For much of March bonds traded in a relatively narrow but choppy range as investors waited details on U.S. tariffs that were pushed back to April 2nd. Conflicting comments by U.S. President Trump and by his various competing aides made it difficult to anticipate what the tariff policy would ultimately be. However, it appeared that Trump was determined to impose significant tariffs despite their negative impact on the U.S. economy and the economies of its trading partners. The resultant economic uncertainty made investors risk averse causing sharp declines in equity markets. The S&P/TSX declined 1.87%, while the U.S. S&P 500 fell 5.75% and the tech-heavy NASDAQ dropped 8.21% in the month, which put pressure on corporate bond spreads. Also in the month, the Bank of Canada reluctantly made a reduction in its interest rates while the U.S. Federal Reserve chose to leave its interest rates unchanged. The Bloomberg Canada Aggregate and FTSE Canada Universe indices returned -0.29% and -0.28%, respectively, in the month.

Much of the Canadian economic data received during March referred to activity prior to Trump’s early February tariff threats. That data tended to show the Canadian economy was performing well, offering some hope that it would have resilience once the tariffs were imposed. Growth in GDP during January, for example, was better than expected and on a year-over-year basis had increased at a satisfactory 2.2% pace. In addition, the unemployment rate held steady at 6.6%, with a lower participation rate offsetting weak job creation. The balance of trade showed a record monthly surplus in February as individuals and companies made purchases in advance of the tariffs starting. The CPI inflation rate increased more than expected with the end of the GST/HST holiday, rising 1.1% in February and lifting the annual rate to 2.6% from 1.9%. Of concern to the Bank of Canada, the core rate of inflation increased to 2.9% from 2.7%. As noted above, the Bank chose to lower its overnight target rate to 2.75% from 3.00% despite the increase in inflation. The Bank said the reduction was meant to offset tariff uncertainty, as it would otherwise have left rates unchanged. The Bank also indicated that it expects to proceed carefully with further rate changes.

In the United States, the economic data was more current and indicated businesses and individuals were becoming cautious about investing and purchasing before the impact of the tariffs was known. Expectations for future inflation rose, although the actual inflation rate declined to 2.8% from 3.0% the previous month. The U.S. trade deficit, which is being targeted by Trump, jumped substantially higher because of companies front running potential tariffs. The Fed believed the U.S. economy was performing well and left its interest rates unchanged. Fed Chair Jerome Powell said he thought the inflationary impact of tariffs might be transitory, but some of his colleagues were less optimistic.

Internationally, the European Central Bank lowered its interest rates by 25 basis points while the Bank of England, Bank of Japan, and Sweden’s Riksbank each decided to leave their respective rates unchanged. Notwithstanding the ECB’s move, European bond yields moved higher in March as investors anticipated increased bond supply because countries may be forced to respond to the negative impact of a trade war with the United States with increased spending.

The Canadian yield curve steepened in March as short term bond yields moved lower while longer term yields rose. For example, the yield of Canada bonds maturing in 2 years declined 11 basis points while 30-year Canada bond yields finished 11 basis points higher. The decline in the 2-year yield left it at 2.46%, well below the Bank of Canada’s new overnight target of 2.75%, suggesting investors anticipated further rate reductions in response to the threatened tariffs. The U.S. Treasury yield curve experienced a very similar shift to Canada’s despite the Fed leaving its administered interest rates unchanged. The yield of 2-year Treasuries fell 7 basis points while 30-year Treasury yields gained 10 basis points in March.

The federal sector returned -0.28% in March as the price declines of longer term issues more than offset the gains from short term bonds. The provincial sector, which has a greater proportion of longer term issues, returned -0.71% in the month. Provincial yield spreads edged wider, particularly for longer term issues because of the uncertain economic environment as well as some larger than expected provincial fiscal deficits. Investment grade corporate bonds returned -0.05% in the month. Short and mid term corporate spreads moved wider in March, but average long term corporate spreads narrowed slightly because of an unexpected large repurchase of bonds. Mid-month, BCE Inc. announced that it would run a tender for $400 million of its longer term issues in order to improve some of its financial ratios. Subsequently, late in the month, the company increased the size of the tender and repurchased $1 billion of one of its issues maturing in 2050. Investors who had tendered their bonds to BCE scrambled to reinvest the proceeds, which led long term corporate spreads to narrow close to month end.  High yield corporate issues earned -0.08% in the month, while Real Return Bonds returned -0.35%. Preferred shares returned -0.12% in the month, bolstered by the reinvestment activity resulting from more than $600 million of redemptions on the final day of the month.

This outlook is being written following Trump’s rambling Rose Garden speech in which he imposed 10% tariffs on virtually all U.S. imported goods, as well as “reciprocal” tariffs on 60 countries. The rates of the reciprocal tariffs were based on a formula that divides a country’s trade surplus with the U.S. by its total exports. Concepts such as relative advantage were not considered. Nor was size of the country or its trade surplus, as reciprocal tariffs were applied to the French archipelago St. Pierre and Miquelon in the Gulf of St. Lawrence, as well as the Falkland Islands. Canada and Mexico were spared (for now) any reciprocal tariffs, but the earlier tariffs on steel, aluminum and autos still apply. Goods that qualify under the USMCA free trade agreement (also known as NAFTA 2.0) will still be tariff free and companies that have not completed the paperwork to register those goods now have a strong incentive to do so. Estimates of the percentage of Canadian exports currently registered under USMCA are in the 38% to 40% range, but new registrations could take that to 80% or more.

The full impact of the tariffs will depend on how countries respond, including retaliatory tariffs on U.S. goods and services. Those have yet to be determined but, on their own, the U.S. tariffs are likely to result in slower U.S. growth and higher inflation in the United States. The slowdown in growth will occur because the increased uncertainty is already showing up in consumers becoming cautious and businesses deferring investments. In addition, U.S. exports are likely to fall as other countries respond. Inflation will rise because the tariffs will increase the cost of imports and the U.S. will not be able to replace them with domestic production for at least a few years.

In Canada, the uncertainty is also likely to slow economic activity somewhat. Already, we have seen a slowdown in housing sales. However, Canada’s exporters may benefit from the reciprocal tariffs imposed on other countries because that makes Canadian goods relatively more competitive to U.S. buyers. We also believe Canadian inflation is unlikely to change significantly due to the trade war because the Canadian government has chosen retaliatory tariffs on U.S. goods that do not impact day-to-day purchases of average Canadians. Given the relatively good performance of the Canadian economy prior to Trump’s tariff threats, we believe the Bank of Canada is likely to hold interest rates steady at its next announcement on April 16th. Only if there is marked deterioration in the economy in the next two weeks will the Bank move, and that is not enough time for the tariffs to have much impact.

Given the economic uncertainty and market volatility, we are keeping portfolio durations close to benchmark levels. Long term bond yields are not attractive given current levels of inflation, but investors such as pension funds have ongoing needs to hedge their long term liabilities. We also acknowledge the potential for a flight-to-safety bid for bonds developing if equity markets react negatively to the trade war.

The widening of corporate yield spreads since the start of the year has not been enough to make them attractive. The uncertain impact of the trade war, in our opinion, has not been properly reflected in the risk premiums/corporate spreads. We also believe corporate yield spreads may widen if equity markets experience significant weakness as a result of the needless trade war. Accordingly, we are cautious about adding corporate bonds. Indeed, we anticipate the allocation to the corporate sector will decline somewhat in the next few months as corporate maturities are reinvested in government bonds.