Bond yields in major markets dropped rapidly this summer, delivering returns in excess of 1.5%, way exceeding expectations. Over the course of [the] next 12 months, we expect that drop to be reversed and yields to move higher.

Often when investors think about changes in yields, they think about changes in inflation expectations. That’s not what drove the drop in yields this time. This time, the drop in nominal yields has been aligned with drop in real yields, which, theoretically, should be stable, but this year they have been moving around a lot.

So what are real yields? Well, the first thing to know is that they are a bit of a theoretical construct. Market participants often look at yields on inflation-protected bonds, TIPS, or RRBs, even though these are changed significantly by liquidity premium that’s different than on nominal yields. Academics often look at subtracting inflation from nominal yields to arrive at history of real yields. And, of course, we can also look at forward-looking estimates based on survey-based inflation expectations subtracted from nominal yields.

It’s worth noting that real yields have been on a multi-decade declining trend, reflecting potentially a decline in GDP growth potential, whether it’s due to aging population, or lackluster productivity, or growing debt burden.

Either way, whether we’re looking at history or cyclical picture, real yields are at all-time lows. In the most recent episode, they have been probably pulled down by the changes in growth expectations, which had been disappointing compared to the first quarter of this year because of the potency of the Delta variant of COVID virus.

Perhaps they started also reflecting the fact that Fed hike expectations are being pulled forward, which means shortening the potential length of the economic cycle. Or, dropping liquidity premium on TIPS, which makes them very expensive.

We may never know what exactly pulled these real yields down over summer, but we can judge that the real rates have dropped too far. And to do that, we look at the long-run estimate of neutral policy rate as the Fed estimates it to be at 2.5%, compared to the same estimate in the market, which is at 1.5%. Subtract inflation from either of these measures and you will arrive at the long-run neutral real policy rate between negative 50 basis points and positive 50 basis points. So let’s call it zero, on average.

Now, if we look at real rates on 10-year bond being at negative 1% now, short real rates would be even lower than that. So looking at the difference between what we have in the market now and the long-run neutral policy real rate, we have at least 100 basis points difference, which we expect will be pulling real rates and nominal rates higher over the next year.

Only time will tell what will peak these rates higher. After all, the unknowns of 2021 are still unknown, whether inflation will be transitory, if Powell will be reappointed when the Fed starts tapering. We should know answers to these questions by the end of the year. We believe these answers will drive bond yields higher over our forecast horizon, reversing the summer drop.

Well, it’s not unusual to see individual currencies rise or fall by 15% or even 20% in any given year. But the experience for developed market currencies this year has been well shy of that. The trade-weighted U.S. dollar, for instance, has kept to a fairly narrow 4% band.

And so, by historical standards, this has been a pretty quiet year for foreign exchange markets, even as investors fret about the Delta variant, about the Chinese regulatory crackdown, and about whether the Fed might be tapering some of its asset purchases later this year.

We think that these things have offered the U.S. dollar a little bit of support, having it trade sideways in what would otherwise be a negative-dollar environment. And as these themes become more well-priced, we think that this pause that we’ve seen in the dollar sell-off will end and we’ll see that longer-term dollar decline resume.

So our forecasts for this year are dollar bearish. And the currencies that we like most these days are the cyclical ones; the ones that benefit from commodity strength; the ones that benefit from the global economic reopening underway.

Of particular note, we like the currencies where central banks are hiking rates faster than the Fed. Those higher interest rates attract capital, and that’s supportive for these currencies.

The Canadian dollar is one of those cyclical currencies with its link to oil and equities and global growth. And the Bank of Canada is also supportive for the loonie because they seem to be one of the more aggressive central banks in raising rates, and that’s a response to stronger labour markets and a successful vaccination campaign.

And so the combination of these things, a weaker U.S. dollar, and some Canadian dollar positives, has us set our dollar Canada forecast at 1.15 for the year ahead. And that translates into roughly a 10% gain for the loonie.