Global financial markets experienced a wave of optimism in January, as investors anticipated improving economic conditions. Equity markets surged higher, with many bourses gaining more than 5% before receding late in the month. The United States’ avoidance of the fiscal cliff, improving economic data from China, and a lack of headlines regarding the European debt crisis (“no news is good news”) contributed to the positive sentiment. The S&P 500’s so-called fear gauge, the VIX, was quite low, which indicated a lack of anxiety by investors. In this environment, demand for the safety of fixed income fell and global bond yields rose. Only the European countries at the centre of the crisis (viz. Greece, Portugal, Italy, and Spain) experienced significantly lower yields. Canadian yields moved higher in sympathy with the global trend, but generally less than most other bond markets. In part, the relative strength of Canadian bonds may have been the result of a new, more dovish stance by the Bank of Canada. The DEX Universe declined 0.74% in the month.

Canadian economic data was mixed in January. On the positive side, robust job creation led to a drop in unemployment to 7.1% from 7.3% a month earlier. As well, manufacturing sales rebounded from weakness the previous month, and housing starts remained strong. Less positively, Canada’s trade balance deteriorated sharply, with the monthly deficit jumping to $1.96 billion from $170 million the previous month. A sharp drop in exports to Europe was the primary cause, but imports also rose due to good domestic demand. The worsening trade balance will result in slower economic growth, and many forecasters revised their estimates of Canadian GDP growth in the fourth quarter of 2012 to less than 1% per annum.

The Bank of Canada had one of its regularly scheduled rate setting meetings in January. With regard to its rate decision, Douglas Porter, Chief Economist of the Bank of Montreal, said it best: “To the surprise of precisely no one, the Bank of Canada kept its key overnight lending rate at 1.0% today for the 19th meeting in a row.” However, the Bank of Canada finally acknowledged that the Canadian economy was growing too slowly to warrant imminent rate increases, which many observers interpreted to mean no change for the balance of this year. The Bank’s statement, however, still hinted that the next move, whenever it occurs, would be to higher rates. The Bank believed that such a message had value as a monetary policy tool, but as we said to a Deputy Governor later that day, if the same message is repeated 19 times over a period of 2 ½ years, it loses much of its impact. In our opinion, the Bank should refrain from providing “guidance” until changes are, in fact, imminent. We also believe that the Bank’s message may have had the unintended effect of raising the Canadian exchange rate, as the Canadian dollar immediately dropped below parity with the U.S. dollar once the Bank indicated rate increases were not imminent.

U.S. economic data was also mixed in January. Job creation was good, but failed to lower the unemployment rate. Consumers acted optimistically, with retail sales showing good gains. However, subsequent consumer confidence surveys dropped to the lowest levels since November 2011, suggesting future spending may be weak. The housing sector continued to recover, with starts jumping 12% from a month earlier. In the last year, starts have surged 37%. US Housing StartsLess positively, U.S. GDP was estimated to have actually shrunk in the final quarter of 2012, as defence spending plummeted unexpectedly. On balance, the data suggested the U.S. economy was growing moderately as it entered 2013. With the payroll tax increases and other fiscal tightening likely in the first quarter, U.S. economic growth faced significant headwinds. The Federal Reserve Board agreed with that assessment, as it continued to provide remarkable amounts of monetary stimulus. In particular, the Fed continued its programme of purchasing about $40 billion of mortgage-backed securities per month and, additionally, initiated a programme to buy $45 billion of U.S. Treasury bonds each month. The Fed’s objective with these programmes is to keep bond yields low and encourage borrowers, particularly in the housing market. In the near term, the Fed’s purchases should keep yields lower than they would otherwise be, but longer term it may have problems unwinding its holdings once the stimulus is no longer required. The Fed’s holdings of securities currently stand at a little less than $3 trillion and pose a potential refinancing problem when the Fed starts to shrink its balance sheet. On the political front, it appeared that the debt ceiling would be temporarily extended, which would reduce the likelihood of the United States defaulting on its financial obligations. Paradoxically, the reduced likelihood of default lowered demand for bonds, as investors sought riskier assets.

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