Flattest Curve in Developed World Tells the Bond Market’s Tale

To get a sense of how blasé investors are about inflation look no further than Canada, which sports both the fastest growth among its developed peers and the flattest yield curve.

Source: Bloomberg Markets

The premium investors demand to hold 30-year bonds over two-year securities shrank to as little as 82 basis points this month, the least since 2008, as yields on shorter maturities shot up to a six-year high after the Bank of Canada tightened policy twice in a row. Yields on longer-maturity bonds remain depressed and are trading close to their six-year average.

While a flat yield curve typically suggests investors are worried about the outlook for the economy, that doesn’t appear to be the case in Canada. The languor in the long end of the curve is largely related to a global trend: there’s hardly any inflation anywhere. And even though Canada boasts the fastest economic growth among Group-of-Seven countries, there’s little belief among investors that 4.5 percent growth will trickle down to significantly accelerate prices.

‘Close Attention’

“The bank can put pressure on the short end of the curve by moving the rates, but the long end is much more difficult to influence,” said Randall Malcolm, managing director at Sun Life Investment Management in Toronto which has around C$37 billion in Canadian fixed income. “Inflation has been dead for so long that it’s hard to see it coming back strong.”

Bank of Canada Deputy Governor Timothy Lane said on Monday policy makers will be “paying close attention” to how the economy responds to higher borrowing costs and a stronger Canadian dollar following rate increases in July and earlier this month. That widened the spread between two-year and thirty-year bonds to 88 basis points.

Rate Surge

That compares with 97 basis points for the same gauge in Japan and 125 basis points for Switzerland. Two-year yields in these two countries are negative, while their 30-year rates below 1 percent. The U.S. gap stands at 141 basis points.

To be sure, yield curves in some emerging markets are flatter than in Canada. In South Korea and Mexico, where short-term rates are higher as the countries run tighter monetary policies, the longer bonds yield 50 to 60 basis points more than the shorter bonds. Similarly in China, the spread is at 74 basis points, according to data compiled by Bloomberg.

The yield on Canada’s two-year bond has surged 82 basis points since June 9, one working day before the Bank of Canada first signaled it was considering an increase in interest rates. The yield on the country’s 30-year bond has added 41 basis points in the same period, which is nine basis points less than the total monetary tightening the central bank rolled out at its last two meetings.

There’s a good chance the flattening of Canada’s yield curve will continue as the Bank of Canada will probably continue increasing borrowing costs, which will impact the short end of the curve. For the long end to move higher, however, it will require pressure from abroad, which won’t come as fast, according to David Stonehouse, a Toronto-based portfolio manager who helps oversee C$6 billion in fixed-income assets at AGF Management Ltd.

“This is the best year for growth globally, but it’s still not gangbuster,” he said. “We’re certainly going to need to see a lot more traction on inflation than we’ve seen so far.”