Bond investors know just how bad the first half of 2001 has been.
The Canadian benchmark 10-year bond has fallen 40 basis points in yield since the beginning of the year.
After that kind of thumping, it may seem tempting to shy away from the bond market in the hope that equities and the economy have bottomed out.
However, such apprehensiveness would ignore a number of key factors that support investing in the bond market.
These factors, combined with the recent rise in yields, indicate the current market may provide investors with an opportunity to lock in higher yields while simultaneously offering the possibility of enjoying capital gains by year end.
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Inflation, which raised concerns for the bond market when it ran up to a high of 3.9 percent in May, turned lower in June.
While today’s 3.3 percent inflation rate is still above the Bank of Canada’s target of one to three percent, investors should understand that inflation provides a rear view mirror of the economy. Current inflation is simply the residue of yesterday’s strong economy.
Inflation down the road is what investors need to consider. A good measure of that is capacity utilization, which determines the extent that a company is producing goods or services relative to its potential output if all plant, equipment and labour are fully used.
It is near a 10-year low in the United States, and unemployment is creeping up. There is a lot of room for the inflation rate to tumble in coming months, supporting the American and Canadian bond markets.
Weaker overseas economies are also leading to discounting on a broad range of manufactured products.
If this downtrend in worldwide inflation continues, bond prices appear to be relatively cheap. Bonds’ current levels assume a global recovery in the second half of 2001 and renewed inflation pressures thereafter.
In Canada, there is even more room for a bond market rally.
The Bank of Canada has so far been reluctant to engage in the kind of easing carried out by the U.S. Federal Reserve Board, whose cuts since the beginning of the year are almost twice as much as the 150 basis points its Canadian counterpart delivered over the same period.
Despite economic growth grinding to a near halt in April, our central bank was preoccupied until recently with the risks of inflation caused by rising energy costs.
Since that seems more unlikely with recent declines in the price of oil and gas, the Bank of Canada should feel free to cut interest rates more to stimulate a sluggish Canadian economy.
As always, investors need to be careful about bond market investments in this uncertain phase of the business cycle. Turning points in the business cycle are difficult to pinpoint.
The U.S. Fed seems ready to continue its aggressive easing of monetary policy. The lower interest rates and resulting upturn in the economy should help stocks regain their attraction at some point.
Any decision to invest in bonds must therefore be weighed against the potential for significant longer-term returns in the equity market and the need to ensure a properly balanced asset mix of stocks, bonds and cash.
Nevertheless, anything less than a quick and sharp economic recovery in the second half of 2001, which most economists think is unlikely, should be good news for the bond market.
Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
