With yields on Canadian and U.S. bonds at their lowest levels in a generation, the only direction for interest rates would seem to be upward.
But investors and savers may be waiting far longer than they expect for those higher rates.
A weakening global economy, combined with a flood of money from safety-seeking investors has dragged borrowing costs dramatically lower over the past year and a half. Neither trend shows signs of reversing direction and long-term yields could have even further to fall before the trend to lower rates that began more than three decades ago finally hits bottom.
"I don't think [that falling yields are] over by a long shot," said Lacy Hunt, an economist at Hoisington Investment Management Co. in Texas.
Low bond yields are important because they set the stage for borrowing costs across the broad economy, from mortgage rates to the payouts on savings accounts. They make it easier for governments to finance large deficits and for borrowers to support their debt loads, but punish savers with paltry rewards for thrift.
Bond prices move in the opposite direction to bond yields, so falling yields would mean more profits for bond investors. However, they would also create pain for pension funds and insurance companies that must fund long-term obligations with bonds that are paying less and less.
Bond yields have been tumbling for years. In Canada, 10-year federal government bonds paid over 11 per cent as recently as 1990, but hit a record low below 1.6 per cent last week.
Back in 1981, with inflation at full roar, 30-year U.S. Treasuries offered a lush 15.21-per-cent payout. This week, it was a scant 2.6 per cent.
Gary Shilling, president of A. Gary Shilling & Co., a New Jersey-based money manager, and Mr. Hunt both believe that yields on long-term U.S. government bonds will eventually bottom out at 2 per cent.
Mr. Shilling, who made a name advising investors to load up on Treasuries back in 1981, says bond yields will fall because of the global economic slowdown, a flight to quality by investors fearful over the safety of their money, and a turn to deflation, or falling consumer prices.
He's confident bonds aren't yet in the irrational buy-at-any-price stage that typically signifies the end of a bull market because so many investors remain skeptical that yields can go lower. Bonds, in his view, remain a contrarian play.
"At every step of the way down in yields and up in price, the consensus has been: 'Okay, it can't last, yields can't go any lower,'" he observed.
That consensus remains in place. A survey by Bloomberg News shows that economists expect the 10-year Canada bond rate to climb to more than 2 per cent by year-end. It closed Friday at 1.613 per cent.
In contrast, Mr. Shilling said, bond yields will inevitably be pulled lower by a faltering global economy. Europe is already in a downturn, while China's growth rate is slowing.
In the U.S., retail sales have fallen for the past three months. On 25 of the 27 occasions since the late 1940s that retail sales have fallen three months in a row, the U.S. was either in recession or within three months of the start of one, he says.
Another factor that may drive down yields in North America is an inflow of skittish cash from Europe. A Statistics Canada report last week showed record purchases of Canadian securities by foreign investors in May. Even German government bonds, currently considered a haven, could lose their lustre because the country is exposed to European bailout costs, Mr. Shilling said.
If deflation breaks out, Mr. Shilling said consumer prices may start falling by about 2 per cent a year, which means that even with a lowly yield of 2 per cent, U.S. Treasuries would still be decent investments providing a real return of around 4 per cent annually. This would echo the experience of Japan, which went into a deflationary funk after its economy tanked in the early 1990s and where 10-year government bonds now pay a nearly invisible 0.74 per cent a year.
Mr. Hunt based his yield forecast on the history of the bond market after previous debt-induced financial panics. After the panic of 1929 and a similar collapse in 1873, "long bonds" with 30-year maturities eventually bottomed at 2 per cent yields, with the lowest point reached 14 years after the crash. In both cases, interest rates were still around the 2.5 per cent level 20 years after the beginning of the panic.
If the current blowout dating from the 2008 collapse of Lehman Bros. follows the same script, yields could stay low for far longer than is widely expected. "You go down there and then you bounce along the lows for a long time," Mr. Hunt said.