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Canadian bond yields rose slightly in October as better than expected economic data, particularly in the United States, and confusing messages from the Bank of Canada regarding future rate increases weighed on bond prices. While benchmark Canada bonds remained within the trading range that began three months ago, the decline in bond prices during October was greater than the interest income earned, leading to modest negative returns in the period. The DEX Universe Bond index declined 0.19% in the month.
The economic news in Canada during the month was mixed. Of particular concern was the revelation that the Canadian economy shrank 0.1% in August. That was much weaker than many economists had predicted and it suggested that the Canadian economic situation might be more precarious than previously thought. In addition, the unemployment rate edged up to 7.4% from 7.3% a month earlier, but this was in spite of surprisingly rapid job creation that occurred. The trade deficit fell to $1.3 billion from $2.5 billion a month earlier, as imports contracted more than exports. More positively, housing starts were at robust levels, even with the recent tightening of mortgage rules. As well, demand for Canadian bonds remained strong, with international investors purchasing $4.7 billion in the most recent month.
Central banks in recent years have tried to be more open about their exercise of monetary policy. Decisions to adjust interest rates, or leave them alone, are generally accompanied with explanatory statements. Prospective changes in monetary policy are often hinted at in those statements or in speeches by senior central bank staff between rate setting meetings. Above all, central bankers have wanted to avoid surprising markets and investors by sudden shifts in policy, preferring consistency and gradualism. The Bank of Canada has generally followed this approach, but in October, its communications to the markets sent mixed signals and caused noteworthy volatility in the Canadian bond market. For several months, the Bank had indicated that it would prefer to remove some of the current monetary stimulus; that is, raise interest rates from their very low levels. However, some of the Bank’s statements in October failed to mention the need to eventually raise interest rates, and this led some investors to conclude that there had been a change in the likely path of interest rates in the future, and a bond market rally resulted. Unfortunately, subsequent Bank of Canada statements reiterated the need to raise rates and bond prices quickly fell back.
We believe that the Bank of Canada is, in fact, on hold for the next few quarters. The Canadian economy is not yet operating at full capacity, and the pace of growth is too slow to eliminate the slack until mid-2013 at the earliest. Indeed, in October, the Bank of Canada extended its own estimate of when full capacity would be reached to the end of 2013. With global growth still decelerating, we do not believe that the Canadian economy will require higher rates for some time. In our opinion, the Bank of Canada’s mention of higher rates was designed to slow the growth in household debt (which has risen to worrisome levels) without actually raising rates.
U.S. economic data received in October tended to surprise to the upside. The labour market, for example, saw unemployment fall to 7.8% from 8.1%. Job creation was in line with expectations, but the estimates of jobs created in the past two months were increased significantly. Overall, the U.S. economy grew at a faster-than-expected 2.0% pace in the third quarter. American consumers were clearly in a good mood, with a strong increase in retail sales. This was also evident in new car and truck sales, which grew to their highest level since the financial crisis.
The housing sector also showed improvement, as home prices continued to firm. Rising prices are critical to the recovery, because they will boost consumer confidence through the wealth effect and also encourage new construction. Indeed, housing starts jumped 15% in the most recent month, but remain far below pre-crisis levels. The only noteworthy weakness in the U.S. economy was business investment in plant and equipment; weak global growth and the uncertainty surrounding the U.S. fiscal cliff discouraged firms from adding capacity.
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