The Canadian bond market traded in a narrow range in August, finishing with a small gain as the combination of interest income and slightly higher prices on shorter term bonds more than offset the lower prices of long term bonds. Some weaker than expected economic data prompted speculation of easing by the Bank of Canada and the U.S. Federal Reserve at their next rate setting meetings, coincidentally both on September 17th. Despite buoyant stock markets, Canadian corporate bonds took a breather in their yield spread tightening trend, underperforming government bonds for the first time in six months. The FTSE Canada Universe Bond index returned 0.37% in August.

Canadian economic data received in the month was mixed but showed the economy was struggling with the uncertainty of the tariffs. The unemployment rate was unchanged at 6.9% only because a drop in the participation rate offset the loss of 40,800 jobs. In addition, on the final business day of August, we learned the Canadian GDP contracted in the second quarter at an annual rate of 1.6%, roughly twice as bad as the consensus forecast. Trade was the main source of the weakness as exports plunged 27%, although the comparison is with the previous quarter when frontrunning of tariffs boosted export volumes. Trade uncertainty was also responsible for a 10% drop in business investment. More positively in the GDP release, we  learned that household consumption rose 4.5%. Headline CPI inflation declined to 1.7% from 1.9% the previous month, but core inflation remained stubbornly above 3.0% with the prices of groceries (especially coffee), vehicles (tariffs), and rent and mortgage interest pushing up the average.

The key piece of U.S. economic data came on the first day of the month with the labour market statistics. The unemployment rate edged up to 4.2% from 4.1%, and job creation was somewhat weaker than expected. Critically, the estimates of job creation for the previous two months were lowered by a combined total of 258,000 positions and the 3-month average fell to only 35,000 from the previous 150,000 estimate. Bond yields fell sharply on the news as investors believed the weaker labour conditions would be sufficient to convince the Fed to lower interest rates. Subsequent economic data, such as retail sales and housing starts, suggested the U.S. economy remained resilient but, on August 22nd, Fed Chair Jerome Powell gave a major speech that suggested the Fed was more likely to lower rates at its September meeting. Yields of shorter term U.S. Treasuries rallied over the balance of the month.

Long term Treasuries, though, rose in yield in late August as President Trump increased his efforts to control the Fed by trying to fire one of its seven governors. If Trump is permitted to fire the governor, he potentially will have enough appointees on the Board to control the annual reappointments of the presidents of the twelve Federal District Banks who help set interest rate policy. Bond investors were concerned about higher inflation if Trump is successful. Long term yields also rose following a U.S. appeals court ruling that many of Trump’s tariffs were illegal, raising the possibility the U.S. would have to repay the many billions of tariffs collected to date.

The weaker Canadian economic data led investors to believe the Bank of Canada may resume lowering interest rates at its next meeting on September 17th. As a result, the yields of 2-year and 5-year Canada bonds declined 13 basis points in August. Investors in long term bonds though were more focused on the growing fiscal deficit and sticky inflation than a potential rate cut by the Bank, leading the yield of 30-year Canada bonds to rise 7 basis points in the month. With shorter term yields going down and longer term ones going up, the Canadian yield curve steepened in August. The U.S. yield curve also steepened in the month. The yields of 2-year and 5-year U.S. Treasuries fell 21 and 32 basis points, respectively, in the period, while 30-year yields rose 4 basis points. The rise in long term yields was attributed to concerns about the Fed losing its independence as well as the potential need for the United States to refund much of the recently collected tariffs when its fiscal situation is already stretched.

With just under half of all Canada bonds maturing in less than five years, the federal sector benefitted from lower short term bond yields, returning 0.53% in August. In contrast, the provincial sector earned only 0.29% as its higher proportion of long term issues reduced average returns in the month. As noted above, investment grade corporate bonds trailed the government sectors, earning only 0.21% in the month. Corporate yield spreads widened an average 4 basis points, with long term spreads widening significantly more. One of the catalysts for the increased spreads was a large, multi-tranche issue by BCE Inc. In the last several months, the three large telecom companies, BCE, Rogers and Telus, have executed tenders to redeem billions of dollars of their long term bonds to satisfy rating agency demands to improve their financial condition. The reduction in outstanding long term corporate bonds caused long term yield spreads to tighten to historically low levels. The BCE issue in August, however, suggested a reversal to that trend. Non-investment grade corporate bonds gained 0.92% in the period, buoyed by equity markets hitting all-time highs. Real Return Bonds earned an average 0.42% in the month, as investors remained concerned about inflation. Following three months of robust gains, preferred share returns were more modest in August with the S&P/TSX Preferred Share index rising just 0.22%.

While more economic data will be released before the Fed makes its decision on September 17th, including unemployment and job creation statistics later this week, we believe the Fed is likely to lower its interest rates by 25 basis points. The Fed has described its current level of rates as modestly restrictive, so the recent softening in the labour market easily justifies moving toward a more neutral level of rates. However, if the tariffs remain in place, their often delayed implementation means their impact has yet to be fully seen in U.S. inflation. So, we do not expect the Fed to ease aggressively until inflation is proven to be under control. If the Fed does lower rates this month, shorter term Treasury yields will probably decline a little as some investors anticipate additional monetary easing in the future, but longer term Treasury yields seem unlikely to rally much until inflationary risks are reduced and Trump’s challenges to the Fed’s independence are defeated.

In Canada, we are less confident that the Bank of Canada will reduce interest rates in the near term. Canada’s economy is still growing, albeit slowly, and the Bank is rightly concerned about inflation possibly reaccelerating. As well, the current level of Canadian interest rates is already in the middle of the Bank’s estimated ”neutral” range, so there is a less compelling argument for rate cuts here compared with the United States. Also, we suspect the Bank may wish to keep its powder dry and leave more room for easing in case economic activity slows substantially more. If, on the other hand, Canada and the United States arrive at an agreement regarding trade and tariffs, we may see the Canadian bond market rally because the federal and provincial governments may be able to reduce spending on programmes to offset the negative effects of the U.S. tariffs.

Despite the modest widening of corporate yield spreads in August, they remain near multi-year lows. Given the economic uncertainty, we do not believe the current level of spreads is properly compensating investors for risk. Accordingly, we are cautious regarding corporates and continue to look for opportunities to reduce credit risk.