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Jeffrey Rubin

Saturday, January 26, 2002

Why all the fear and trembling in the bond market? In case it hasn't noticed, the economy isn't going anywhere. And inflation is nose-diving, not that at 2 per cent it posed any real threat in the first place. Yet the bond market is expecting interest rates to rise nearly 200 basis points in the next two years, telling investors that today's interest rates aren't going to last.

Get into the head of any fixed-income portfolio manager these days and you will quickly find that it's not rip-roaring growth that he fears. Most will acknowledge that growth prospects look tame, and inflation prospects even tamer. What makes them uneasy is the very level of today's interest rates and their sustainability. Even with today's gap between long- and short-term interest rates on bonds (almost 400 basis points), bondholders are being asked to accept yields that have never held during the entire post-war period. All of a sudden passively investing in a 10-year government bond has become a huge call on interest rates.

Deconstruct a 10-year bond and what you will find is a series of 10 one-year bonds. If you're holding the bond to maturity, as many investors like life insurance companies do, the yield you are willing to accept depends on where you think short-term interest rates will be going over the duration of the bond. Herein lies the true nature of the bond market's angst.

If you think short-term interest rates will peak at 8 per cent and average 6 per cent, you're not going to want to buy a 10-year bond that pays you an annual yield of only 5 per cent. By your own expectations, you would be better off to simply roll over one-year bonds for the next 10 years and get the full benefit of rising interest rates over the period. Alternatively if you thought interest rates would peak at only 6 per cent and average 4 per cent, then all of a sudden locking into a 5-per-cent yield for the next 10 years isn't such a bad idea.

The problem, of course, boils down to what is a reasonable set of assumptions about the cyclical trajectory of short-term interest rates. Expectations are adaptive. We come to expect what we have experienced. We do not expect something we haven't seen before.

Neither do financial markets. The reflexive instinct of markets is to look back at the level of rate settings that triggered past recessions and calibrate the future accordingly. By those benchmarks, you should stay away from the bond market like the plague.

Even today's overstretched yield curve would give bondholders little protection against the rise in short-term interest rates that they would face. From today's level of interest rates, a return to anything even closely resembling the rate peaks of past cycles would imply negative, if not devastating, returns.

But are those past benchmarks relevant? The rate setting that induced this recession is a fraction of the level that triggered downturns in the past. It took almost a 20-per-cent federal funds rate to create the double-dip in 1981 and an 8-per-cent funds rate to deep-six the expansion in 1990. This time the federal funds rate barely touched 6.5 per cent before the economy buckled.

Of course inflation has fallen concomitantly with the decline in interest rates. Inflation was in double-digit territory in the early 1980s, 4.5 per cent on the eve of the 1990 recession and peaked at only 3.5 per cent prior to this recession. Looking ahead, inflation is likely to trend even lower in an increasingly globalized economy over the next decade where international competition challenges every nook and cranny of domestic pricing power.

Instead of a 6-per-cent handle, short-term interest rates are more likely to peak around 5 per cent next cycle, and only after years of sitting at hundreds of basis points below that level. So forget about any big backup in interest rates. The Federal Reserve Board could afford to sit with a sub 3- per-cent federal funds rate through most of the next business cycle -- a posture that will ultimately bring long-term interest rates down and flatten today's yield curve like pancake.
Jeffrey Rubin is chief economist and managing director of CIBC World Markets.

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