The Canadian bond market experienced a seesaw month in March. Initially, stronger economic data in Canada and the United States caused bond prices to fall and yields to rise. However, new concerns emanating from the European debt crisis led to a resurgence in the flight-to-safety bid for bonds. In the end, bond yields and prices were little changed from month earlier levels. The DEX Universe Bond index returned 0.44% in March.

Canadian economic data released in March was generally better than expected. Of particular note, job creation was robust with 50,700 new positions in the month. The unemployment rate held steady at 7.0% as the participation rate increased. Retail sales rebounded from weakness the previous month, as did housing starts. The trend of housing starts, however, remained toward lower levels of activity. Canadian Housing StartsGrowth in Canadian G.D.P. was slightly ahead of forecast in the most recent month, but an increase of only 1.0% over the last year demonstrated that growth remained disappointing. It was encouraging, therefore, that Canada’s trade deficit was the smallest in nearly a year as exports of oil and bitumen increased. Less positively, manufacturing sales declined for the fourth time in the five months. In addition, inflation had its largest monthly increase in more than 20 years, but the annual rate, at 1.2%, remained near the bottom of the Bank of Canada’s 1% to 3% target band.

In the United States, the economic data was even stronger. The labour market continued its recovery, with initial claims for unemployment benefits falling to 5-year lows, robust job creation, and a drop in the unemployment rate to 7.7%. Output of factories, mines, and utilities experienced good growth, led by continued recovery in the manufacturing sector. Personal income recovered some of the payroll tax-induced drop of the previous month, and consumer spending continued to increase. (The muted impact of the payroll tax increase was perhaps explained by a poll that showed almost half of Americans were not aware of any change in their paycheques since it occurred in January.) Consumer sentiment rose to a four-month high on accelerating home prices as well as the stock market rally that saw the Dow and S&P 500 indices hit record highs. Importantly, Congress avoided further brinksmanship and passed legislation funding the government for the next several months as it tries to resolve the longer term fiscal challenges facing the United States.

In Europe, a flawed attempt to resolve a banking crisis in Cyprus resulted in a bond market rally as investors worried that it was a precedent for future European bank bailouts. The Cypriot banking sector was substantially larger than necessary for the island’s economy and had attracted substantial offshore funds, particularly from wealthy Russians. Poor investment decisions, including loans to Greece, left a number of Cypriot banks insolvent and in need of government support. Healthy European governments, though, balked at bailing out Russian oligarchs. The proposed approach would have penalized even deposits subject to government insurance (i.e. those under €100,000), although larger, uninsured deposits would have fared worse. Not only was this the first time in the European crisis that any depositors would lose money, it suggested that even supposedly guaranteed deposits were not safe. That raised concerns that depositors might start withdrawing funds from other weak banks in countries such as Spain and Italy. If the Cypriot banking rescue prompted bank runs in other countries, the crisis could quickly spin out of control. That risk prompted substantial buying of bonds in both the United States and Canada, which pushed prices up and yields down. In the end, the terms of the Cypriot rescue were changed so that small depositors did not lose any money, but the possibility that future bailouts might penalize small depositors kept the flight-to-safety bid for Canadian bonds.

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