Back to the Future for Bonds
Market analysts put a great deal of effort into analyzing long-term historical trends to better understand the cyclical nature of human behaviour and its impact on financial market prices. Interest rates are no exception. In fact, as Sidney Homer writes in hisHistory of Interest Rates: 2000 B.C. to the Present:
“A bird’s-eye view of the history of interest rates will unsettle most preconceived ideas of what is a high rate or a low rate or an average rate. Each generation tends to consider normal the range of interest rates with which it grew up; rates much higher suggest a crisis or seem extortionate, while rates much lower seem artificial or inadequate. Almost every generation is eventually shocked by the behaviour of interest rates because, in fact, market rates on interest in modern times have rarely been stable for long. Usually they are rising or falling to unexpected extremes. A student of the history of interest rates will not be surprised by volatility.”
In the past 5,000 years of recorded history, from the Mesopotamian era in 3000 B.C. to the present, two factors have influenced the level of interest rates more than any others:
Typically, declining confidence reduces demand for a nation’s debt, while wars, which are very expensive, often increase the supply of bonds; in many cases, both these factors go hand in hand. The rise and fall of the Roman Empire provide the classic tale of interest rates following the ebb and flow of the tides of a nation and its people. Rates declined from its earliest history (500 B.C.) until a period of great commercial development (100 B.C. to 100 A.D.) and then rose significantly until 300 B.C. in line with the relentless expansion of the empire externally combined with a breakdown in Rome’s political, economic and social confidence internally.
For a more recent analysis, consider Figure One, a chart of long-term UK bond yields over the past 300 years, for further evidence of the interplay between confidence, war and the level of interest rates.
Analysis of long-term UK bond yields over the past 300 years provides further evidence of the interplay between confidence, war and the level of interest rates. The peaks in 1784 and 1798 coincide with the Napoleonic Wars, while the high rates in 1920 followed the end of the First World War. The Vietnam War coupled with the uncertainty of the Arab oil embargo in the early 1970s plus the Iranian Revolution in 1979 shook investors’ confidence in the international system in the late 1970s, causing inflation and interest rates to skyrocket to previously unseen levels. By comparison, the relatively low and calm interest-rate environment in the latter half of the 1800s resulted from peace among the major nations of Europe. While these periods span many years, these themes recur often enough over varying periods to show how war and confidence significantly affect bond yields.
So what does all this mean for the individual deciding between a fixed- or floating-rate home mortgage, the corporate treasurer thinking about locking in an anticipated debt issue, or the fund manager readjusting the duration of a pension plan?
Given the ongoing war in Iraq and the War on Terrorism, the loss of confidence on Wall Street and Bay Street over the past few years, and the scandal-prone administrations in both Washington and Ottawa, don’t be surprised by higher interest rates in the future. This does not mean that bond prices will plummet but rather that there will likely be an inherent bias towards higher rates.
The Fed Reserve only began the rate-rising cycle with its first 25-basis-point increase on June 30. These administered short rates are controlled by central bankers. Bonds and forward-rate contracts follow a much freer rate set by the marketplace. In fact, these open-market rates have been trending upward for some time. For example, one-month Libor rates in both the UK and Australia have risen 100 basis points over the past year. Short-term interest rates, according to C$ Bankers Acceptances and US$ time deposits futures contracts, have been rising in Canada and the U.S. since March and are still pricing in another 200- and 100-basis-point increase, respectively, in each country. Bond markets have been slowly pricing in higher rates for over a year. U.S. 10-year bond yields have risen from 3.07% in June of last year to a near-term interim high of 4.87% on June 14.
Bottom Line: The lows in bond yields reached in June of last year probably marked the bottom. There will be many trading opportunities as bond yields move sideways to higher from near 50-year low in the U.S. So expect a lot of volatility given our increasingly uncertain times brought on by shaken confidence in our systems and outbreaks of war and terrorism.
David Derwin is a member of the Investment Strategy Committee at Jory Capital Inc. in Winnipeg, Canada. This report was prepared under the supervision of Patrick Cooney, CEO.
1- Homer, Sidney, A History of Interest Rates: 2000 B.C. to the Present, Rutgers University Press, 1977.