Show Transcript
It’s still the early days of 2021, but government bond yields in Canada and the U.S. have surged on the prospects of an improved economy. Anthony Okolie speaks with James Orlando, Senior Economist, TD Bank, about the higher yields and the outlook for future growth and inflation.
Print Transcript
- James, let's start with the big picture. Government bond yields in the US and Canada have jumped in early 2021. Given the expectations of lower for longer interest rates, what's driving these yields higher?
- Yeah, a great question. It really is based on the belief in the economic recovery. Go back to the summertime when we had the absolute lows for government bond yields. During that time, it was expected that it could take upwards of a decade for us to recover from the pandemic, and we know from central banks, the Federal Reserve Bank of Canada, that they're not going to raise policy rates until we're fully recovered from this. So that means it gets-- everyone that wants a job, everyone that is working less hours to make sure they're able to get the-- getting the jobs they want to be able to work the hours they want.
And so that gets passed through into bond yields. It means that if a bond investor's looking at, pulse rates is going to be effectively zero for the next 10 years. They're not going to demand much a premium over that. But since that time, a lot of good news has come in. We've seen how strong the economy can bounce back from lockdowns. We saw that in 2020.
We had news of the vaccine. We have vaccine deployment right now. All of this, what it does, it crystallize in our minds how early we can actually have the economy recover from the pandemic and also how early central banks can actually raise policy rates in the future. And so if you're a bond investor and you're saying, OK, policy rates are zero right now, but we think that there's going to be a chance that they're going to be higher in the future, today you're going to demand a higher yield and compensation for that potential for higher interest rates in the future.
- I think the next question that follows is, what are the implications for inflation?
- So economic growth tied to inflation. If we have a stronger, earlier rebound to economic growth, what that does is it puts pressure on supply chains. When we're talking about the recovery, we're talking about people having jobs, people being able to make more money-- have income security that causes them to spend more. And when you have high levels of demand for goods and services, at a time when supply is just catching up to that demand, you have generally pressure on prices. And so you have higher inflation that comes with that.
And when we're looking at that story, we're seeing inflation expectations pricing this in. We had really low expectations when things were looking very dire, but now that the recovery is being priced in, you're seeing inflation being priced above 2% five years from now. And so that's something else that policymakers are looking at. You know the Federal Reserve Bank in Canada. Their target is 2% inflation and for inflation to actually overshoot a little bit to be able to offset the fact that we have low inflation right now. And so that's another indicator that the recovery is being priced right now by market participants.
- And I want to talk a little bit about currency, particularly the US dollar. What's the impact on the greenback? And what does it say about the economic recovery so far?
- So go back to like the worst times of the pandemic in March and April. We saw a huge flight to safety, we call it, so this is demand for safe assets. And the safest asset in the world is considered the US treasury bond. And so for investors all around the world, they were buying US treasuries. And you've got to sell your currency to buy that US dollar to buy that US treasuries. So that causes higher demand for US dollars.
But since then, we've had a big rebound in risk assets. We've seen the unwind in that flight to safety trade. But what's happened over the last few weeks really is that the US dollar is now trading below where it was pre-pandemic.
And what that is is that is people pricing in how this recovery is unfolding. And the recovery isn't pulling in unique ways in the sense that look at China, for example. China is doing really well right now. It's the only major economy in the world that is looking at positive economic growth for 2020-- the only economy. And whereas the US at the same time, we just got GDP numbers today, and we're some 2% or 3% below 2019 levels.
And that extra growth that's going into China means that what it's doing, the products that it specializes in are doing really well. And we know China is exposed or leveraged to exports, and specifically manufacturing. And we've seen the manufacturing recovery going on around the world. We've seen how people are just buying goods, whether it be furniture, whether it be gym equipment-- stuff that if you dropped on your foot would hurt is selling right now. And so China is very much leveraged that-- to that narrative. And so as a result, the Chinese currency, the renminbi, is doing very well against the US dollar.
