RISKS, HEDGES AND OPPORTUNITIES: GOVERNMENT BONDS

Why One Should Worry About Government Bonds

Guest post from Hubert Marleau, Chief Investment Officer, Palos Management Inc.

There is sufficient North American economic interdependence, trade relations and financial similarities to support, perhaps in an oblique fashion, the hypothesis that some sort of equilibrium – like little interest rate differentials and exchange rate parity – should exist (for most part) between Canada and the United States. However, differences in money costs often occur because the application of monetary policies can vary in degree of magnitude. On Friday last, the exchange value of the Canadian dollar was fetching 102.35 U.S. cents and Canadian and U.S. ten year bonds were both yielding 2.99%. However, the Bank of Canada target rate was 1.00% versus 0.25% for the Fed’s target rate, reflecting the exercise of easier monetary policies in the U.S. than in Canada. Assuming that there is validity to the aforementioned supposition, then it very puzzling as to why government bond yields are as low as they are.

Economic theory presumes, if all other things are equal, that a reduction in demand should occur when the Fed ends QE2, the Standard & Poor places U.S. debt on negative watch and default risk is up in the air. Such circumstances should derail the government bond market. I understand that the above factors are playing with investor expectations, making the bond market sentiment bond bullish. Nevertheless, at some point, bond investors will come to their senses and realize that they are accepting negative real rates. As a matter of fact, they are being financially repressed by a hidden tax that greatly benefits, at their expense, governments. Surely, bond investors will eventually get tired of seeing their wealth transferred to irresponsible governments.

Dark thinking like grimmer economic prospects or bumps in the road is par for the course. May’s paltry 54,000 jobs gain is below expectations but not a collapse in employment growth. Moreover, the credit markets are sound and money growth is rising. Experience shows that financial repression is a hold back on bond investors that cannot last indefinitely. One hundred years of monetary history should be good enough to prove that in the end, ten year government bond yields usually equal about 80% of the yearly percentage change in nominal GDP, if there are no default risks.

A few weeks ago, Statistics Canada reported that nominal GDP in the quarter ended March 2011 was 6.0% higher than a year ago. In this connection, ten year Canada bonds should trade around 4.80%. One could argue that 180 bps of wealth is, day-by- day, being transferred from private investment and pension accounts to you-know-who. What can one think is going to happen to bond prices when Congress lifts the debt ceiling in August and permits more fiscal largeness?

 

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