The Canadian bond market was buffeted by a number of factors during July. The Greek debt crisis generated plenty of worrisome headlines in the first half of the month that caused some flight-to-safety buying of bonds. The price of oil fell more than 20% in the month, which caused the Loonie to plummet to its lowest level in over a decade. The Bank of Canada lowered its trendsetting interest rates in a potentially futile effort to stimulate a moribund Canadian economy. Falling commodity prices and concerns about the pace of Chinese growth generated economic pessimism and a risk-off attitude that led to wider corporate yield spreads. After rising and then falling to lie unchanged after the first two weeks, the bond market rallied over the balance of the month. The FTSE TMX Canada Universe Bond index returned 1.44% in July.

Canadian economic data during July was mixed, but the market focussed more on the negative news than the positive surprises. One negative area was trade: many observers, including the Bank of Canada, had expected that the precipitous drop in the Canadian exchange rate over the last year would lead to stronger net exports. However, in July we learned that the trade deficit in May was the second largest ever, trailing only the March 2015 record. Instead of helping growth, the export sector was depressing Canadian economic activity. Also of concern was the decline in oil prices, which gave back most of the May and June rally. As a result, a number of Western Canadian oil companies announced job cuts and reduced capital spending plans. Manufacturing sales in the most recent month were also weaker than expected. On the positive side, unemployment held steady at 6.8%, but there was a large shift from part time positions to better paying full time ones. Housing starts and retail sales were both stronger than expected.

The Bank of Canada revised lower its forecast for Canadian economic growth, and reduced its interest rates by 25 basis points on July 15th. (The efficacy of the reduction was somewhat muted as banks responded by lowering their prime lending rate by only 15 basis points.) Greater weakness in the energy sector and disappointing non-energy exports were the primary factors behind the revised outlook. The Bank acknowledged that its rate reduction might cause further distortions to areas such as house prices, but it felt obliged to respond to weaker than expected economic activity with the only tool it had. Unfortunately, the federal and provincial levels of government were busy with other priorities such as balancing their respective budgets and raising taxes to address the weakening economic environment. Increased fiscal stimulus, more rational electricity pricing, and more accommodating industrial prices would all have been helpful alternatives/additions to the Bank’s move. As it was, we learned late in July that Canadian GDP shrank in May for the fifth consecutive month, and investors began discounting a third easing move by the Bank of Canada.

In the United States, the economic news was also mixed. On the positive side, the unemployment rate dropped to 5.3% from 5.5%, although much of the improvement was due to a sharply lower participation rate. Construction spending was higher than expected, led by non-residential spending. Vehicle sales remained robust and housing starts were much stronger than expected. Much of the negative news centred on weak hourly and weekly earnings growth. Indeed, the Employment Cost Index for the second quarter was much weaker than expected, with the smallest wage increase on records going back to 1982. The U.S. central bank, the Federal Reserve, left its interest rates unchanged in July, but many observers believed its accompanying statement was slightly hawkish and strengthened the probability of a first rate increase in September. We disagree, believing that the lack of wage inflation will permit the Fed to be patient and not raise interest rates before December.

In international developments, Greece avoided defaulting and its debt renegotiations moved off the front page, thereby removing one source of volatility in the bond market. Also in July, Iran concluded negotiations to limit its nuclear programme in exchange for relief from economic sanctions. That put pressure on oil prices, because Iran would once again become a significant supplier when the oil market is already suffering from a glut. While Iranian production would not ramp up for several months, the prospect appeared to be the catalyst for a month-long slide in oil prices. Lower oil prices over the last year have not proved to be the economic stimulant that many, including ourselves, anticipated. Instead, the prices of other commodities, including copper and steel, have also declined in recent months. That development raised concerns about global demand weakening that, in turn, led to bond buying and lower yields.

Anticipation that the Bank of Canada would lower its benchmark interest rates again in July caused shorter term bond yields to fall close to the year’s lows reached in early February following the Bank’s first, surprise rate cut.

Short Term Bond Yields Reach New Lows

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