The Canadian bond market enjoyed strong gains in May, as developments south of the border drove yields lower and prices higher. Canadian bond yields have taken their lead from the U.S. bond market throughout 2014, and last month was no different. In the U.S., however, many investors struggled to reconcile the bullish behaviour of U.S. Treasuries with record levels on stock markets, improving second quarter economic data, and reduced bond purchases by the Federal Reserve. The consensus explanation for the bond rally appears to reflect concerns about global growth prospects, continuing low inflation, and low probability of central bank monetary tightening. Asset mix shifts from equities to bonds by pension funds and short-covering by speculators have also contributed to the rally this year. Speculation that the European Central Bank would initiate a quantitative easing programme of bond purchases also spurred some bond purchases during May. The FTSE TMX Canada Universe Bond index returned 1.22% in the month.

Canadian economic data was mixed in May as it experienced some variability on a period to period basis. Growth in the Canadian economy was slower than expected as first quarter GDP was estimated to have increased 1.2%, but that pace was substantially better than the U.S. pace for the second consecutive quarter. The unemployment rate held steady at 6.9%, although 28,900 jobs disappeared following the robust 42,900 increase the previous month. Housing starts rebounded to an annual rate of 194,800 units following a plunge to 156,700 the month before. Manufacturing sales were better than forecasts, but retail sales were weaker. Inflation rose to 2.0% from 1.5% a month earlier. Attaining the 2% inflation target occurred more quickly than the Bank of Canada had projected, but it was unlikely to cause an immediate change in monetary policy.

American economic news was also mixed but, on balance, tended to be more positive. Unemployment fell to 6.3% from 6.7%. Robust job creation was a factor, but declines in the size of the labour force and in the participation rate had larger effect. Personal income and spending were stronger than expected and consumer borrowing rose by the most in a year. Manufacturing surveys were stronger than expected, as were housing starts. Less positively, industrial production unexpectedly fell in the most recent month and the estimated growth in U.S. GDP during the first quarter was revised from +0.1% to   -1.0%. The revision to GDP was the result of lower estimates of inventory accumulation in the period, and that actually bodes well for future activity as businesses rebuild their stocks.

Globally, the main focus of fixed income investors was disappointing economic growth in Europe. Weaker than expected German and French industrial production and retail sales raised concerns than the European economy was stalling. With inflation in the Eurozone holding at only 0.7%, many observers worried about possible deflation and called for the European Central Bank to implement additional monetary stimulus. Such stimulus, which is expected to be announced at the ECB’s June 5th meeting might take the form of negative interest rates on bank reserves and possibly the implementation of quantitative easing (bond purchases) similar to programmes in the United States, Great Britain, and Japan. The latter possibility was one of the factors behind the global bond rally in May as investors sought to position themselves in advance of possible ECB purchases.

The Canadian yield curve flattened in May. The yields of 2-year benchmark Canada bonds declined slightly, while the yields of 5, 10, and 30-year Canada bonds each fell roughly 15 basis points. In doing so, the changes in Canadian yields closely paralleled the yield moves in the U.S. bond market during the month. Lower yields resulted in good price gains in each of the market sectors. Federal bonds, for example, returned 0.94% in the period. Provincial bonds earned 1.77%, as their longer average durations resulted in larger price gains as yields declined. Corporate bonds returned 1.02%, with yield spreads moving a basis point wider. New issue supply of corporate bonds was relatively light at $8.8 billion, as the Big 6 banks avoided issuing debt while they announced their second quarter financial results. However, investors’ demand for corporate bonds appeared in better balance than recent months, as new issues failed to rally following pricing and investment dealers reported increased selling to pay for new purchases. As a result, corporate yield spreads were little changed. Real Return Bonds gained 2.89% in the month, with their very long durations being the driving factor behind their returns. High yield issues earned 0.87%, slightly underperforming investment grade issues.

In market parlance, “pain trade” describes how markets occasionally deliver the maximum punishment to the most investors. A pain trade occurs when a popular asset class or widely followed investing strategy takes an unexpected turn that catches most investors flat-footed. For example, a significant number of investors may have structured their portfolios in anticipation of the market moving in a particular direction (either up or down), but the market in fact moves in the opposite direction. Pain trades sorely test the resolve of even the best traders and investors, since they must face the dilemma of whether to hold on in the hope that the trade will eventually work out, or take their losses before the situation worsens.

The bond market rally this year has been a classic pain trade. At the end of 2013, many investors were bullish about economic growth and anticipated that bond yields would continue to rise as the U.S. Federal Reserve tapered its bond purchases in preparation of eventual increases in interest rates. As a result, many fixed income investors set their portfolio durations shorter than their respective benchmarks. (We did not follow this approach and our client portfolios had neutral durations at the start of the year.) Unfortunately for those investors, bond yields have fallen instead of rising and the shorter durations have meant that those investors have lagged the market performance. As the market has rallied, there has been an absence of investors willing to sell bonds. Those with offside positions didn’t want to compound their losses and other investors chose to wait out the rally rather than selling. As a result, the upward move in bond prices has had little resistance.

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