How much higher can bonds go?

In case you haven’t noticed, the TSX is down 5% YTD and 10% from April 2011 highs… which puts it squarely in a typical correction territory… while Bonds (as represented by XBB – DEX Universe Bond Index) are up 2.5% and 4.25% for the same period as illustrated by the TSX/XBB weekly charts

Here is look at the bond performance over the past decade… and today XBB gaped up!

The question is not how low can stocks go but rather how much higher can bonds go?

Bond prices are inversely related to interest rates i.e. if bonds are rising then interest rates/yields are falling… for all intents and purposes, XBB reflects all rates along the yield curve i.e. short and long term rates…

short term rates are above their record lows but 1% is still low historically

10 yr GOC yield is at 2.8%… which is ~10 bp higher than the most recent low of 2.68% from a year ago

So there is room for bonds to go up further especially considering the Euro area weakness… but will we see new lows in 10-year yields?

(in case you are wondering why the 10-year yields… the trend of 10-year yields is usually considered a good barometer of future economic growth)

Canadian Interest Rates & Fixed Mortgage Rates

Fixed mortgage rates are no longer “historically low” … 1, 3 & 5 year fixed rates increased by 15, 20 & 25 basis points in the 2nd week of Feb 2011… this is the beginning of a trend that might pick up pace given that the Canadian economy (& global economy) is performing better than forecast.

BOC is scheduled to announce interest rate decision tomorrow and market expects no change to the BOC rate, currently at 1% …

The bond markets expect the BOC rates to rise 25 basis points in the next 3 months… look at the steepening yield curve.

Rising Interest Rates – thanks to QE?

If you haven’t already heard so…interest rates have reversed their downward trend to dramatically move up since the November Federal Reserve meeting, Quantitative Easing (QE2) announcement… QE2 is supposed keep US interest rates low… would you have thought that it would affect rates elsewhere?

Year-to-Date chart of Canadian interest rates…

As marked on the chart, interest rates in Canada have risen significantly over the last 6 weeks… especially the medium to long term rates in the 2-10 year terms. The 5-year rate is at 2.56%, same as in mid-July.

Here is the term chart or the Canadian yield curve… see the parallel shift in yield across all terms!

This means, borrowing costs will increase in proportion… yes, including mortgage rates, particularly fixed rates.

The 5-year fixed rates are as low as they have ever been… but they will be rising shortly; see this

The Bank of Canada hasn’t indicated any shift in monetary policy since the last rate hike in Sep-2010… so why are rates in Canada rising? Possible reasons:

· Higher inflation expectation

· Better than expected economic growth

· Bond markets are overbought

· Rising risk of default (!)

Stay tuned… I will explore each of these possibilities in the coming days…

Interest Rates in the future

Ever wonder what interest rates will be in the future? If you have a mortgage, you probably have the typical 5-year (or shorter) term. At the end of your term, you have to renew your mortgage for the remaining balance at the then prevailing mortgage rates.

So how can you tell today what rates will be at the end of your mortgage term? The answer is Forward Rates, which are rates implied by current interest rates on various maturity/term bonds.

I have charted the path of 5-year bond yields on the current day (also called Spot Rate) and 2 & 5 years from current day (also called Forward Rates). In other words, the 5 year interest rate, 2 years from now and the 5 year interest rate, 5 years from now.

It is very easy to calculate forward rates and the theory is rather simple, lets calculate the 5-year rate, 2 years from today.

The formula is:

F5 = ((1+S7)^7)/((1+S2)^2)^(1/5) -1

F5 is the 5-year forward rate 2 years from today

S7 is the current 7-year spot rate (5 years 2 years from today = 7 years from today)

S2 is the current 2-year spot rate

Source: Bank of Canada

The 5-year rate, 2 years from now (red line) has been steadily trending down and is around 3.00% now which is higher than today’s 5-year rate of about 2.00%. The down trend is due to yield curve flattening or becoming less steep. I commented on this earlier today.

In other words, 5-year bond yields will increase by 1.00% in the next 2 years.

Word of Caution: Forward rates change continuously with bond yields and hence are not guaranteed future rates for any day other than current day.

Flatenning Yield Curve – Canadian Bond Yields go down

Government of Canada Yield Curve flatenned since April 2010… flatenning means the long term bond yields decrease more than short-term yields… in fact short term yields on treasuries rose in direct response to increase in Bank of Canada rate in June & July 2010. 

Flatenning of yield curve is a sign of weak economic outlook and tame inflation. The economic outlook in Canada has deteriorated since April 2010… Last week’s release of Canadian economic indicators – wholesale sales, retail sales & consumer price index – were less than forecast

Source: Bank of Canada

Flatenning yield curve has the effect of reducing medium to long-term borrowing costs for business and households… E.g. – The 5-year fixed mortgage rate is priced relative to the 5-year Government of Canada bond yields which are currently at 2.4%… Usually the spread is about 120-150bps… which would mean the 5-year fixed mortgage rate should be about 2.4+1.5 = 3.9%… the best posted rate is about 4.25% … so if you are negotiating a mortgage be sure to use this and other research from here & here

Coming next… profit margin on Fixed rate mortgages

i.e. the difference between what the Banks charge customers and what it costs them…