Update: Charts and data after the read more.
With the Fed completing a two day meeting and Bernanke holding a press conference today it may be a good time to make a few comments about bond yields.
In an open economy with a current account deficit the equilibrium interest rate is the one that attracts sufficient foreign capital to finance the current account deficit with a stable exchange rate. If the currency is rising it indicates that yields may be too high, while a falling currency implies that yields are too low. This is important to understand because the US 10 year T-bond yields rose 46 basis points in May and the bulk of the increase stemmed from a rise in Japanese yields. They surged because investors decided that Abenomics was working. This, in turn, pulled bond yields up some 25 to 35 basis points in Britain, Germany, the US and many other countries. All of this preceded the release of the Fed minutes and Bernanke’s Congressional testimony. Yet Wall Street and many bloggers seem to ignore the point that two-thirds of the May bond yield rise was due to foreign factors, not the possibility of Fed tapering.
If you are going to model Canadian interest rates the first thing you do is put the US bond yield in the model. After that you work on including the factor that drive the spread between US and Canadian rates. I think you should do this in models of US interest rates.
In my model I include the average of the British, German and Japanese yields. I’ve been running this model for almost 20 years and over that time the foreign become more important while domestic variables, like fed funds, have declined in importance.
The other variables include things like nominal income growth, the trade weighted dollar, fed funds and a couple of other variables.
I have not altered the model to include any measure of QE or other special moves by the Fed. Since the bond value model has continued to work throughout this period it suggest that QE may not be having as great an impact as some assume.
The overwhelming consensus is that rates are going to soon rise and bond investors will soon start earning negative returns.
Maybe, but before you get too confident in that belief maybe you should look at this chart I have been publishing on the back cover of my monthly publication for many years.
Remember, over the long course of history that the 1970s-1980s rise to double digit yields was really a historic anomalie.