Bond market sends positive signals

The bond markets are telling us a very interesting story these days. If it’s true, it could be good news.

Falling interest rates have been in the headlines for the past month. At the end of January, the U.S. Federal Reserve Board announced its second half point cut in four weeks. Coming on the heels of the January 3 cut of the same amount, it means the Fed has slashed its key rate by a full percentage point so far this year.

And they indicated at the January meeting that more cuts are likely on the way.

In this country, the Bank of Canada has been slower to move – we have only seen one quarter-point cut so far this year. But lenders are slashing their rates, with mortgage rates leading the way.

Of course, all of this is a typical and predictable response to slowing economic growth. We’ve been down this road before, many times. The central bankers will continue to cut rates, aggressively so in the U.S., until consumer confidence is restored and the economic engine revives. Then we’ll move back towards a tightening phase to keep inflation at bay.

Impact on bonds
A falling interest rate environment is normally very good for bo markets. When interest rates drop, bond prices rise and vice versa. But lately the bond markets have been behaving in a rather unusual way – perhaps sending us a signal that the economic slowdown is not going to be as long or as deep as some people fear.

There are three parts to the bond market:

    1. Short bonds (maturities of five years or less)
    2. Mid-term bonds (five to 10 year maturities)
    3. Long bonds (10 to 30 years).

Like the stock markets, bond markets are leading indicators of what’s coming down the road.

Last summer, long bond prices started to head up as yields moved down. This was a signal that bond traders believed that economic growth had peaked and that interest rate cuts were coming. Over the last half of 2000, long-term bonds scored big gains. The benchmark 30-year Government of Canada bond showed a 13 per cent gain over the 12-month period to January 31. The 30-year benchmark U.S. Government bond did even better, advancing 24.9 per cent over that period.

Read the signals
But recently it’s been a different story. During January, these benchmark bonds actually declined in value, by more than 5 per cent in both cases. On the other hand, short and mid-term bonds are continuing to display strength.

What does it all mean? The bond market seems to be telling us that, while we should expect more cuts in short-term rates, long-term rates have dropped as much as they are likely to, at least for now. If we can believe this signal, it suggests that the economic slowdown is going to be relatively short and that we should see a turnaround by mid-year – which, of course, would be very good news for the stock markets.

Junk bonds moving
There’s another bond market phenomenon taking place which may also be a portent of better times ahead. Last fall, we told you about how badly high-yield bonds (junk bonds if you prefer) were being beaten up. No one wanted to buy them. Spreads between the high yield bonds and government bonds reached levels unseen for a decade.

Recently, the picture has changed. Money is starting to move into the high-yield market again, to take advantage of the attractive yields. Prices for low-grade commercial bonds have been improving and the asset values of the mutual funds that invest in them have been rising. Some high-yield bond funds have moved up more than 5 per cent in the past 30 days. Altamira High-Yield Bond added 6.8 per cent.

Traders signal spring?
This suggests increased confidence on the part of investors and diminishing concern about wide-scale defaults. Again, it appears to be a positive signal.

I’m not suggesting that you should go out and bet the house on this. But these are interesting developments that have been lost in all the news about shutdowns and layoffs and plunging consumer confidence.

Let’s just hope that the bond traders (like the groundhog) are right and that spring is indeed just around the corner – both weather-wise and economy-wise.

Adapted from the Internet Wealth Builder, a weekly e-mail financial advisory newsletter edited and published by Gordon Pape.