- And as you mentioned, the US dollar has weakened, but our loonie has strengthened. What accounts for that strength? And where do you see the loonie going over the next little while?
- Yeah, the loonie has also been a big beneficiary of the way in which this recovery has unfolded. Just go back to the China narrative. We know and we saw in the past that when China does well, countries that are exposed and leveraged to raw materials, the commodity-- commodities in general do very well. Things like iron ore, base metals, copper, all of them are seeing price appreciation that's extremely significant, that's well above prices where they were last year. And so as a result, the loonie has appreciated. We're pretty much around fair value levels based on where we think long term fair value really is, so somewhere around 78, 79 US cents is where we think the long term value is for CAD.
Australian dollar, that's another currency that's doing really well. Also a country and a currency that is leveraged to what happens with China and China's economic recovery. So where we think the loonie could go? We've seen a lot of price pressure based on the base metal story, but it could actually go even higher if we see energy prices start following base metals higher. Energy prices haven't recovered as well as base metals, but there's opportunity for that to go up in 2021 as we have more mobility, as people start driving and flying more. That would push energy prices up and also push the Canadian dollar with it.
- And I want to go back to bond yields again. If we continue to see the yield curve steepening, how likely is it that the Fed and the Bank of Canada can continue to maintain this lower for longer rate policy?
- Yeah, so I don't think the steepening yield curve is going to put pressure on the Bank of Canada or the Federal Reserve to do anything. I think what these central banks are looking at is how long or how is the economic recovery going. That's all that really matters to them. If we're seeing job gains or we're seeing the unemployment rate going down or we're seeing economic growth getting back past pre-pandemic levels and really up to our potential economic growth rate, that is the signal for raising rates.
Rising bond yields, what they're doing is they're just reflecting the potential for economic growth to rebound faster and to a higher level than they had expected before. And so that's why you're seeing that steepening of the yield curve. And I got to say that's actually a very natural phenomenon to occur at this point in time in the cycle. We're at the point in time in the cycle where the recession has started and we're recovering out of it.
In the past three economic cycles, the rising long term yields relative to short term yields-- extremely common. They're just pricing in that optimistic future at a time when the central bankers are committed to keeping rates low for the next few years.
- James, thank you very much for your time.
- Thank you.
[MUSIC PLAYING]
- Yeah, a great question. It really is based on the belief in the economic recovery. Go back to the summertime when we had the absolute lows for government bond yields. During that time, it was expected that it could take upwards of a decade for us to recover from the pandemic, and we know from central banks, the Federal Reserve Bank of Canada, that they're not going to raise policy rates until we're fully recovered from this. So that means it gets-- everyone that wants a job, everyone that is working less hours to make sure they're able to get the-- getting the jobs they want to be able to work the hours they want.
And so that gets passed through into bond yields. It means that if a bond investor's looking at, pulse rates is going to be effectively zero for the next 10 years. They're not going to demand much a premium over that. But since that time, a lot of good news has come in. We've seen how strong the economy can bounce back from lockdowns. We saw that in 2020.
We had news of the vaccine. We have vaccine deployment right now. All of this, what it does, it crystallize in our minds how early we can actually have the economy recover from the pandemic and also how early central banks can actually raise policy rates in the future. And so if you're a bond investor and you're saying, OK, policy rates are zero right now, but we think that there's going to be a chance that they're going to be higher in the future, today you're going to demand a higher yield and compensation for that potential for higher interest rates in the future.
- I think the next question that follows is, what are the implications for inflation?
- So economic growth tied to inflation. If we have a stronger, earlier rebound to economic growth, what that does is it puts pressure on supply chains. When we're talking about the recovery, we're talking about people having jobs, people being able to make more money-- have income security that causes them to spend more. And when you have high levels of demand for goods and services, at a time when supply is just catching up to that demand, you have generally pressure on prices. And so you have higher inflation that comes with that.
