Length - 4:07

Rates are Rising but Still Chronically Low

Pat O’Toole
Vice-President, Global Fixed Income,
CIBC Asset Management
“Well we've seen the Bank of Canada start to increase its interest rate, and it sounds like some people are taking that to mean that there is going to be a full-blown interest rate hike cycle. The Bank, I don't think, was committing to anything of course. It's not in their self-interest to commit to anything at the moment. So they're basically giving guidance saying, yeah we're still going to look to remove some of that emergency 50 basis points of cuts that we did in 2015. I think the press is maybe overhyping the fact that this is a full-blown interest rate hike cycle coming up. And that gets people scared because they remember the past where you had the Central Bank raising rates three, four, five percentage points and then bond yields jump and you have a bad bond market. This cycle is much different. We all know it's different. This whole growth cycle has been lower. Inflation has been lower. Inflation hasn't come close to what the central banks have been expecting. And even though it's below their target level, they are starting to hike interest rates a little bit believing inflation is coming back. We think the bank is going to hike once more maybe in the next six months, nine months maybe they'll get away with two hikes or three in the next 18 months but it's going to be a very different cycle than we've seen in the past.”

Low growth means low rates
“Well they started increasing interest rates, and you know the prime rates going up and some people think like Mick Jagger said the prime rate is going up up up up up. Now we're not so sure. We think people should get, temper their enthusiasm here a little bit given the fact that we have a much lower growth environment than we've seen in the past. Now why has growth been lower? It's not a surprise growth has been lower. We should have all been expecting growth to slow from the levels we saw 10, 20 years ago. And that's because we've seen a drop in the labor force growth rate. We all know that demographic story. The boomers are aging, and you can see it from labor force growth rates from 10, 20 years ago, it was two and a half percent in the late 70s early 80s. That's dropped down to about point six percent. So how does that impact growth? While the economy grows basically through two vehicles, more workers in the workforce, so labor force growth rate is going up or productivity is increasing. Those workers are making more widgets next year than they made this year or it's a combination of both of those factors, means you have a higher trend growth.  And what you also notice is that nominal GDP follows that labor force growth rate with a bit of a lag. And we expect that trend to continue as well so nominal growth nominal GDP will be lower in 10 years than it is today as a potential growth level.”

Bond yields follow GDP levels
“So what does that mean for bond yields? Well there's always been a good rule of thumb that long-term government bond yields follow nominal GDP and there are always wiggles back and forth above their respective lines. But if you look today those bond yields are lower than nominal GDP. So this is not like cycles we've seen in the past. It's not like bond levels, bond yield levels we've seen in the past. We're pretty much stuck in a pretty low-yield environment. That means lower returns for pretty much all asset classes not just bonds.”

Where should investors turn?
“We believe that corporate bonds are going to continue to outperform government bonds. So government bond yields can move up a little bit as the economy does continue to be okay, even maybe a little above trend growth in the next year or so. And inflation stays fairly stable, that means a pretty moderate interest rate hike cycle from the central bank here in Canada and the Federal Reserve in the U.S. and that will push bond yields up very minimally. We think the bond market is already priced in a large part of what the central banks might do over the next 12-month period. So we don't see those government bond yields rising much and people are going to continue, in our view, to look to alternatives than government bonds to actually have higher yields in their portfolio, and that means investment grade and high yield corporate bonds are the better place to be. That's been the story the last several years. We think it's going to continue to be the story going forward. So you want to focus on those portfolios that are overweight corporate bonds, don't have as many government bonds - there’s nothing wrong with having a little bit in there for some insurance - or look to pure corporate bond funds that have a good mix of investment grade and high yield, to try and keep yields higher, your overall yield higher, than what you're getting on pure government bond portfolios.”