Following two months of negative returns, the Canadian bond market turned positive in August. In part, the move higher in bond prices appeared to be simply a rebound from excessive pessimism the previous two months. As well, the U.S. government’s ability to borrow and refinance existing debt requires an increase in the debt ceiling by the end of September, but the dysfunctional state of U.S. politics increased the risk that the United States could technically default on its debt. Perversely, that possibility prompted some investors to buy government bonds. More importantly, the nuclear tensions between North Korea and the United States cast a pall over most markets. The resultant risk-off sentiment prompted a flight to safety bid for government bonds and modest widening of corporate bond yield spreads. The FTSE TMX Canada Universe Bond index returned 1.41% in August.

Canadian economic data received during August was generally positive. Of particular note was the second quarter growth rate in Canadian GDP; at 4.5% it was well above expectations of both economists and the Bank of Canada’s forecasts. Over the last 12 months Canada’s economy grew 4.3%, tops in the Group of Seven countries. Given that the Bank had already predicted that Canada’s economic slack, known as the output gap, would disappear by the end of this year, the robust growth in GDP prompted some forecasters to bring forward their projections of the next Bank rate increase from this October to September. Other good news included the unemployment rate dropping to 6.3%, its lowest level in almost nine years. Inflation was minimal in the most recent month, but the year over year rate increased to 1.2% from 1.0%.

Economic data in the United States was mixed, with some indicators stronger than expected and others weaker. The estimate of second quarter GDP growth was revised to a 3.0% rate from 2.7%, and unemployment declined to 4.3% from 4.4% even as the participation rate edged higher. Inflation, though, remained well below the U.S. Federal Reserve’s 2.0% target. The Fed’s favourite measure of inflation, the core Personal Consumption Expenditure deflator, declined to 1.4% from 1.5%. The impact of U.S. economic news was muted, however, as most market participants do not expect the Fed to make another interest rate increase until December. Until then, there will be numerous data releases to provide more current indications of the strength of the U.S. economy and the need for further monetary tightening.

The Canadian yield curve flattened in August, as short term bond yields were little changed while longer term yields dropped significantly. Yields of Canada Bonds maturing in 2 years declined 2 basis points, while 10 and 30-year bond yields each fell 21 basis points. The shift in the Canadian curve was quite similar to, but slightly larger, than the U.S. yield curve; 10 and 30-year U.S. Treasury yields each declined 17 basis points in the month. In both countries, the expectations of central bank interest rate increases in the next few months kept 2-year yields from moving much lower.

The declines in yields pushed bond prices higher, which helped the federal sector earn 1.19% in August. Provincial bonds benefitted from their longer average duration, earning 1.84% in the month. The strong returns came despite provincial yield spreads versus Canada Bonds widening 3 basis points in the risk-off sentiment that dominated the market. Corporate yield spreads also widened 3 basis points in the month, leading the sector to trail government bond results as it earned 1.14%. New corporate issues totalled only $6.6 billion in the traditionally quiet summer period. High yield bonds earned 1.05% in August. Real Return Bonds earned 2.26% on average, as their long durations meant larger price moves as yields fell. Preferred shares lagged bonds in the month, returning -0.74%, but their year to date results continue to exceed bond returns by a wide margin.

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