What Current Short-Term Yields Mean for Canadian Investors

Yesterday, I had the Canadian dollar on the “menu.” Let’s talk this time about the Canadian bond yield curve. Why, you may ask? Simply, I find it very peculiar how in Canada, the economy is slowly but surely breaking the usual molds of economic theory.

You see, yield curve in Canada has gotten itself inverted. What this means is that interest-rate sensitive, short-term bonds are yielding more than their long-term counterparts. Typically, an inverted yield curve is a prelude to a recession.

Last time the yield curve was inverted was in December 2000. And justly so, since it had happened just before the tech bubble burst. Within a year — and particularly after the September 11 terrorist attacks — the Bank of Canada cut interest rates from 5.75% to 2.25%.

When fear of looming economic slowdown rears its ugly head, investors flee to the safety of long-term bonds. As more buying pressures ensue in that particular segment on the yield curve, prices of long-term bonds go up, pushing their yields down. As short-term bonds yield more, the yield curve inverts itself, sloping downward.

Yet the Bank of Canada is hinting it may have to raise interest rates in the near term to prevent the country’s economy from overheating. The increase of 25 basis points is expected both in July and September from the current 4.25%. Obviously, a forecasted move such as that is a far cry from recession.

Furthermore, economists are predicting that the Canadian bond yield curve will keep on sloping downward for the remainder of the year and potentially during the first quarter of 2008. Notably, the yield curve was inverted for the better part of last year in the U.S. as well. And while there are signs of economic slowdown south of the border, we are still not seeing signs of recession there either.

While it might be easy to dismiss the inverted yield curve, you should not do so. The trouble with fiscal policy is the issue of timing. It takes time to recognize the problem, adopt adequate policies, and implement those policies. If government officials are too early in applying the breaks, they may squeeze the economy unjustly; if government officials are too late, they may just prolong the effects of the very problems they are trying to prevent. Either way, the costs of poorly timed fiscal policy could be quite high.

With that in mind, I have to acknowledge that inflation in Canada is creeping up. By the same token, there are hardly any signs of it getting out of hand. So, if and when the Bank of Canada increases interest rates, short-term rates may be temporarily higher than the long-term rates. Bringing other macroeconomic Canadian factors into the equation, there is little danger of the Bank of Canada missing its mark.