The Canadian bond market closed out 2011 with another month of strong performance. The DEX Universe Bond Index gained 1.68% as asset/liability related buying drove a rally in long term bonds. Yields fell to record lows, even as economic growth remained positive and new issue supply remained robust.

Canadian economic data received in December was mixed. Retail sales and building permits were both much stronger than expected. As well, capacity utilization in Canada during the third quarter hit a four-year high. Less positively, unemployment ticked up to 7.4% from 7.3%, as there were fewer jobs for the second consecutive month. The composition of jobs improved though, as full time positions replaced part time ones, self-employment declined in favour of regular employment, and the average increase in hourly earnings of permanent employees was double the pace of the previous month. Canada’s trade balance fell back into deficit as exports declined, particularly those of energy and industrial goods. This reinforced concerns that slowing foreign demand would negatively impact the Canadian economy in coming months.

Indeed, having grown faster than the U.S. economy for six consecutive years, we believe that the Canadian economy will be more dependent on the U.S. in the next few quarters. In that vein, though, U.S. growth actually improved with recent data consistently surprising to the upside. The U.S. labour market, for example, experienced a drop in unemployment to 8.6% from 9.0%, and initial weekly claims for unemployment benefits fell to their lowest level in 3½ years. Excluding the “cash-for-clunkers” spike of late 2009, total vehicle sales also rose to their best level in 3½ years. Manufacturing activity and consumer sentiment showed good improvement from their respective summer-time lulls. Even the U.S. housing sector saw some improvement, with new home starts and permits for construction hitting recent highs, although home prices experienced some further erosion.

The Canadian yield curve experienced a “bull flattening” in December, as long term yields fell more than shorter term yields. Thus, the rally in prices was particularly strong for long term bonds. Yields of benchmark 10 and 30-year Canada bonds declined roughly 20 basis points, while 2-year bond yields went down only 6 basis points. The shift in the Canadian yield curve was similar to the bull flattening that occurred in the U.S. bond market, although the decline in Canadian yields was slightly larger. The provincial sector enjoyed the strongest gains, rising 2.81% in the month. Provincial bonds were helped by their typically longer durations, as well as an average narrowing of their yield spreads by 5 basis points. News that Moody’s was considering downgrading the Province of Ontario was largely ignored, because that agency had a higher rating on the province than other agencies and a downgrade would merely bring the Moody’s rating in line with the others. Corporate bonds, which experienced little change in spreads, returned 1.39% in the period. Federal bonds trailed the other sectors with an average return of 1.14%. New issue activity in December included approximately $10.7 billion of federal, $3.8 billion of provincial, and $4.0 billion of corporate securities.

Monthly data showed that foreign investment in Canadian bonds remained subdued, continuing a trend that has seen the unwinding of much of the strong demand experienced in 2010. U.S. based investors have reduced their purchases by half since the peak reached in late 2010. Non-U.S. investors, who bought over $30 billion of Canadian bonds during 2010, actually became net sellers more recently. This lead us to believe that the rally in Canadian bonds during December was a function of domestic investor activity, rather than due to foreign buying. The fact that Canadian yields fell more than U.S. yields supported our view.

Foreign Purchases of Canadian Bonds

1 2