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Global Fixed income markets • Soo Boo Cheah, CFA • Suzanne Gaynor
our view that both economies are
in better shape than suggested by
their bond markets. For Germany,
the U.K. and Japan, yield forecasts
have been slightly lowered to reflect
shifts in the political and economic
landscape. In the near term, the threat
of even lower yields is real should
the European debacle worsen. The
initial reaction would be for investors
to flee to government bond markets
outside Europe until aggressive
policy steps bring yields into line with
fundamentals. This could be a long
work-out period and non-European
government-bond markets are the most
likely beneficiaries.
Given the headwinds facing global
governments, we expect major central
banks to keep monetary policy
accommodative. The ECB is likely
to cut its short-term rate further to
0.50% from the current 1.00%, and
to implement further non-traditional
monetary stimulus. At home, however,
we expect the Bank of Canada to
tighten its policy rate within the next 12
months because the bank is concerned
about excessive consumer debt,
especially in home mortgages.
We recognize that bond yields are far
too low and that we are potentially
in the last phase of the 30-year bull
market for bonds. However, near-term
uncertainties would suggest that we
should not totally give up on bond
allocations just yet since there is still
the potential for a final surge in prices.
We are also cognizant that
policymakers will likely implement
further measures to hold down yields.
Taking all factors into consideration,
we expect the market to wade through
the current impasse and eventually
Exhibit 6.
Predicted minus Actual (%)
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
U.S. 10-Year Treasury Yield Is Extremely Rich
Intercept + UST 2-Year + Business Cycle Index
Actual 10-Year Yield = 1.78
Model-Predicted Forecast = 2.75
Bonds Expensive
-0.5
Bonds Cheap
-1.0
2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011
Source: Deutsche Bank, RBC GAM
refocus on fundamentals. This makes
us mildly bearish on bonds but not
“super bears.”
U.S. – There is no change to our fed
funds forecast from the previous
quarter. Our 0.25% prediction is in
line with market expectations for low
front-end rates. As long as the policy
rate remains well anchored, yields
further out the curve are expected
to remain low. The binary nature of
the European crisis has shortened
investment horizons for most investors
and held down Treasury yields. Since
our forecast is for 12 months out, we
are hopeful that the current tensions
will have subsided by then. We expect
economic data to surprise to the upside
later this year as household balance
sheets strengthen. In this scenario
of gradual economic improvement,
we expect the Fed to stay sidelined
and yields to move toward fair value.
Our fair-value model, which takes
into account short-term yields and
the business cycle, suggests that the
10-year Treasury yield should be at
2.75% (Exhibit 6).
SAMPLE
Another powerful tool for forecasting
the direction of U.S. 10-year Treasury
yields is an examination of bond
returns relative to growth in the money
supply (Exhibit 7). This model shows
that bond returns have been keeping
pace with money-supply growth. For the
relationship between bond returns and
38 I The global investment outlook RBC INVESTMENT Strategy coMMITTEE Summer 2012