And when we're looking at that story, we're seeing inflation expectations pricing this in. We had really low expectations when things were looking very dire, but now that the recovery is being priced in, you're seeing inflation being priced above 2% five years from now. And so that's something else that policymakers are looking at. You know the Federal Reserve Bank in Canada. Their target is 2% inflation and for inflation to actually overshoot a little bit to be able to offset the fact that we have low inflation right now. And so that's another indicator that the recovery is being priced right now by market participants.
- And I want to talk a little bit about currency, particularly the US dollar. What's the impact on the greenback? And what does it say about the economic recovery so far?
- So go back to like the worst times of the pandemic in March and April. We saw a huge flight to safety, we call it, so this is demand for safe assets. And the safest asset in the world is considered the US treasury bond. And so for investors all around the world, they were buying US treasuries. And you've got to sell your currency to buy that US dollar to buy that US treasuries. So that causes higher demand for US dollars.
But since then, we've had a big rebound in risk assets. We've seen the unwind in that flight to safety trade. But what's happened over the last few weeks really is that the US dollar is now trading below where it was pre-pandemic.
And what that is is that is people pricing in how this recovery is unfolding. And the recovery isn't pulling in unique ways in the sense that look at China, for example. China is doing really well right now. It's the only major economy in the world that is looking at positive economic growth for 2020-- the only economy. And whereas the US at the same time, we just got GDP numbers today, and we're some 2% or 3% below 2019 levels.
And that extra growth that's going into China means that what it's doing, the products that it specializes in are doing really well. And we know China is exposed or leveraged to exports, and specifically manufacturing. And we've seen the manufacturing recovery going on around the world. We've seen how people are just buying goods, whether it be furniture, whether it be gym equipment-- stuff that if you dropped on your foot would hurt is selling right now. And so China is very much leveraged that-- to that narrative. And so as a result, the Chinese currency, the renminbi, is doing very well against the US dollar.
- And as you mentioned, the US dollar has weakened, but our loonie has strengthened. What accounts for that strength? And where do you see the loonie going over the next little while?
- Yeah, the loonie has also been a big beneficiary of the way in which this recovery has unfolded. Just go back to the China narrative. We know and we saw in the past that when China does well, countries that are exposed and leveraged to raw materials, the commodity-- commodities in general do very well. Things like iron ore, base metals, copper, all of them are seeing price appreciation that's extremely significant, that's well above prices where they were last year. And so as a result, the loonie has appreciated. We're pretty much around fair value levels based on where we think long term fair value really is, so somewhere around 78, 79 US cents is where we think the long term value is for CAD.
Australian dollar, that's another currency that's doing really well. Also a country and a currency that is leveraged to what happens with China and China's economic recovery. So where we think the loonie could go? We've seen a lot of price pressure based on the base metal story, but it could actually go even higher if we see energy prices start following base metals higher. Energy prices haven't recovered as well as base metals, but there's opportunity for that to go up in 2021 as we have more mobility, as people start driving and flying more. That would push energy prices up and also push the Canadian dollar with it.
- And I want to go back to bond yields again. If we continue to see the yield curve steepening, how likely is it that the Fed and the Bank of Canada can continue to maintain this lower for longer rate policy?
- Yeah, so I don't think the steepening yield curve is going to put pressure on the Bank of Canada or the Federal Reserve to do anything. I think what these central banks are looking at is how long or how is the economic recovery going. That's all that really matters to them. If we're seeing job gains or we're seeing the unemployment rate going down or we're seeing economic growth getting back past pre-pandemic levels and really up to our potential economic growth rate, that is the signal for raising rates.
Rising bond yields, what they're doing is they're just reflecting the potential for economic growth to rebound faster and to a higher level than they had expected before. And so that's why you're seeing that steepening of the yield curve. And I got to say that's actually a very natural phenomenon to occur at this point in time in the cycle. We're at the point in time in the cycle where the recession has started and we're recovering out of it.
In the past three economic cycles, the rising long term yields relative to short term yields-- extremely common. They're just pricing in that optimistic future at a time when the central bankers are committed to keeping rates low for the next few years.
- James, thank you very much for your time.
- Thank you.
[MUSIC PLAYING]
