Alive and well

For quite some time now, market “experts” have predicted that bond prices would fall, stating that interest rates were going to rise soon, entailing a weak bond market.

These pundits believed that, as the economy recovered, the Bank of Canada and the U.S. Federal Reserve Board would raise interest rates. Thus, as a result bonds yielding say 2 percent would fall in order to adjust to the higher interest rates that were certain (?) to be forthcoming. Bond prices move in the opposite direction to bond yields- as interest rates rise, bond prices fall.

The interest rates on bonds are responsive to inflation, basically the so-called “core” rate. When consumer prices start rising, bond yields go up. Investors want an extra cushion to make certain that their bond payments will not be adversely affected by higher prices.

It should be noted that the move to higher bond prices and lower interest rates has been going on for more than 30 years. At one point U.S. Treasuries had an interest rate of more than 25 per cent, which now are just over 2 per cent.

Now there is absolutely no evidence that the core inflation rate will start rising, nothing to precipitate higher inflation.

Heretofore inflation was associated with war. Government increased credit demands to pay for war expenditures and cut back on consumer goods. Thus, beginning in the 1970’s, except for brief bouts of inflation induced by OPEC’s rising oil prices, steady consumer prices should have occurred.

Consumers, with an eye to the past, bet on ever-rising prices. They borrowed excessively to buy houses, which soared in price. Government spending climbed, fueled by rising debt as all assumed that prices would spiral upward indefinitely.

Then excessive debt loads became unsustainable, and the public was no longer able to pay the huge interest payments triggered by all this borrowing. Soon, as inflation was followed by deflation, a business contraction ensued. Real estate prices crashed, layoffs followed, and a deflationary cycle started.

When will this deflationary cycle end? Probably it will continue for at least a year. The Bank of Canada and the U.S. Federal Reserve Board have pledged to keep interest rates near zero for at least another year.

Furthermore, there are no indications that inflation will rear its head as the business recovery remains subdued. Until then, the bond market will be alive and well and bonds will remain a premier investment.


Bruce Whitestone