VGSH - What Rising U.S. Bond Yields Are Telling Us About Financial Markets

2023-08-24 00:00:00 ET

Summary

• Why U.S. bond yields are surging.
• Are U.S. bond yields likely to continue trending higher?
• The implications of rising bond yields for the Fed.

Transcript

Greg Bonnell: While headline inflation has cooled this year, bond yields continue to grind higher. So what's the market trying to tell us about the future direction of interest rates? Joining us now to discuss, Michael Craig, head of asset allocation at TD Asset Management. Michael, great to have you back on the program.

Michael Craig: My pleasure, Greg. Great to be here.

Greg Bonnell: So I don't know if this is in a lot of people's playbooks this summer with yields and the bond market grinding higher, and grinding to multi-year highs. I think in some, maybe the tenure and further out, we're back to pre-financial crisis highs. What's going on out there?

Michael Craig: Yeah, there's been a little bit of a head-scratching. There's been some negative news this month. The US [cap] was downgraded. So that certainly wasn't great for sentiment. And more recently, they've announced higher amounts of funding. So they're actually issuing more bonds than what was expected. And so that's putting a bit of pressure. But it's August. A lot of people are on vacation.

The speculative community has taken a fairly large short position in treasuries. And that's pushed it higher. And I would say that you really aren't going to get a good feel for where we're going to be until about the third week of September when people are back at their desks and kind of reassessing.

At these levels, you are starting to trigger by programs from large managers that are moving from equities to debt. And it would be interesting to see where we are in about a month's time once everyone's back at their desks and at work.

Greg Bonnell: You mentioned it's the summer doldrums. You do see the bond yields are grinding higher. It gets tongues wagging, of course. Because people still need to fill programming time on different business networks. People start saying, well, if we're following this, why not 6 on a tenure? I mean, is it realistic that bond yields could move substantially higher from here absent some massive triggering event?

Michael Craig: Yeah, I would look at it two ways. There's a move higher. And then there's the durability of kind of stay at that level for any period of time. 6 seems a bit aggressive. But can tenure rates move to 5%? I mean, it's possible.

But how long can they withstand there? How long can the world function? How long can companies and households get financed at those higher rates as people reset their mortgages or look at their variable lines of credit or companies look to refinance debt moving from coupons of 3 to 7 or 8?

All of a sudden, that starts to affect our demand. As a definition, as the cost of money goes higher, we'll consume less. And that is in itself is deflationary. So look, anything can happen in the near term.

Look, there's a limited liquidity right now so things can move around. But I struggle to see rates staying at a high level for a long period of time without material economic damage being inflicted on the global economy.

So long story short is for income investors who are looking not so much for the next quarter, but for longer periods of time, these are fairly attractive income yields that you can garner from fixed income right now.

Greg Bonnell: On the equity side, even though August has been choppy after July was pretty strong in the equity market, they're still holding in considering how much rates have grinded higher. I mean, there's been a pullback, but nothing too dramatic. I mean, what's the dynamic there?

Michael Craig: Well, year-to-date returns are still very, very good. But Europe's pretty much been flat since the spring. When you look at the TSX versus the S&P, they're very different markets. The S&P is up give or take 15% of the year. And TSX is up maybe with dividends maybe 3, 3 and a bit. That is really an example of how this has been driven by just a handful of stocks.

A lot of good news has been priced in now. Can they go higher? Absolutely. In videos of earnings tomorrow, AI is all the rage. Lots of capital. There's lots of investment going there. But you do - when you do look at - when people start quoting price-to-sales and you don't - your return is in sales. It's earnings.

People start using different metrics to kind of ascribe value. You do have to kind of - you should have a bit of pause and think how much of it has already been priced in. So I would say on equities - and again, it's been a tough month for equities. We're going into seasonally a very challenging period. August and September tend to be quite tough for equities.

Again, when we get back into work next month, when you look at earnings yields or the price what you pay for a stock versus its earnings, versus what you get for cash versus what you can get in fixed income, right now it's very, very tight - the tightest it's been in 20 years, making both cash and fixed income. It's more attractive on an earnings perspective than stocks.

Greg Bonnell: We are going to get one event where last summer it turned out to be sort of a big one - Jerome Powell at Jackson Hole. Go back to almost a year because he'll be there at the end of this week really laying it down and sort of bringing the hammer down. And there was a big reaction. What do you think the message would be from him this time around? I mean, it's been a full year of hiking rates. Headline inflation is coming down. What does Powell have to tell people?

Michael Craig: I don't think he needs to do a whole lot. I don't think there is the urgency to warn the market about higher rates. The higher rates are already here. When you look at the SOFR or the old euro-dollar market, the market's pricing in elevated short rates in the US for some time now. We're looking at a terminal rate of 4%. It was 3% a few months ago. I don't think the world has changed that much.

So I think financial conditions are already quite tight. Inflation is coming down. You're going to see, just based the way it's calculated, rent start to really - rental disinflation starts to help the inflation numbers. So I mean, longer term, we can have a different argument on inflation. But near term, I think that inflationary pressure is still continuous.

So I think he's kind of got what he's wanted. And remember, Fed's got dual mandate - inflation and maximum employment. Employment's still very strong, but it has started to soften.

I don't think this is a time for him to start shifting to the growth narrative. But I don't think there's a lot of value in him doubling down on that we're going to keep raising rates. And we're kind of at the end of the cycle, anyway.

Maybe they get one more hike in, maybe not. So I think in many ways, he might actually start talking about the success they've had, if anything. And as I said, I don't think this is going to be as much of a market event as it was last year.

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