Financial markets in October were dominated by speculation about the imminent implementation of a second round of quantitative easing (QE2) by the U.S. Federal Reserve. Fed officials gave broad hints that it would soon start buying large quantities of U.S. bonds, but investors were left to guess about the size and effectiveness of the coming programme. The bond marketed fluctuated in a narrow range as investors tried to anticipate the potential impact of QE2 . Equity markets tended to be correlated with bond markets in that environment, because a large quantitative easing programme would mean more bond purchases and higher bond prices, as well as greater economic stimulus that would be beneficial for equities, while a small or unsuccessful QE2 would have the opposite effects. The DEX Universe Bond index gained 0.22% in the month, as interest income offset small average price declines.

The relatively small change in the Canadian bond market also reflected the mixed economic news received during October. On the positive side, Canada’s unemployment rate declined to 8.0% from 8.1% a month earlier, and full time job gains mostly offset part time losses. Retail sales rose at the fastest pace in six months and Canadian GDP growth rebounded in the most recent month. Bank of Canada surveys found Canadian businesses increasing their investments in machinery and equipment, and credit conditions easing for the fourth consecutive quarter. In addition, manufacturing sales were stronger than expected, led by the automotive industry. On the negative side, the Bank of Canada paused in its monetary tightening programme, leaving its overnight target interest rate at 1.00%. The Bank explained that it had become less optimistic about the pace of Canadian economic growth over the next two years, and that it was concerned about the high level of household debt in Canada slowing the pace of consumer spending.

In the United States, economic growth accelerated marginally, thereby reducing concerns about a possible double dip. Consumer confidence improved, which led to stronger than expected retail sales and, in particular, improved vehicle sales. Car and light truck sales were up 10.3% year to date, with domestic vehicle sales higher by 15.4%. In addition, housing starts unexpectedly rose to a 5-month high, although that sector remains very depressed. The pace of growth was too slow, however, to reduce the tremendous slack built up in the U.S. economy during the recession. Critically, the unemployment rate remained unacceptably high at 9.6%, and CPI inflation held steady at 1.1%. With the Fed concerned about reducing unemployment and avoiding deflation, these data ensured that QE2 would soon be implemented. The Fed will also be spurred on by the continuing political deadlock in the U.S. that will prevent any further fiscal or legislative initiatives to stimulate the economy.

Foreign buying of Canadian bonds remained robust. In the most recent month for which data is available, August, foreign net purchases were $10.8 billion. While monthly amounts have fluctuated considerably in 2010, there has been a clear and significant increase over previous years. This has pushed bond prices higher and yields lower. Reasons for the increased foreign purchases include central banks and sovereign wealth funds diversifying foreign currency holdings from the U.S. dollar and the Euro, as well as global bond funds seeking the relatively higher yields and fiscal stability of Canada.

1 2