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Bond yields sending ominous signal about Canada's economy

By LUKE KAWA | The Globe and Mail | January 29 2015

The bond market is sounding the alarm about what’s in store for the Canadian economy.

On Tuesday morning, the yield on the five-year Government of Canada bond sank below the Bank of Canada’s overnight rate of 0.75 per cent, and remained five basis points below that level when the markets closed on Thursday.

The overnight rate – the interest rate at which banks lend one another funds for one day – is usually lower than the interest rate that investors demand to be paid by the Canadian government in exchange for a five-year loan. A normal yield curve slopes upward; that is, investors require more compensation the longer they are willing to part with their principal. As the yield on the five-year note is lower than the overnight rate, this suggests that market participants expect the Bank of Canada to lower interest rates again in response to deteriorating economic fundamentals due to the plunge in the price of oil. Simply, investors are betting that Canadian growth and inflation are poised to slow.

The inversion of the overnight rate and the five-year yield is a relatively rare phenomenon, and often bodes ill for the economy. The two previous periods in which this occurred were in the run-up to the Great Recession and in 2000-01 as the dot-com bubble was bursting.

“While the yield spread between the overnight rate and the five-year Government of Canada note isn’t a surefire predictor of slowing growth, it’s gotten more effective in that respect over the past decade and a half,” researchers at Bespoke Investment Group said. “This suggests downside risk to Canadian growth given the inversion that has taken place.”

The decline in Canadian yields accelerated after the Bank of Canada’s surprising move on Jan. 21, but falling bond yields are by no means a uniquely Canadian development. Around the globe, there is more than $7-trillion in debt from the euro zone, Switzerland and Japan that carries a negative yield, which makes the yield on Canadian debt appear more attractive. This, as well as the country’s AAA credit rating and the shortage of safe-haven assets due to a global savings glut, have combined to put persistent downward pressure on government borrowing costs.

The speed of the recent decline, however, is staggering. On Thursday afternoon, the yield on the Government of Canada 10-year bond traded at 1.37 per cent, which is where five-year bond yield was sitting just one month earlier. During this period, the five-year yield has been cut in half.

In the United States, for instance, the yield on the 30-year Treasury has dropped to record lows. But this decline has been accompanied by an appreciation in its currency, indicative of a “flight to safety” in which investors flock to assets denominated in the world’s reserve currency.

Bespoke observed that since the mid-1990s, this relationship has often held true for Canadian assets: When Canadian bonds outperform their U.S. counterparts, the loonie has tended to strengthen against the greenback.

This time around, the loonie has tumbled along with bond yields, hitting a five-and-a-half-year low against the U.S. dollar, signifying that the drop-off in Canadian bond yields is primarily linked to reduced expectations for growth, inflation and the Bank of Canada’s short-term rate.

The Bank of Canada reduced its estimate for economic growth in 2015 to 2.1 per cent from 2.4 per cent following its latest meeting, and a number of private forecasters have followed suit.

Bespoke noted that Canada’s long-standing economic ties to the United States, which was the only one of the G7 or BRIC economies that had its growth outlook upgraded by the International Monetary Fund, may help the country stave off economic disaster.

In fact, over the past 30 years, quarterly economic growth in Canada has been positive 95 per cent of the time if the U.S. economy expanded during that period.

Canadians may also want to take solace in the fact that the bond market, an amalgamation of the beliefs of fallible humans, is not omniscient.

“Diving yields like we’re seeing do tend to suggest genuine concern about a more lasting slump; the market seems to be pricing in that lower oil prices and weak global growth may be more of a permanent shock,” said CIBC World Markets chief economist Avery Shenfeld. “However, the bond market’s record of forecasting has some hits and some misses, and in this case, it seems unduly pessimistic about the medium-term economic landscape.”