not reflect the situation well, and are likely to rise. Our target for the U.S. year yield is.% at the end of. For the end of 8, it is.%. In Canada, short-term bond yield rise should be similar to that in the United States. Yield spreads should therefore be more stable in 8. Long-term yields are also likely to shoot up in the fourth quarter. Our target for Canada s year yield is.5% for the end of and.5% for the end of 8. U.S. FEDERAL BONDS In the U.S. bond markets, the dynamics for short- and long-term yields are still sharply divergent. The Federal Reserve (Fed) has ordered three key rate hikes since December. A year ago, the financial markets did not see this scenario as very probable. Another rate increase is likely in December, which would take the increases to three in, consistent with the scenario Fed leaders were banking on at the start of the year. In response, year yields have tended to increase over the year, although relatively slightly. On the other hand, the 5 year yield is still slightly below where it started the year, while the year yield is down basis points since January. This indicates that the markets are quite skeptical about the prospect of rate increases. Although the Fed has delivered the goods so far, all year long, markets still have trouble pricing in more than one increase over a month horizon. Many investors thought, with inflation still weak, that the Fed was on the wrong track in raising key rates. Over the summer, some of the Fed s most dovish leaders bolstered this perspective by challenging the need to raise rates again failing more convincing signals from inflation. That, combined with the many uncertainties, like the surge in geopolitical tension and the new U.S. administration s inability to move its reforms forward, has helped keep longer-term yields on a downward trajectory. The year yield even came very close to dropping below.% on September 8, something not seen since Donald Trump was elected. Fed in December, an assumption the markets have adhered to since the last Fed meeting. In 8, the Fed should once again announce three key rate hikes. Among other things, it is increasingly clear that the Fed is not as worried about low inflation against the backdrop of an economy that is running at full capacity and a jobless rate that is below equilibrium. Janet Yellen described inflation s weakness in this context as a mystery, but the leaders forecasts clearly signal that they do not expect the situation to persist. And, although the Fed had been going it alone on normalization, it now has company: the (BoC) and, perhaps soon, the Bank of England and the (ECB). A concerted key rate movement (graph ) combined with a decline in quantitative easing in Europe and a reduction of the Fed bond holdings would be a context not seen since the crisis. Yet longer-term bond yields are not yet positioned substantially differently than they were in the context of firmly accommodative monetary policies. Expectations could thus start being re-evaluated and, given where yields currently are, this argues for still fairly large movements in long-term yields. It would not be the first time rates shot up in the fourth quarter (graph on page 7). GRAPH Monetary policy normalization is no longer only the Federal Reserve s business Key rates However, on September, the Fed announced that it would start to shrink its balance sheet, as it had signalled earlier in the year, and Chair Janet Yellen was much less alarmist about inflation than some expected. This cooled enthusiasm for longerterm bonds somewhat; however, at the time of writing, the year yield was at just.5%, almost basis points below its most recent peak, reached just over a month after Donald Trump was elected. In our opinion, long-term yields should continue to rise through the end of this year. We expect another key rate hike from the Quarterly annualized variation in % Federal Reserve Bank of England Forecasts according to swap markets Sources: Bloomberg and Desjardins, Economic Studies SEPTEMBER

7 GRAPH In recent years, rates have often gone up in the fourth quarter U.S. -year yield Total variation in basis points 5 8 Unlike other central banks, which were careful to telegraph their moves, the BoC seems to want to limit its transparency to avoid complacency in expectations, among other reasons. Given the greater uncertainty over the BoC, there could be a little more volatility than usual on the release of each piece of economic data. Officials remarks could also be analyzed in great detail and perhaps over-interpreted OCT. NOV. no BoC official had made a public appearance since the July meeting. The BoC later pointed to second-quarter real GDP growth that was higher than it expected (.5% vs. the projected.%) to justify the decision, but the fact that rates were adjusted without a previous signal convinced investors and forecasters that the BoC was data dependent. DEC. CANADIAN FEDERAL BONDS We saw Canadian bond yields escalate dramatically over the summer, reflecting the similarly spectacular shift in the BoC s tone. Last March, Governor Stephen Poloz was still not ruling out a possible rate cut, but the economic numbers were so convincing that the BoC announced an increase to its overnight rate in July, then another one in September, which took the rate to %. The short-term yields reacted the most: the year rate has gone up more than 85 basis points since May. The spread between the year rate and its U.S. counterpart went from - basis points to 8 basis points during this time. We had not seen a positive spread since the start of 5, when the BoC had relaxed its monetary policy (graph ). The 5 year spread also went into positive territory at the start of September, but has since relapsed. Even the year spread shrank to -7 basis points on September 8, before widening again subequently. GRAPH Policy rates should continue to rise in North America Policy rates GRAPH Short-term rate spreads went into positive territory Canada U.S. rate spreads In basis points -year 5-year Federal Reserve* 7 9 Desjardins forecasts 5 9 * Upper bound for the federal funds rate. Sources: Bloomberg and Desjardins, Economic Studies -9 - Our own economic scenario for the third quarter calls for real GDP to grow well above growth potential. Underlying inflation is still edging up and, in a context in which excess capacity has been completely absorbed, the BoC should have the arguments it needs to decrease the level of monetary easing once more, which it characterized as considerable in its last statement. We are therefore expecting an increase at the October 5 meeting. With the impacts of the increases on the real estate market (along with the tighter regulations), and on net exports (through a stronger currency), the BoC should adopt more gradual normalization after that. For 8, we expect one rate increase in January, and two increases in the second half of the year, in July and October. Our scenario therefore calls for four further rate increases in Canada by the end of 8, similar to our scenario for the United States (graph ). 5 Sources: Bloomberg and Desjardins, Economic Studies The Canadian bond markets are quite nervous, given the ups and downs of the BoC s communications. Officials had skilfully steered investors into pricing in the July increase. However, the markets were left on their own for September s decision, as PROVINCIAL AND CORPORATE BONDS Spreads between provincial and federal bond yields were fairly stable until June. They then moved downward until the start of August. This was primarily due to the surge in federal bond yields over the summer, rather than movements in the provincial yields. Although this source of downside pressure on spreads has SEPTEMBER 7

