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How Low Can Yields Go?

Rate-LimboThe 5-year government yield is doing the limbo, and the bar keeps being lowered.

It closed Friday at 1.35%. How low it goes depends on how bad things get economically—and how bad investors think things will get.

It’s interesting to contrast Canada to other countries because our yields are still notably higher than many. That’s despite a relatively stable fiscal and economic outlook.

Here’s a sampling of 5-year yields from around the globe, including each country’s debt-to-GDP and unemployment rates (UR):

  • Canada1.35%  (Debt/GDP: 36%; UR: 7.3%)
  • U.K.1.32%  (Debt/GDP: 86%; UR: 7.8%)
  • Germany0.91%  (Debt/GDP: 44%; UR: 6.1%)
  • U.S.0.87%  (Debt/GDP: 61%; UR: 9.1%)
  • Switzerland0.38%  (Debt/GDP: 20%; UR: 3.9%)
  • Japan0.35%  (Debt/GDP: 183%; UR: 4.7%)

Economically, these other countries don’t compare cleanly to Canada, but they do have a few things in common:

  1. Each is being impacted by the same worldwide trends (including a global slowdown and flight-to-safety).
  2. There are plenty of investors willing to settle for ultra-low yields (temporarily at least) on the debt of countries that are arguably less fiscally and/or economically stable.

It’s therefore not inconceivable that Canada’s 5-year yield could inch closer to 1.00%. If it does, and financial crises don’t further inflate liquidity/risk spreads, fixed mortgage rates could potentially keep falling.

European-RisksEurope is a huge wildcard, though. Rising risk of default by one of the PIIGS could boost liquidity/risk premiums in the mortgage market and offset falling yields. That could actually drive fixed mortgage rates higher unexpectedly (we all remember spreads in 2008).

Looking out longer-term, one has to wonder when:

  • Investors will tire of negative real returns on bonds (after factoring in inflation)
  • Economic growth will return to some semblance of “normal” (both globally and in North America)
  • The spectre of insolvencies will diminish in the Eurozone
  • Core inflation will start a steady march above the BoC’s 2% target
  • The U.S. will stop coaxing yields lower (using its ever-creative monetary policy toolbox)

It seems the market is betting these collective changes might take anywhere from 9-24 months or more.

When global prospects finally do turn around, it could spark a stampede out of bonds—and a rapid rebound in yields. “A lot of capital just has nowhere to go right now,” says analyst Colin Cieszynski, “and when you have people piling into one thing, it can be disruptive when they come out.”

In the meantime, we’ll keep an eye on indicators like the TED spread (a gauge of credit market risk), government yields and the “posted5-year GoCspread for hints about where fixed mortgage rates are headed.

Source for debt-to-GDP and unemployment rates: OECD

Rob McLister, CMT