The Canadian bond market declined in October as yields across all maturities rose despite a greater than expected decline in inflation and a larger than normal interest rate reduction by the Bank of Canada. The cause of the weakness was a very weak U.S. bond market that experienced large increases in yields as investors scaled back expectations of future rate cuts by the U.S. Federal Reserve. The Bloomberg Canada Aggregate and FTSE Canada Universe indices returned -1.03% and -1.01%, respectively, in the month.

Canadian economic data received in October was mixed. On the positive side, the unemployment rate declined to 6.5% from 6.6%. Job creation was strong with 46,700 net new positions created, including 112,000 new full time jobs that more than offset a 65,300 decline in part time ones. A drop in the participation rate to 64.9% from 65.1% also contributed to the decline in the unemployment rate. Less positively, Canadian GDP experienced little growth in August, although StatsCan’s flash estimate for September showed a more robust 0.3% increase. Inflation slowed more quickly than expected, dropping to 1.6% from 2.0% the previous month. A 7% decline in gasoline prices was the main driver of the better than expected inflation rate, leaving core measures of inflation unchanged at 2.4%.

Following three consecutive interest rate cuts of 25 basis points, the Bank of Canada lowered rates by 50 basis points on October 23rd. The larger size of the reduction had little impact on the bond market as it matched what had become the consensus expectation. The Bank cited the lower inflation rate and slack in the economy as reasons for the larger move. We note that one often mentioned measure of that slack is the unemployment rate, but in a subsequent discussion with a Deputy Governor, he acknowledged there has been little change in the unemployment rate for Canadians other than newcomers and youth. The last two years’ surge in immigration is the cause of the rising unemployment rate, rather than economic weakness.

In the United States, the economy continued to grow robustly, which led investors to sharply revise their expectations of future rate cuts by the Fed. Early in the month, the unemployment rate declined to 4.1% from 4.2%, as job creation was much stronger than expected. The relatively tight labour market conditions contributed to growth in average hourly earnings accelerating to 4.0%, a pace seemingly inconsistent with the Fed’s 2% inflation target. Inflation edged lower to 2.4% from 2.5%, but core inflation rose slightly and remained above 3.0%. Late in the month, U.S. GDP was estimated to have grown at a 2.8% pace in the third quarter, only slightly slower than the 3.0% rate of the second quarter and well above estimates of the U.S economy’s long term potential growth rate. The U.S. presidential campaign remained too close to call but concerns about potentially higher inflation from former president Trump’s proposed policies and about the massive ongoing fiscal deficit contributed to the selloff in U.S. bonds. The Fed did not have a rate setting meeting in the month, but several Fed speakers emphasized that future interest rate cuts would be more gradual than the 50 basis point reduction in September.

Internationally, the trend to lower interest rates continued with the European Central Bank lowering its rates by 25 basis points and the Reserve Bank of New Zealand dropping its rates by 50 basis points. Most countries, though, experienced weaker bond markets with most seeing yield increases similar to those that occurred in Canada. Only Great Britain had bond yields rise as much as in the U.S., with an expansionary budget by the new Labour government prompting a sharp selloff in Gilts. Looking ahead, November 7th will be a busy day for central bank announcements with the Fed, the Bank of England, Riksbank (Sweden), and Norges Bank (Norway) scheduled to make interest rate decisions.

The Canadian yield curve shifted upward in October. Yields of 2-year Canada bonds rose 14 basis points while 30-year yields finished 16 basis points higher. However, mid term bond yields moved somewhat more, with 5-year and 10-year yields up 28 and 27 basis points, respectively. Profit taking by investors that had anticipated the recent normalizing of the yield curve may have been behind the underperformance of mid term bonds. As noted above, the shift in U.S. yields was much more dramatic than in Canada, with 2-year Treasury yields jumping 55 basis points and 30-year yields rising 39 basis points. The U.S. selloff was remarkable as it followed the Fed’s 50 basis point rate cut in mid-September and seemed to ignore the widely anticipated rate reduction in early November. The relative outperformance of Canada bonds resulted in Canadian yields across the entire yield curve being more than 100 basis points below comparable U.S. Treasury yields for the first time.

