“Much Ado About Nothing” is the title of a comedy by William Shakespeare, but also describes the markets’ reaction to the U.S. Federal Reserve decision to leave interest rates unchanged. In the days leading up to the Fed’s September 17th announcement, observers were evenly divided about whether there would be a rate increase or not. After the announcement and a subsequent dovish press conference by Fed Chair Janet Yellen, equity, commodity, and bond markets adopted a risk-off attitude that anticipated significantly weaker economic activity in the future. It seemed that investors reacted to the Fed’s inaction by wondering “What do they know that we don’t know?” Global equity markets fell 7% to 8% in the days following the Fed meeting and the prices of copper, aluminum, and oil dropped similar amounts. In the Canadian bond market, the yield spreads of provincial and corporate bonds moved wider as economic expectations were lowered. Yields of federal bonds, in Canada and the United States, declined due to a flight-to-safety bid. The FTSE TMX Canada Bond Universe returned -0.27%in the month.

Canadian economic data did not corroborate the more pessimistic economic outlook, as most news was better than expected. For example, Canadian GDP grew faster than forecast in July, confirming the positive growth in June following five weak months to start the year. Unemployment rose to 7.0% from 6.8%, but the increase was due to an increase in the participation rate as more workers entered the labour force. Job creation was satisfactory and there was also a significant switch from part time positions to better paying full time jobs. The trade deficit was smaller than expected as exports grew more rapidly than imports. Retail sales were weaker than forecasts, but still grew satisfactorily. With growth improving, the Bank of Canada left administered interest rates unchanged at its September meeting. That decision was not a surprise, given the Bank’s reluctance in the past to change monetary policy during a federal election.

In the United States, the economic news was mostly positive, although the manufacturing sector slowed. The unemployment rate fell to 5.1% from 5.3% as job creation remained strong. In addition, average hourly earnings and the workweek grew more than expected, resulting in increased incomes for workers. Consumer credit continued to grow robustly as Americans were more willing to borrow for big ticket purchases, reflecting the favourable labour market and improving personal finances, including rising home values. The manufacturing sector, however, was negatively affected by continued weakness in energy investment and the challenges that exporters were encountering with the elevated U.S. dollar and decelerating global growth.

As noted above, the Fed left administered rates unchanged at its September meeting. A significant factor behind the decision was the Fed’s concern about uncertain global growth and the potential impact on the U.S. economy. (Ironically, the Fed also stated that it was concerned about global market volatility.) Initial statements by Fed officials gave investors the impression that the Fed might not raise rates before next year. However, subsequent statements suggested that a rate increase later this year was in fact quite likely. Investors were, of course, confused and that resulted in reduced liquidity and increased volatility in bonds and other markets. One estimate of the bond volatility in September suggested that it was the highest in 40 years. The Fed’s concern about global growth also heightened investors’ fears of a recession and that led to a widening in credit spreads of corporate and provincial bonds.

The Canadian yield curve flattened somewhat in September. The yields of benchmark 2 and 5-year Canada bonds rose 9 and 4 basis points, respectively, due in part to international selling of Canadian bonds. The yields of 10 and 30-year bonds, however, fell modestly, as they tracked developments in the U.S. bond market. In the U.S., yields fell across the yield curve as investors who had anticipated a Fed rate increase were forced to cover their short positions by buying bonds.

The federal sector returned -0.01% in the month, as interest income and the price gains of longer term Canada bonds were offset by the price declines of shorter term issues. The provincial sector returned    -0.72% in the period as provincial yield spreads widened an average 9 basis points. Investment dealers reported selling by international investors almost every day, and that was likely the main source of the sector’s weakness. The corporate bond index earned -0.06% in the month, but actual returns were highly dependent on the industry and specific issuers. In the automotive sector, Volkswagen’s “Dieselgate” caused its yield spreads to widen by as much as 250 basis points, those of other German car companies by 20 to 30 basis points, and other global manufacturers, such as Toyota, by 10 to 15 basis points. New issue supply of $13.3 billion that was the highest on record for any September also caused yield spreads to widen. Of note, new issues would be offered at yield spreads 8 to 15 basis points cheaper than outstanding issues. While the new issues often tightened slightly after they were sold, the impact was a net widening of the spreads of outstanding issues. The effect was particularly pronounced in the bank sector where issuance was substantial and more was expected in the near future. For example, only one NVCC sub-debt deal (TD Bank) came in September, but the prospect of additional ones in the next month or two caused existing NVCC sub-debt issues to widen 15 to 20 basis points in the month. Other corporate sectors that experienced wider spreads as a result of new issues repricing older issues included communications and securitizations. High yield issues continued to struggle, with the index returning -1.20%. The relatively poor performance was not simply about commodities, but also about highly-indebted borrowers struggling to grow in a weak economy and investors becoming more cautious about credit risk. Bargain hunting in Real Return Bonds during September resulted in relatively strong performance as the sector returned +0.70%.

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