Bonds Part 2: Interest Rates, The Bank of Canada and Bond Yields

Remember: Bond Markets Lead All Financial Markets.

In other words, the bond market already knows the Bank of Canada's mandate (which they are very transparent about) is to "preserve the value of money by keeping inflation low, stable and predictable". The BOC's acceptable range for inflation is 1-3%, with a target in the middle of 2%. If economic indicators are showing increasing inflationary pressures (usually on the back of a strengthening economy) bond market participants will have already anticipated what the Bank of Canada will do next: raise the interest rate that Canadian banks borrow and lend to each other at, called the "overnight rate". This rate influences where banks lend to their clients: the prime rate and any other adjustable rates (which are usually a function of the prime rate).

So the bond market has already built this in to its pricing and for bond market participants, these rate increases are expected and  bond yields adjust well in advance of any action by the BOC. All of the various bond yields plotted on a graph with the Yield To Maturity on the vertical axis and the Term To Maturity (3 month T-bills to 30 year bonds) on the horizontal gives us what we mysterious bond types in bond jargon refer to as the Yield Curve:

If you recall yesterdays exciting discussion around the 10 year bond which jumped from a yield to maturity of 2% at issue to a current yield of 2.38% and a price discount of $3.65 because bond investors became a little more concerned about future inflation (highlighted above): the yield curve shifted higher.

This is where it gets really crazy (so hold on to your hats!): Last June, The BOC decided to go from inflation stimulator (easy monetary policy following the oil price crash) to inflation fighter and has raised rates on three occasions (3/4%) since last July.

Here is what happened to the yield curve:

Wild eh?! Note that the 3 month, 10 year and 30 year yields (red arrows) have all moved differently. The shortest maturities closest to the "overnight" rate have moved exactly 3/4%, following the BOC. The 10 year has moved almost a full 1% and the 30 year less than 1/2%. Remember that the BOC is still expected to continue to fight inflation with another one or two 1/4% rate increases (gold arrow). Clearly this is already anticipated in the 10 year yield and way out at the 30 year end of the spectrum, the expectation of inflation getting out of control is not a worry: bond investors are comforted by the inflation fighting stance of the BOC, so they are demanding less inflation premium to buy those bonds.

Question 1: if you have to have the safety of Government of Canada bonds in your portfolio (always part of good balance), where on the yield curve might you wish to own them (us bond folk refer to the maturity spectrum as "duration")? 

So what duration is best? Short or long?

Remember, prices go down as the yields go up.

Question 2: If mortgage rates are a function of bond yields, where is the best place to borrow? Short (floating) or long (fixed)?

Stay tuned! (so very exciting!)