E Canadian Long-Term Interest Rates Tell The Real Story For 2020

Investors looking for clues to the behavior of financial markets in 2020 should look no further than what is currently taking place in the market for long-term government bonds. Beginning in January 2019, the nominal returns on Canadian bonds over 20 years was 2.7% and today the rate sits at 1.45%. More significantly, the real return bonds --- nominal rates less the inflation rate--- dropped dramatically over the year from 0.72% to 0.10% today, virtually a zero rate of return (Figure 1). What is behind this dramatic drop in long-term rates, both nominal and real, and what does this indicate for 2020?

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Figure 1 Real Return on Canadian Long-Term Bonds

Several factors explain this dramatic drop in yields over the last twelve months. Inflation was once again the driving force as evidenced by the measure of the final consumption expenditure deflator which came in at paltry 1.8% for 2019. Inflationary expectations continue to remain very subdued. Corporate profits, as measured by GAAP rules, have been flat for the past three years and have been the primary reason that business investment have consistently been a disappointment. Canadian potential growth has actually slid over the past year, in part because of the failure of business investment to add to the nation’s productive capacity. At the same time, the output gap – the measure between actual and potential growth—has started to widen in the last half of 2019. All the while, Canadian monetary policy remains very restrictive, despite the protestations to the contrary by officials of the Bank of Canada.

The decline in Canadian real rates of interest are consistent with global trends. Over the past twenty years, real yields have fallen in the US, Japan, the euro area and the U.K. (Figure 2).

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Figure 2 Real Rates of Return for Major Economies

Source: Hoisington Economic Review

There is every reason to expect that these deflationary conditions will continue throughout 2020. Internationally, growth momentum is to the downside since late 2019 and the prospects are fading for any revival. International economic organizations, such as the IMF and OECD, have been scaling back on their original growth estimates for 2020, as trade concerns dominate world growth.  U.S. monetary conditions continue to be restrictive, as the Fed has yet to signal that it will be cutting rates in the near term. The Bank of Canada continues to maintain a stand pat position, regardless of a spade of weak economic data received so far and offers up no clues as to any change in policy. The longer the Bank holds onto this belief, the more we can expect long term rates to remain at these levels or lower. In sum, we can expect slower growth and continue to subdue core inflation in 2020. Those purchasing long term bonds today can expect gains over the year.

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