Following a number of months that experienced headline driven volatility, the Canadian bond market was much more subdued in August. Bond prices and yields moved within narrow bands all month, although it felt like some of the flight-to-safety bid for bonds from previous months was unwinding. Investors’ attention was taken up mainly with relatively high levels of new provincial and corporate issuance. However, a number of times during August U.S. central bankers stirred up speculation of a September interest rate increase and those prompted bond market adjustments. The FTSE TMX Canada Bond Universe returned 0.09% in the month.

Canadian economic data received during August was somewhat negative. The unemployment rate rose to 6.9% from 6.8% a month earlier as 31,200 jobs disappeared from the economy. The unemployment rate might have risen even more but for a decline in the participation rate. Canada’s trade deficit set a new record, rising to $3.63 billion in the most recent month. Notwithstanding the Bank of Canada’s forecast that exports would be driver of faster Canadian growth, they have fallen 7.7% in the last twelve months led by a 27.7% plunge in energy exports. More positively, Canadian GDP increased 0.6% in June, as the economy rebounded from the impact of the Alberta wildfires in May. The June increase was not enough to offset weakness earlier in the second quarter, but it did suggest that growth was accelerating into the third quarter. On balance, the data in August was not enough to cause the Bank of Canada to change monetary policy or to change the market consensus of subpar Canadian growth.

U.S. economic news was generally more positive than Canadian data. The unemployment rate held steady at 4.9%, but only because very strong job creation was masked by an increase in the participation rate. The housing sector continued to improve: housing starts were better than expected and new home sales were the highest since October 2007. Industrial production was higher than forecast as all three sectors (viz. manufacturing, utilities, and mining) featured robust growth. Business investment spending was also noteworthy: following several weak months, U.S. investment spending increased for the second consecutive month. Overall, the favourable U.S. economic data should have been a small negative influence on the bond market, but pronouncements from a number of Federal Reserve Board officials played a larger role in pushing U.S. bond yields higher. In recent months, the market consensus has been that the Fed was unlikely to raise interest rates before December, but several Fed speakers in August including Chair Janet Yellen pointed out that interest rates might rise as early as the upcoming meeting on September 20th and 21st. Short term U.S. bond yields rose in reaction as investors discounted the increased potential for a September move.

The Canadian yield curve was marginally flatter in August as 2-year Canada Bond yields rose 4 basis points, while 30-year yields edged 1 basis point lower. In the United States, the yield curve also flattened but the moves were somewhat larger. Short and mid-term bond yields rose 11 to 15 basis points in reaction to the increased possibility of a September rate increase by the Fed. Long term U.S. Treasury yields rose a more modest 4 basis points in the period.

The Canadian federal bond sector earned 0.07% in August, as interest income was sufficient to offset small price declines in short term bonds. The provincial sector returned -0.16% with average provincial yield spreads increasing 4 basis points in the month. In part, the widening was a reversal of the late-July rally, but it also was the result of some poorly received new issues in August. The investment grade corporate sector earned 0.46% because strong investor demand for higher yielding securities caused corporate yield spreads to narrow by 3 basis points. Corporate new issue activity slowed from the frenetic pace of July, but it was still the busiest August on record. A total of $9 billion was raised in 15 transactions. Investors were clearly hungry for yield as lower rated corporates sold well; in one noteworthy day in August, three BBB-rated issuers raised a total of $3 billon. High yield bonds enjoyed another strong month, gaining 1.95%. Real Return Bonds also performed well, returning 1.02% in the month. Preferred shares similarly outperformed the Bond Universe, earning 1.12% in August.

In the last year or two economic fundamentals have not been the principal drivers of the bond market. Instead, in the absence of coordinated fiscal support from their respective governments, some major global central banks have implemented unconventional monetary policies in efforts to stimulate economic growth. With interest rates at or close to zero, the increasingly desperate central banks, such as the Bank of Japan and the European Central Bank, have implemented quantitative easing (i.e. bond purchases) and negative interest rates for deposits from commercial banks. These unconventional policies have resulted in bond yields globally hitting record lows, notwithstanding the lack of actual recessions that have traditionally caused bond yields to fall. The policies have also led to significant volatility in bond yields, which has prompted us to keep portfolio durations close to benchmarks.

We do not expect the impact of extraordinary monetary stimuli on bond yields to decline significantly in the near term. Consequently, economic developments will continue to take a backseat in terms of determining the overall level of yields. However, the pace of economic growth will continue to influence corporate and provincial yield spreads. So our outlook for the balance of the year for a rebound from disappointing growth in the first half is supportive corporate and provincial bond valuations. We believe corporate yield spreads, in particular, are attractive and we are maintaining an over-weight allocation to the sector.

Economic developments in the United States will clearly affect Fed interest rate decisions. The likelihood of a rate increase at the September 20/21 Fed meeting is dependent on U.S. growth remaining robust until the meeting. If the data leading up to the meeting is at all disappointing, we believe the Fed will put off raising interest rates until its meeting in December, which remains our forecast. Should the Fed surprise and raise rates in September, the largest impact will likely be in short and mid-term yields as investors begin to anticipate the next move. In the Canadian bond market, the 5-year part of the yield curve is expensive, yielding only 9 basis points more than 2-year bonds. Consequently, it is at greatest risk of a surprise Fed move. We have reduced short term bond holdings in favour of a combination of longer term issues and cash equivalents.