Looking at the returns of the different market sectors, federal bonds returned -1.13% in October, as bond prices declined in response to higher yields. The provincial sector returned -1.25% as the impact of its longer average duration was partially mitigated by a 4 basis point narrowing of provincial yield spreads. The investment grade corporate sector returned -0.50%, with robust investor demand causing corporate yield spreads to narrow an average 6 basis points in the month. Non-investment grade bonds earned +0.73%, as they benefitted from relatively short durations and high yields. Real Return Bonds returned -0.65%, substantially outperforming nominal bonds with similar long durations despite the larger than expected drop in inflation. Profit taking and a slowdown in the pace of redemptions resulted in preferred shares declining 1.38%.

The Canadian dollar weakened 2.9% versus the U.S. dollar in October, in part because of the Bank of Canada’s larger rate reduction. But the shift in exchange rates was primarily about the strength of the U.S. currency which appreciated against all major currencies in October. The relative strength of the U.S. economy and the relatively higher yields of the U.S. bond market led all other currencies to cheapen. The Euro fell 2.3%, while the British Pound declined 3.6% and the Yen dropped 5.5%.

The U.S. elections on November 5th appear to be a toss-up. While investors have been concerned about potentially higher inflation if Trump returns to the White House, the magnitude of October’s selloff suggests a rebound is possible. We also believe once the election results have been settled, the U.S. fiscal deficit, estimated at $1.9 trillion or over 6.3% of GDP, will receive much needed attention. At a time when the economy is healthy, the federal deficit should be reduced, which would alleviate the supply pressure of U.S. Treasury bonds.

We believe the trend to lower interest rates will continue. The Bank of Canada’s next rate announcement is scheduled for December 11, and we expect it will lower rates by 25 basis points although another 50 basis point move is clearly possible. As noted above, we believe the rise in the unemployment rate does not reflect economic weakness. Rather, it has been caused by the federal government’s immigration policy. We also believe that concerns that economic growth will suffer significantly in 2025 and 2026 as a result of mortgage renewals are overblown. While interest rates are higher than in 2020 and 2021, they have dropped significantly from their peaks of last year. For floating rate borrowers, we expect the Bank of Canada will continue lowering rates into the first half of next year, thus further reducing the potential shock of increased mortgage payments. We also note that the higher than normal wage inflation of the last few years has resulted in increased employment incomes for most borrowers, making mortgage payments more affordable.

As we noted last month, the pace of the Bank of Canada’s rate reductions is less important than the level at which it stops. The Bank’s most recent estimate of the neutral rate, which is neither restrictive nor stimulative, is 2.75%, or 100 basis points lower than the current rate. That seems like a reasonable point for the Bank of Canada to at least pause, given the economy is not in a recession, the scale and pace of easing from the 5.00% rate peak, and the lag with which the economy responds to rate changes. While some observers are forecasting a terminal rate as low as 2.00%, we are not convinced that is the most likely outcome. If we are correct that the Bank will pause at 2.75%, the yields of longer term bonds are unlikely to decline substantially from current levels. That, combined with potential volatility from the U.S. election, leads us to leave portfolio durations close to benchmark levels.

We do believe there is room for the yield curve to normalize further, with shorter term bond yields moving further below longer term yields. As a result, we are maintaining the emphasis on mid term issues which should outperform a combination of short and long term bonds. Regarding the sectoral mix, we believe corporate yield spreads are historically tight, so we are keeping that sector’s allocation roughly in line with the benchmark and waiting for better opportunities to add corporate holdings.

The duration of the FTSE Canada Universe Bond index will increase by 0.06 years on November 1st due to the removal of $19.45 billion of one year bonds and payment of $1.5 billion in coupon interest. We also note that, starting in January 2025, the index will begin including newly issued Maple bonds in the Universe index. Outstanding issues of bonds from foreign issuers will not be added, however.