The U.S. 2-/10-year slope inverted in mid-2022, and we are still waiting for the recession that was allegedly predicted by the yield curve. At this point, the yield curve maximalists have to be hoping for a recession triggered by a trade war in the coming months. At which point, the maximalists will argue that the yield curve predicted the trade war in 2022 the same way it predicted COVID-19.

For those of us who are not yield curve maximalists, we can argue that the yield curve roughly predicted what it is supposed to: an end to the Fed rate hike campaign as well as cuts. The problem for bond bulls is that the cuts were relatively mild, and as Friday’s labour market report showed, the economy remains resilient. My favourite labour market indicator — the employment-to-population ratio — is doing nothing interesting, which is consistent with steady growth.

If the United States did not face erratic policy shifts, one could argue that the small positive slope puts bonds in a decent position. There is a small cushion of carry versus the front end, and although a re-acceleration of growth might prompt some hikes, the possibility of some sort of growth accident would trigger deep cuts by the Fed, making the risk profile asymmetric (although the steady growth scenario would be more likely).

Unfortunately, we do not live in that magical world of limited policy uncertainty. Tax cuts are a priority, and even though there are Republican spending cut targets, they are too small versus the hoped-for tax cuts. Using tariffs to keep the CBO happy is easily going to trigger “Transitory Inflation 2.0.” The only major growth/inflation moderating story would be the effect of countervailing tariffs. Although the Fed might attempt to “look through” the immediate price shock of tariffs, their willingness to do will be limited by the outcome of “looking through” the post-pandemic price spike. (I don’t think monetary policy had that much effect on the inflation miss, but I am certainly not on the FOMC.)

Canadian Yields

The fragile state of the Canadian economy has left the Canadian 10-year yield much lower (at the time of writing, 3.5%). This would be upsetting to the many economists who insist that Canadian bond yields trade as a spread to U.S. yields if they were capable of examining their beliefs based on data. (In case it’s not obvious, this is based on multiple conversations I have had with economists over the years. Many point out that the Bank of Canada’s internal models were based on this assumption, without ever questioning whether this point was in their favour.)

For semi-retired Canadians doing some asset allocation shifts at the beginning of the tax year, it would appear advantageous to shift bond holdings to U.S. dollar ones. Unfortunately, the Canadian dollar has not been cooperative, weakening to historically cheap nominal levels.

• If the U.S. dollar bonds are unhedged, the yield advantage could easily be wiped out by a mean-reversion in the currency. Although it is hard to get too excited about the Canadian dollar when Canada is in Trump’s tariffs crosshairs, the U.S. economy itself is in the crosshairs of the same person.
• Hedging the currency — not a trivial task for a retail account — results in (roughly) flat carry, and leaves you exposed to relative growth strength in the United States. There might be an argument that this relative position would have interesting risk management characteristics, but my gut reaction is that most of the volatility will show up on the U.S. rates leg, so the position would end up directional with U.S. rates.

This situation is interesting from the perspective of pop currency trading theories. Since Canadian yields are lower, the dominant theory is that the Canadian dollar will continue to lose value (making unhedged U.S. Treasury longs/Government of Canada shorts irresistible). Although this time could be different, I would point to past history — the CAD/USD traces out an extremely wide trading range, and trade fundamentals will eventually matter. A tariff war might break those fundamentals — but that scenario requires a belief that doing things like trashing the supply chains of the Big 3 automakers and losing cheap Canadian crude is politically sustainable.

The other “interest rates and currency” theory predicts the exact opposite — the Canadian dollar is mechanically priced to appreciate in currency forward markets. This appreciation is referred to as “expected appreciation” — which refers to the expected value in option pricing markets, and is not necessarily a forecast. Some economists appear to be believe that exchange rates are determined by institutional investors arbitraging hedged treasury bills. (Spoiler: this is not true.) The rates market and the currency market are both large markets with largely indirect linkages. Although I respect rate expectations (with some caveats), currency markets can ignore the trade breakeven point (i.e., the forward) created by rate differentials for a very long time.

Although it may have already happened, the situation appears rife for one of the periodic “Canadian bond apocalypse” stories to pop up on hedge fund radar’s. Although some Post-Keynesians also like the idea of bond and currency vigilantes joining forces, my sense is that domestic bond managers would just view any pop in yields a chance to do some duration-matching. If the Canadian economy actually did start accelerating, the Canadian dollar might start performing again.

More By This Author:

Yay For The Bond Vigilantes
Primer: Introduction To Credit Spreads
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