Why Are Bond Yields Falling in the Face of Improving Economic Data?

It must be tough to teach economics in the bizarre world we find ourselves in today.

To wit: Last week Statistics Canada reported that our gross domestic product (GDP) grew by 2.8% on a year-over-year basis in the third quarter, well above the consensus forecast of 2.1%. This positive momentum dovetails nicely with our improving employment picture, which saw more than 100,000 jobs added to our economy over the same period. As one would intuitively expect in such an environment, our overall inflation levels also trended higher during the third quarter, with our consumer price index (CPI) coming in at 2.4% in October and remaining above the Bank of Canada’s mid-range inflation target of 2.0% over that entire three-month period.

Using these key indicators, a student of traditional economics would be correct in assuming that bond yields should typically rise against this backdrop but instead, over that period five-year Government of Canada (GoC) bond yields have traded at their lowest levels since 2012, and fell again last week in spite of the GDP upside surprise.

Meanwhile, the U.S. Commerce Department revised its initial third quarter year-over-year estimate of U.S. GDP growth from 3.4% to 3.9% last week. That impressive result means that the U.S. economy has just experienced its strongest back-to-back quarters of GDP growth since 2003. U.S. employment has also shown steady improvement in momentum for some time now, with average monthly job creation increasing from 186,000 in 2012 to 194,000 in 2013 and to 225,000 in the first nine months of 2014 (as recently reported by The Economist). And while U.S. CPI inflation has held steady at 1.7% of late, there are many Americans who would argue that there has been much more inflation than has been captured in that official measurement (the recent drop in gasoline prices being the exception).

Here again, the high-level indicators of U.S. GDP, employment, and inflation would be expected to correspond with rising bond yields, yet five-year U.S. treasury yields have followed the same downward trend recently.

There are many explanations for the disconnect between the improving high-level economic data and the movement of both Canadian and U.S. bond yields. For example, while the GDP growthrate in both countries is now rising, this increased momentum has not inspired businesses to throw the full weight of their balance sheets into productivity improvements and capacity expansion. On the employment front, participation rates, which measure the percentage of the working-age population who are either employed or actively looking for work, hover near record lows. Both countries are still retooling their economies in the aftermath of the Great Recession and while it’s true that job creation has improved on both sides of the 49^th parallel, the average worker has struggled to have their income barely keep pace with cost-of-living increases. It’s hard to imagine how economic growth can continue to strengthen in either country if the purchasing power of its average citizens varies between unchanged and slowly shrinking.

Specifically in Canada, falling oil prices have recently caused bond-market investors to retool their growth forecasts because our economy has relied heavily on rising oil prices for momentum since the start of the Great Recession. Alberta, which benefits most when oil prices rise, has created the vast majority of high-paying new jobs over that period. If employment creation stalls out we could see a sharp slowing in our economic momentum, and that would exacerbate the risks inherent in today’s record high household debt levels. Also, while the Loonie has fallen precipitously against the Greenback of late, making our exports more competitive in our main foreign market, many businesses remain cautious and still question whether rising U.S. demand is sustainable.

Although the U.S. economy now appears to be on a more encouraging trajectory, it still has significant long-term challenges to address, such as massively underfunded liabilities (Medicare, social security), a bloated Fed balance sheet and a still substantial federal budget deficit. And while the threat of deflation had waned of late, the U.S. dollar now strengthens day by day, increasing downward pressure on average prices, renewing the threat of deflation, and also making U.S. exports less competitive.

So while investors see encouraging headlines that show incremental improvement in both Canadian and U.S. momentum, they aren’t reacting in the way that a student of economics would expect under normal circumstances. And there’s the rub. These are anything but normal circumstances.

Instead of a garden-variety recession where everybody takes their lumps and adjusts before the economy resumes its steady upward trajectory, we remain in the midst of balance sheet recession where most of the world’s largest economies are bowed under the yoke of excessive debt levels. These types of recessions take much longer to recover from, especially today, because instead of taking the necessary pain, most of the world’s largest central banks have engaged in various forms of experimental financial alchemy to counteract the downturn’s negative impacts (in many cases, to allow political leaders to avoid making tough but necessary changes in fiscal policies). Many people believe that these central banking interventions can only provide a temporary reprieve from the inevitable, and that one way or another, the piper will eventually be paid.

In spite of these lingering concerns, unprecedented monetary-policy interventions continue apace, with Japan the latest country to double down on its version of quantitative easing, while European Central Bank Governor Mario Draghi continues to flirt with his own version of trying to print the euro zone out of its current economic malaise.

So while the signs of recovery are apparent in the headline data, there remains a nagging fear that the highly manipulated global economic recovery is built on sand. Those who take the long view know that instability in powerful underlying forces, such as debt levels, could quickly overwhelm the incremental improvements that we see in the macroeconomic data today.

That’s why bond-yield investors are taking note of the improving U.S. and Canadian economic data but are unwilling to bet on them just yet.

Following the above theme, five-year GoC bond yields were thirteen basis points lower for the week, closing at 1.38% on Friday. Five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, and five-year fixed-rate pre-approvals are offered at 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.

The Bottom Line: While Canadian and U.S. economic data continue to improve, government bond yields remain stubbornly stuck at ultra-low levels in both countries, largely for the reasons outlined above. The bond market’s subdued reaction to the stronger headline numbers appears to confirm that the lower-for-longer interest-rate view remains well entrenched. If that is true, our fixed and variable mortgage rates should remain at or near today’s levels for some time yet.