For the second consecutive month, Canadian bonds experienced a sharp selloff in the first half before recovering during the second half. Unlike August, however, bonds actually closed higher in price and lower in yield by the end on the month. The net change was not, in fact, very large, but the volatility was significant. As can be seen in the following chart, benchmark long term Canada bonds traded in a wide 6½ point price range, before closing only a ¼ point higher on the month. The DEX Universe Bond index returned 0.67% in September.

Price of Benchmark Long Term Canada Bond

In large part, economic fundamentals were not the driving factor behind the bond market moves. Instead, overall investor optimism, sometimes referred to as “Risk On/Risk Off”, appeared to be the dominant influence. Optimism regarding the European Central Bank’s plan to resolve the debt crisis in that
region, plus speculation about the U.S. Federal Reserve implementing additional monetary ease, led to a diminishing of the flight-to-safety bid for bonds in early September. Bond prices fell as investors put risk on. However, later in the month, the optimism faded in reaction to more sober assessments of the central banks’ schemes as well as some weaker than expected economic data. “Risk Off” meant increased demand for the safety of bonds, leading to a rebound in bond prices.

Canadian economic news continued to indicate moderate growth, neither slow enough nor fast enough to warrant the Bank of Canada changing interest rates. Indeed, the Canadian economy grew by 0.2% in the most recent month that information was available (July) and by only 1.9% in the last 12 months. Unemployment held steady at 7.3% and while job creation was robust, it was all in lower-paying, part-time jobs as the number of full time positions actually fell. Housing starts were quite strong, but Canada’s trade balance reached a record deficit as exports plunged on declining foreign demand. In the absence of compelling economic developments, Canadian bonds were impacted by developments abroad, as well as international investor flows in and out of our market.

In the United States, Canada’s largest trading partner, the economic news was generally disappointing. The housing sector continued its recovery, but most other areas of the U.S. economy were weaker. Production by factories, mines, and utilities, for example, fell sharply in August. Surveys of manufacturers in September suggested the slowing continued in that month. Unemployment fell to 8.1% from 8.3%, but only because of a sharp drop in the size of the labour force, as job creation was actually weak. Indeed, the U.S. Federal Reserve was sufficiently worried about the lacklustre job growth, that it implemented another round of quantitative easing, dubbed QE3, in mid-September. With QE3, the Fed will purchase large quantities of U.S. Treasuries and mortgage-backed securities to drive yields lower, hoping to stimulate borrowing. Importantly, the Fed indicated that there was no size or time limit on this quantitative easing.

In Europe, the lack of consensus among policymakers continued to hamper efforts to resolve the debt crisis. The Eurozone’s proposed permanent bailout facility, the European Stability Mechanism (ESM), received crucial approval from the German constitutional court, but implementation details remained unsettled. The European Central Bank’s scheme to buy struggling countries bonds also seemed to get bogged down as its details were worked out. The lack of progress on resolving the crisis in Europe meant that foreign interest in buying Canadian bonds as a safe haven continued. The most recent month’s data confirmed that, with foreign investors adding over $6 billion of Canadian bonds to their holdings.

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