THE BOND MARKET: WORTH EXECUTIVE ATTENTION

The behavior of bonds may mystify and even confound some, but not this regular contributor to the Ivey Business Journal. Says Professor McCallum unabashedly: “I just plain like the bond market.” Better still, he understands it better than many, which is why managers trying to divine what impact the bond market might have on their enterprise should read this article.

Executives would do well to keep their eye on the bond market. Its behaviour of late has been on the disturbing side. I do not read the bond market as telling executives to batten down the hatches but I do read it as saying know how to batten down the hatches and be in a position to do so fairly quickly should circumstances warrant.

Former Federal Reserve Board Chairman Alan Greenspan was among the first to note that the bondmarket was behaving in odd fashion. About a year ago, he pointed out that long term maturity interest rates were remaining stubbornly low or even declining in the face of a number of increases in short term interest rates. He called it a “conundrum,” describing the behaviour as unprecedented in recent experience. In central bank double-talk, this is as close to “Wow!” as you get. The situation has more or less persisted in the U.S. and to a lesser extent exists in Canada as well.

I have a career-long relationship with the bond market. I was a trainee bond trader in the late 1960s; the institutions involved have never regretted keeping me on a very short leash. I did my Ph.D. thesis at the University of Toronto on the bond market in the early 1970s: The Expected Holding Period Return, The Term Structure Of Interest Rates And Investment In The Government Of Canada Bond Market (1973). I have taught the graduate capital markets course at the University of Manitoba for over 30 years; a major component is bonds and the interest rates they trade at. I have written numerous articles over the years that relate to bonds and interest rates in one way or another. I just plain like the bond market. Maybe former U.S. Treasury Secretary Andrew Mellon was right: “Gentlemen prefer bonds”. But to put Mellon’s remark in context, it was his response to a question about investing in the overvalued stock market of the late 1920s. That is the same Mellon by the way of a famous four-line schoolyard ditty of the depression 1930s:

Hoover blew the whistle,
Mellon rang the bell,
Wall Street gave the signal,
The economy went to Hell.

I agree with Alan Greenspan. One hesitates to say something is unprecedented and has absolutely never happened before. But the bond market as we now more or less know it goes back to the early 1700s and John Law, installment receipts and the Mississippi Company scheme to manage the French government debt that came out of the reign of Louis XIV. What is happening to long bond interest rates today in the face of rising short rates is sure unusual against that long historical backdrop. A digression: If your tastes run to bubble-class extreme episodes in finance, you will be entertained by some reading on the Mississippi Company or its British counterpart, the South Seas Company. I recommend particularly John Train’s Famous Financial Fiascos (Clarkson N. Potter, Inc., New York: 1985). To wet your appetite, consider a prospectus in 1720 Britain promoting “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” The shares did a booming subscription, at least for a while. Where were Sarbannes and Oxley when they were really needed?

The history of persistently rising short term interest rates and flat or falling long term interest rates tends to the grisly side. Greenspan’s conundrum could be bad news for executives. On the other hand, it may be just noise.

The technical expression for the relationship between interest rates and bond maturities is the yield curve. It is also called the term structure of interest rates. Normally, the yield curve rises through maturities, meaning as maturity lengthens, interest rates get higher. Rationalizing financial market theory for the yield curve’s normal upward sloping shape is extensive, impressive and elegant but what it comes down to is that the longer the maturity, the greater the risk an investor is taking that something will go wrong. The greater the risk, the higher the compensating interest rate the investor requires and it is these “risk premiums” that push longer maturity interest rates up. Normal upward sloping yield curves are generally accompanied by normally functioning economies. Executives have every reason to sleep easily when the yield curve is rising.

When shorter maturity interest rates exceed longer maturity interest rates, the yield curve is called “inverted”. Executives should not sleep easily! The last six U.S. recessions going back to the 1970s have been preceded by a yield curve inversion and that includes 2001 and 1990. It is also noteworthy that the U.S. yield curve does not give many false recession signals. A yield curve inversion is flat out the best single indicator of U.S. slowdown I know of. Its record in Canada for predicting slowdowns is not quite as good but it is still good enough to justify careful executive attention.

An inverted yield curve slows an economy in a number of ways. Consumers defer big ticket spending for the likes of cars and appliances because they do not want to pay the higher financing costs. Consumers also defer spending, preferring instead to get the higher interest rates on their savings. Financial institutions, particularly banks, become less willing to lend because their cost of funds is rising relative to what they can get on a loan. The higher short term interest rates bring increased financial and economic risk leading lenders to raise credit standards. The higher short term interest rates can lead to a stronger domestic currency as international funds flow in to capture the higher returns – a rising currency often takes a bite out of exports. Finally, everyone who is interested knows an inverted yield curve means the probability of trouble is high and that can become a self- fulfilling prophecy.

The yield curve in Canada is farther from an inversion that it is in the U.S., but both bear watching. Both countries’ interest rates bounce around, but in the U.S. the ten-year bond interest rate and the short interest rate are too close for comfort given the rather grim slowdown history of inverts. About 35 percent of our GDP and over two million jobs are dependent on the United States. Canadian executives do indeed have a powerful incentive to be interested in the shape of the U.S. yield curve. Were the U.S. to slow down  the probabilities are high that we would not be far behind.

But things may not end badly. After all, Alan Greenspan called the U.S. interest rate situation a conundrum not an impending disaster. There is a difference. They say the four words “This time is different” are the four most dangerous words in finance because usually this time is not different. History does often repeat itself. This time, however, there are a number of reasons why today’s yield curves may not portend anything sinister at all.

First, the yield curve in the U.S. through ten years at the moment is more flat than inverted. A slight invert to flat situation is different than a sharp invert. U.S. 30 year bond yields are not inverted. Second, demographics, not trouble, may explain the yield curve – the population is aging rapidly and the preference of older people for bonds for security purposes may push bond prices up and interest rates down. Third, the flattening yield curve may reflect a world awash in savings and liquidity – the money associated with the lowest money market interest rates in decades had to go somewhere and a lot undoubtedly went to the bond market putting additional downward pressure on bond interest rates. Fourth, Chinese demand for U.S. bonds driven by their huge trade surplus with the U.S. may be a factor. Fifth, long bond interest rates tend to rise when inflation is an issue and it certainly does not appear to be an issue at the moment. Sixth, perhaps the bond market has just plain misjudged the situation – markets are not right all of the time.

Executives have businesses to run and when a reliable economic indicator like the yield curve starts to flash yellow, they should assure they have their organizations properly positioned. Today’s yield curve situation is a good reason to take a very hard look at customer satisfaction and loyalty, the product line, the cost structure, efficiency and productivity, the capital structure, the balance sheet, the human resource function and all-around competitiveness. If things go south, it is usually the best managed and operated that prevail. Sloppy management practices are no way to enter a slowdown.

The bond market is behaving somewhat peculiarly. Executives ignore bond market messages at their peril. This is a good time to focus on sound management practice. Sound management practice is a good idea whatever the shape of the yield curve. It never goes out of style!