Bond yields may show where interest rates are heading over the long term

The bond market has taken centre stage in recent months as bond yields worldwide have risen to levels not seen in nearly 20 years. Bond prices have plummeted in the process.

But is this just the tip of the iceberg? The answer will affect investment portfolios and has implications for when one should buy GICs, life annuities and long-term bonds. Moreover, a prolonged rise in interest rates will almost certainly affect stock market performance at some point.

While the future is unknowable, a historical perspective may offer a better idea of what we can reasonably expect. The most widely-watched government bond is the U.S. 10-year Treasury bond where yields are close to 4.8 per cent, a level last reached in 2007. At the same time, yields on Government of Canada 10-year bonds have risen to their highest level since 2008.

As the chart shows, yields can go much higher before they level off. The chart also suggests that long-term interest rates might follow a 60-year cycle. If so, the last full cycle bottomed out around 2010. Between 2010 and 2020, we had the lowest long-term bond yields since the 1930s in Canada and, in the United States, the lowest going back to the 1940s.

This was great for borrowers and terrible for fixed-income investors, especially retirees. At the time, these low yields led many of us (me included) to believe that inflation had perhaps been tamed once and for all.

Everything started to unravel with COVID. The pandemic triggered deficit spending on a scale not seen since the Second World War. When coupled with new tariffs, a spike in oil prices and war with Iran, higher inflation returned and correspondingly higher bond yields. But will we see a return to the double-digit bond yields that occurred in the 1980s?

My guess is no – since some important factors are truly different today. First, the U.S. and Canadian governments have both set inflation targets (at 2 per cent) that didn’t exist half a century ago. Second, almost every developed country in the world has an aging population and this has usually been accompanied by lower growth and lower interest rates. On the other hand, governments everywhere are continuing to pile on debt.

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We will probably not see double-digit bond yields again but the chart shows that the trend toward higher yields could prevail for a long time before it reverses itself. If long-term interest rates truly follow a 60-year cycle, the trend might continue for decades.

One more feature of the chart is worth highlighting: it shows the excess – or shortfall – of U.S. bond yields versus Canadian bond yields for 10-year bonds. Until 2011, bond yields were almost always lower in the U.S. That is because the U.S. was seen by international investors as a safe haven with more prudent economic policies than Canada’s.

This flipped in the early days of quantitative easing in the U.S., when the Federal Reserve started buying government bonds to push borrowing costs lower. Since 2012, U.S. bond yields have almost always been higher than Canadian yields and the gap is widening under the Trump administration. This is good for Canada since it means we pay less interest on our debt than we would otherwise, which leaves more money for program spending. At least for now.

Frederick Vettese is former chief actuary of Morneau Shepell and author of Retirement Income for Life.