The Canadian bond market enjoyed modest gains in February, as geopolitical concerns in the Middle East and northern Africa in the second half of the month offset significant new issue supply and generally favourable economic news. For much of the month, bond prices were lower and yields higher, but events in northern Africa and the resultant spike in energy prices raised concerns about slower economic growth and that led to a rebound in the bond market. The DEX Universe Bond index rose 0.23% in the month.

Canadian economic news was relatively robust during February. While the unemployment rate rose to 7.8% from 7.6% the previous month, 69,200 new jobs were created. That restored Canada’s status as having regained all the jobs lost in the recession after a recent census revision reduced the estimate of employment. In addition, Canadian GDP was revealed to have grown at a 3.3% pace in the final quarter. That pace was faster than expected by both market participants and the Bank of Canada, which had predicted a 2.3% pace. It was also greater than the rate of growth in the United States economy over the same period. Significant areas of strength in the Canadian economy included faster consumer spending and better net exports. International trade experienced a dramatic improvement in December as the trade balance swung from a deficit of $100 million to a surplus of $3 billion. A large jump in exports of metals and energy was responsible for the turnaround. On the less positive side, retail sales unexpectedly declined due to a drop in auto sales that is expected to be only temporary. As well, factory sales rose in the most recent period, but by less than expected. To put the state of the manufacturing sector in perspective, sales peaked at $53.2 billion in July 2008, fell to $38.3 billion in May 2009, and have since rebounded to $45.4 billion. Thus the sector still has ground to make up in its recovery, and it faces headwinds from the disappointing pace of U.S. economic growth and the strength in the Canadian exchange rate.

International demand for Canadian securities remained strong in the most recent month, but bond purchases fell to $3 billion from $7 billion in the previous month. Demand for Canadian money market securities and stocks increased and offset the drop in bond purchases in the month. For 2010 as a whole, a record $116 billion of Canadian securities were bought by foreign investors, of which $96 billion were bonds. That bond total was up from $84 billion in 2009, and far higher than the $16 billion and $12 billion totals of 2008 and 2007, respectively.

In the United States, the labour market data followed the opposite pattern to the Canadian information. The unemployment rate dropped to 9.0% from 9.4% due to a lower participation rate, but job creation was disappointing. Indeed, the absolute number of net new jobs, 36,000, was roughly half those created in Canada, notwithstanding the difference in the sizes of the two economies. Interpretation of the labour data as well as some other economic indicators in the U.S. had to be done with some caution, however, due to severe winter storms. Weather disruptions in January and early February significantly depressed economic activity, but there are indications that there has been a significant rebound since then. Weekly claims for state unemployment benefits, for example, indicated a more positive labour situation as they twice fell below the psychologically important level of 400,000 in February. (Two years ago, initial claims peaked at 650,000.) Manufacturing and service sector business surveys showed accelerating activity, and consumer confidence hit the highest levels since April 2008. Personal income jumped 1% in January due to temporary cuts in payroll taxes, although higher gasoline prices discouraged consumer spending. In addition, the estimated rate of growth in U.S. GDP during the fourth quarter of 2010 was revised from 3.2% to 2.8%, but the underlying details indicated considerable strength. In particular, a sharp reduction inventories reduced growth; excluding the change in inventories, the GDP growth rate would have been at 6.7%. The reduction in inventories also suggests that production will increase in coming quarters in order to meet higher demand and rebuild stocks.

Only the U.S. housing sector failed to show significant improvement. Starts of new homes remained depressed, and average home prices fell slightly for the fourth month in a row. We believe that this sector will continue to lag others in the economy, pending significant improvement in the labour market and a reduction in the overhang of foreclosed homes that is keeping the lid on prices. With regard to the labour market, we believe that job creation is likely to accelerate sharply in the coming months as businesses seek to meet growing demand. On the foreclosure front, an important indicator of future foreclosures has started to show meaningful improvement. Before mortgages are foreclosed, they first must fall into arrears and the percentage of outstanding mortgages that are delinquent has recently shown marked improvement. While still high on a historical basis, the improvement in delinquencies suggests that fewer mortgages will need foreclosure. That, in turn, should gradually reduce the inventory of foreclosed homes.

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