Not long ago, investors were asking how low interest rates could go. Now, with most central banks in neutral or tightening mode, investors are asking the opposite.
Despite action from central banks, long-term bond yields are so far unimpressive.
“The significant change in tone by several central banks has had little impact on the financial markets,” says senior economist Mathieu D’Anjou in a Desjardins economics report. “Even in the United States, where the Fed raised its key rates by one per cent, the 10-year yield is staying near two per cent.”
The problem is real yields are low, with the real 10-year yield “hovering at around 0.50 per cent, which is a far cry from the yields of two per cent or higher commonly seen in the early 2000s,” says the report. “After rebounding into positive territory in late 2013, real 10-year yields have not shown an upward trend since the Fed began its key rate hikes in December 2015.”
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As short-term yields rise, however, long-term yields should eventually follow suit.
“It would not be logical for lenders to accept a lower real yield on 10-year bonds than on one-year bonds, unless they are counting on an imminent recession,” says the report.
Over the past year, the yield curve flattened significantly — an unsustainable trend, particularly since the supply of U.S. bonds is abundant.
“In addition, the Fed’s estimates show that the term premium on a 10‐year bond, which reflects the part of the bond yield that cannot be explained by anticipations over short-term rates, is already negative, and an additional drop would be surprising,” says the report.
To assess the future of monetary policy, the report discusses the theoretical concept of the neutral rate, defined as the rate that maintains an economy operating at its full capacity while keeping inflation at the level targeted by the central bank once cyclical influences have dissipated.
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The neutral rate thus indicates when central banks should end monetary tightening.
While there’s uncertainty surrounding the exact value of neutral rates, “the weight of evidence suggests that they are at least 2.5 per cent in nominal terms,” says the report.
At that value, assuming economic growth and inflation both rise as expected, the U.S. Federal and the Bank of Canada can “continue to gradually raise their key rates in the coming quarters without worrying about implementing a contractionary monetary policy.”
That means “a significant increase in long‐term bond yields in the next few quarters.”