Canada Markets

Investors tend to want a higher rate of return for one of two reasons. It could be to overcome current inflation (or an expected increase in inflation during the lifespan of the investment) -- thereby maintaining a desired real rate of return. Or because they perceive the risks to be elevated. If it's the latter, serious difficulties may lie ahead.

The odd part about the significant break in U.S. treasuries -- thereby raising interest rates -- since the U.S. Federal Reserve kicked off this rate cutting cycle with a half percentage point reduction is that inflation doesn't appear to be getting out of hand at all. It hasn't fallen to the 2% Federal Reserve target but is not far off by all widely accepted measures -- even if it has stalled. It certainly is not showing any signs of acceleration like it did in 2021.

Markets try to be forward-thinking, so one plausible explanation is that investors are factoring in an expected increase in inflation, given the interest rate easing by central banks worldwide. The fear would be a repeat of the 1970s cycle when an apparent taming of inflation was followed by a much more problematic acceleration. As many would recall, the crushing interest rate increase required to bring it back under control had serious ramifications.

The Fed has done what it can recently to make sure history doesn't repeat, including keeping rates too high for too long, according to some. That said, it could be that bond investors are not certain and want to be compensated for the risk. It would be reasonable to assume that if this is the cause of recent increased rates, the move should be close to running its course without proof of overheating from future data releases.

A much more sinister explanation would be that investors perceive risks associated with holding U.S. debt as being higher. Two possibilities here have drastically different implications and time horizons.

It would be perfectly understandable to assume investors consider risk as elevated going into the U.S. election. If that is the culprit, assuming that a clear winner is determined and governing carries on as normal going forward, an end to the recent break in treasuries would be expected. A relief rally would be normal, coinciding with Thursdays' FOMC meeting announcement when rates are expected to be cut a further quarter point.

If the increasing risk that investors want to be compensated for is with the level of U.S. debt itself that has been accumulated and the difficulty going forward associated with servicing that debt -- then much darker clouds may be on the horizon. Especially considering neither candidate has shown any desire to curtail spending or address the debt.

It would be hard to imagine anything but a recession resulting from a jump in rates without the prosperity to justify them. Record highs for equities would surely be in the rearview mirror for the foreseeable future with a correction quite likely.

Closer to home, experience has shown that when the economy sneezes, commodities catch a cold. If past economic turmoil is any indication, energy demand and prices will be the first thing hit. Grains and oilseeds won't be far behind due to their energy component and an overall reduction in demand. Cattle markets would likely face their greatest pressure since COVID-19 with beef being considered a luxury item by traders.

It's hard to argue, given consumers' willingness to switch to cheaper protein sources when times get tough. To make matters worse, the interest rate differential would likely push the U.S. dollar higher, adding further pressure to export products. Here in Canada, the resulting weakness in the Canadian dollar may be the only thing that cushions the blow.

Stepping back a bit, I am not suggesting that the potential doomsday scenario is the correct one, merely considering it as another risk that justifies being on the radar. Even if it turns out to be the case, there should be plenty of time to adjust marketing plans, accelerate sales, add put options with higher strike prices -- that sort of thing -- prior to any serious developments occurring.

During the residential mortgage meltdown, it took months to unfold. The Treasury markets started reacting to developments by July 2007. Equities marked record high moves months later in October 2007, only to lose 58% of its value by March of 2009 (in the case of the S&P). It wasn't until a full year later, July 2008 that crude oil reversed from a record high of $147.27 per barrel (bbl), falling to $35.13/bbl by December of that year. Grains and oilseeds suffered a similar fate with corn marking a high of $7.9925 per bushel in June only to fall to $3.05 by December of 2008.

That all said, besides having time to react, it would be reasonable to assume any weakness would pale in comparison to 2008 given the low levels we are starting from vs the lofty highs of 2008.

So, when you wish I would spend a bit more time worrying about how much rain has fallen in Mato Grasso or whether the strong export pace of canola is just China front-loading purchases -- and less time on what impact the latest economic data release may have on interest rates -- at least you'll know what I'm up to.

With that, keep in mind I'm always happy to get feedback along with any suggestions for future blogs.

For more on the interest rate increase, see An Urban's Rural View blog at https://www.dtnpf.com/….

Mitch Miller can be reached at mitchmiller.dtn@gmail.com

Follow him on social platform X @mgreymiller

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