The Canadian and U.S bond markets struggled as bond prices declined and yields increased in the first half of July. A partial recovery over the balance of the month eliminated more than half the losses, but the monthly returns remained negative. Investors hoping for easier monetary policy (i.e. interest rate cuts) were disappointed as economic activity remained strong enough and inflation sufficiently high that central bankers were not compelled to act. The slow, often delayed rollout of U.S. tariffs has meant their impact has generally not been realised yet. In addition, news of U.S. agreements (“deals” without details) with several countries, including Japan and the European Union, led to optimism that the economic pain from tariffs would be less than feared. That optimism led equity markets to rally with the S&P/TSX up 1.7% and the S&P500 up 2.2% in the month. On July 30th, both the Bank of Canada and the U.S. Federal Reserve confirmed that they felt current interest rates were appropriate and left them unchanged. The FTSE Canada Universe Bond index returned -0.74% in July.

Canadian economic data received in July was generally better than expected. The unemployment rate declined to 6.9% from 7.0%, with 83,100 new jobs created and a small rise in the participation rate. Housing starts were better than expected, manufacturing sales in May were less bad than forecasts, and retail sales in the same month were in line with expectations at a time of maximum trade uncertainty. Of particular importance for the Bank of Canada, the CPI inflation rate rose to 1.9% from 1.7%, while core measures increased to slightly above 3.0%. On the final day of the month, Canadian GDP was estimated to have declined 0.1% in May, but on a year over year basis, the Canadian economy grew 1.2%.

U.S. economic data was also positive in the month. Labour market data appeared satisfactory as the unemployment rate declined to 4.1% from 4.2%, job creation was averaging 150,000 new positions over the last three months, and initial claims for state unemployment benefits remained low. Growth in the U.S. GDP during the second quarter was estimated at 3.0% compared with -0.5% the previous quarter, although both figures were distorted by the surge in imports earlier this year with frontrunning of the tariffs. Estimates of underlying growth in the first half of this year suggested a pace of 1.5%, not robust but also not weak enough to spur Fed action. Retail sales in June were much better than forecasts. Of concern, although tariff induced price increases have been rare so far, CPI inflation rose to 2.7% from 2.4% and core inflation edged up to 2.9%.

Yields of all Canada bond maturities rose between 17 and 19 basis points in July, effectively executing a parallel shift upward in the Canadian yield curve. Yields of U.S. Treasuries also rose in the month but with a little more variation. Yields of 2-year and 30-year Treasuries increased 8 and 11 basis points, respectively, while 5-year Treasury yields jumped 17 basis points and 10-year yields increased 15 basis points. Despite concerns that foreign investors might avoid investing in U.S government bonds, there was no indication of that happening in the Treasury auctions that occurred in the month.

The federal sector returned -0.77% in July with higher yields pushing bond prices lower. The provincial sector declined 1.24%, as its higher average duration meant the rise in yields had a larger impact. Investment grade corporate bonds fared substantially better than government bonds, returning -0.02% in the month. Yield hungry investors bid up corporate issues which caused their yield spreads versus Canada bonds to narrow by 11 basis points and hit levels not seen since before the Great Financial Crisis. Bonds with the highest yields (i.e. the ones with lower creditworthiness) attracted the most interest with BBB-rated issues narrowing an average of 14 basis points. New issue supply of $8.8 billion was slightly above average for the summer month, but clearly insufficient to meet investor demand. Non-investment grade corporate bonds also benefited from the demand for yield as well as rallying equity markets, gaining 0.78% in the month. Real Return Bonds returned -0.62%, which was substantially better than nominal bonds with similarly long durations. Preferred shares enjoyed another strong month, gaining 3.19% as redemptions continued to push the prices of remaining shares higher.

As this is being written, the U.S. has released disappointing labour statistics. Job creation was slightly below forecasts in July, but the estimates for May and June were very substantially reduced. That led to a small increase in the unemployment rate despite a decline in the participation rate. In addition, the news gave rise to significant speculation that the Fed will lower its interest rates at its next meeting in mid-September. The disappointing job creation data also led President Trump to fire the head of the Bureau of Labor Statistics, giving rise to concerns that future economic data would be subject to political manipulation, making them less reliable.

The Fed will have another month’s data on unemployment and inflation before it makes its decision regarding interest rates. With the potential of recently implemented tariff being passed through to U.S. consumers, there is growing risk of stagflation, the combination of disappointing growth and excessive inflation. Until the Fed’s next meeting, the U.S. bond market will likely fluctuate as investors continually reassess the potential for lower interest rates. Any volatility in U.S. bonds may cause Canadian bonds to move in similar, albeit smaller, fashion. Canadian bond yields remain well below comparable U.S. yields, making it less likely that a U.S. bond rally would cause a major shift in Canadian yields.

In Canada, we believe the Bank of Canada will keep interest rates at current levels unless significant weakness becomes evident. So far, the trade war has created plenty of uncertainty, sapping both consumer and business confidence in this country. However, the Canada US Mexico trade agreement (CUSMA) has protected the vast majority of Canadian exports to the United States from tariffs. Only the sectoral tariffs targeting steel, aluminum, and autos have led to a significant reduction in sales to the United States. A recent increase in U.S. tariffs on Canadian softwood lumber will likely add to the economic pain, but most of the Canadian economy remains relatively unscathed from the trade war. Negotiations between Canada and the United States regarding tariffs continue, and any agreement would likely be viewed as positive for the Canadian economy. Unlike other countries, CUSMA gives Canada and Mexico the ability to be patient in their negotiations and for the U.S. public to react more negatively to the trade war raising prices and slowing U.S. growth.

With corporate credit spreads at multi-year tights, we are cautious about the sector. We are maintaining the sector’s allocation at roughly benchmark levels but looking for opportunities to upgrade credit quality further. We are especially cautious regarding long term corporate bonds as we believe the current spreads do not appropriately reflect the risk in this environment.