8 waned, spreads are still well below where they started the year (graph ). GRAPH Spreads between provincial yields are narrower than they were at the start of the year Gap between -year bond yields and the federal bond yield In basis points 95 Quebec 9 Ontario British Columbia JAN. FEB. MAR. APR. MAY. JUN. JUL. AUG. SEP. Sources: Bloomberg and Desjardins, Economic Studies Among the major debt-issuing provinces, yield movements were very synchronized over the summer. The biggest difference is in the year yield spread between British Columbia and Ontario. It was -9. basis points on average during the first four months of this year, but has been at an average of -5.5 points since May. British Columbia has slightly less advantageous borrowing costs than Ontario, primarily as a result of the advent of a new government formed from an alliance between the New Democratic Party and Green Party. Earlier in September, the government tabled a budget update which showed only a very slight decrease in the surpluses forecast for this fiscal year and the next. Some were initially concerned about a major erosion of public finances given that the political landscape had tilted to the left. So far, that has not materialized. This helped limit yield spread narrowing, but the fact remains that the next budget is when the government will have the opportunity to completely put its plan into action. Further east, yield spreads between Quebec and Ontario are seeing a flat calm. For the year horizon, Quebec s yield is remaining very slightly lower than Ontario s. Both provinces are benefiting from lively economic momentum this year. Next year will be an election year in both provinces, which could bring on some volatility. In the corporate bond market, the environment is characterized by a quest for yield and very low borrowing costs. The yield spread between U.S. corporations with AAA ratings and federal year bonds has narrowed to 7 basis points, the smallest spread in seven years. Businesses are capitalizing on the situation to do extensive issuing. In the United States alone, issuance for recently crossed the $,B mark; giants like Apple, IBM and Home Depot have been especially active. The situation could change in 8, as the ECB should start to gradually reduce its securities purchases, which are still fuelling the quest for yield. Combined with the upside impacts on longer-term rates of the Fed starting to shrink its balance sheet, this could be the last chance corporate treasurers have to issue at a bargain. SEPTEMBER 8

9 TABLE Key interest rates 8 Q Q Q Q Q Q Qf Qf Qf Qf Qf Qf United States Federal funds Canada Overnight funds.75. Zone euro Refinancing rate.5 United Kingdom Base rate END OF PERIOD IN % Japan Main key rate f: forecasts TABLE Fixed income market END OF PERIOD IN % UNITED STATES Treasury bills -month Federal bonds -year 5-year -year -year Yield curve slopes 5-year - -month -year - -year -year - -month 8 Q Q Q Q Q Q Qf Qf Qf Qf Qf Qf CANADA Treasury bills -month..9 Federal bonds -year year year.. -year..7 Yield curve slopes 5-year - -month..8 -year - -year.9.5 -year - -month.5. Yield spreads (Canada United States) -month.. -year year year year f: forecasts SEPTEMBER 9

10 Schedule of Central Bank Meetings Date January 8 9 Central banks Decision Rate. February Federal Reserve Bank of England 8 Reserve Bank of New Zealand 9 Bank of Mexico 5 Bank of Sweden Bank of Brazil +5 b.p. -75 b.p March Federal Reserve Bank of England Bank of Norway Swiss National Bank Reserve Bank of New Zealand Bank of Mexico +5 b.p. +5 b.p April 7 7 Bank of Brazil Bank of Sweden - b.p. - Federal Reserve Bank of Norway Reserve Bank of New Zealand Bank of England Bank of Mexico Bank of Brazil +5 b.p. - b.p Federal Reserve Bank of England Swiss National Bank Reserve Bank of New Zealand Bank of Norway Bank of Mexico +5 b.p. +5 b.p Bank of Brazil May June Central banks Decision Rate +5 b.p. - b.p Bank of England Reserve Bank of New Zealand Bank of Mexico September 5 Bank of Brazil 7 7 Bank of Sweden Bank of England Swiss National Bank Federal Reserve Bank of Norway 7 Reserve Bank of New Zealand 8 Bank of Mexico - b.p. +5 b.p July -75 b.p. 8 Date 9 August 9 October Bank of Sweden Federal Reserve Bank of Brazil Bank of Brazil Bank of Norway Bank of Sweden November Federal Reserve Bank of England 7 8 Reserve Bank of New Zealand 9 Bank of Mexico 9 December 5 Bank of Brazil Federal Reserve Bank of England Bank of Norway Bank of Mexico Swiss National Bank Bank of Sweden NOTE: Certain banks may decide to change rates in-between the scheduled meetings. The abbreviations and b.p. correspond to status quo and basis points respectively. SEPTEMBER