The decline in yields produced price gains that propelled Canadian federal bonds to a return of 1.80% in the month. The longer average duration of provincial bonds meant they had larger gains as yields declined, leading to a 2.45% return for the sector. Provincial bond returns were limited, however, by a 6 basis point widening of provincial yield spreads in the risk-off environment. Similarly, corporate yield spreads widened 12 basis points, which resulted in the sector gaining only 1.21% in the period. Energy related issuers, including pipelines, experienced the greatest widening, but telecommunication bonds were also relatively weak. High yield bonds earned only 0.25% in the more cautious sentiment of August; the return was less than the coupon income which meant the average non-investment grade corporate bond declined in price. Real Return Bonds earned +1.80% in the month, which was somewhat disappointing considering their long average durations and the upside surprise of CPI. Preferred shares performed poorly in the uncertain environment, falling 3.97% in the month.

As this is being written, the Bank of Canada has left its administered rates unchanged at its September 4th announcement. The Bank noted that the Canadian economy was near full employment, inflation was at the 2% target, and the housing sector had “regained strength more quickly than expected”. The Bank also acknowledged that the U.S./China trade dispute was negatively impacting the global and Canadian economies. It will continue to monitor global developments but, for now, the current level of monetary stimulus was deemed appropriate.

In contrast, the Fed is widely expected to lower its administered rates again at is September 18th meeting. In a late August speech, Fed Chair Jerome Powell implied that a follow-up to its July rate reduction was quite likely. However, there are several reasons for the Fed to stand pat in September. First, the U.S. economy is performing well and does not need additional stimulus at this time. Second, when a recession does occur, the Fed will need the ability to provide stimulus that a current rate cut would reduce. Third, Trump has been calling on the Fed to lower rates for months, and to maintain its independence the Fed needs to be seen as not taking political direction in setting monetary policy. Another reason the Fed may choose to keep rates unchanged is it may not want to enable Trump’s trade tactics. The trade dispute with China is at present the largest risk facing the U.S. economy and if the president thinks the Fed will keep lowering rates to offset slowing growth, he may make further trade moves that increase the risk to the economy. Finally, the July 31st rate reduction had two dissenters and other Fed voters may add their voices to holding rates constant.

We believe the bond market is pricing in substantial deterioration in the Canadian and global economies in the next few quarters. While the ongoing U.S. trade disputes with China and other countries is causing uncertainty that has led to some slowing of growth, particularly with regard to business investment spending, we believe the outlook is not as pessimistic as current ultra-low bond yields imply. We also believe that, with the election looming next year, the U.S. administration desperately wants to avoid causing a recession and will settle for a less than perfect trade deal with China. While the negotiations will likely remain noisy and result in continued volatility, there will gradually be progress that will ameliorate concerns about a global recession. If we are correct, bond yields should rise from present levels. We are, therefore, maintaining portfolio durations somewhat shorter than benchmarks but, given the volatility of the markets, we are not making a large bet on duration at this time.

The yield curve is currently saucer-shaped with mid term yields below those of both short and long term bonds. We do not expect this to last very long. Eventually, the yield curve should normalize, with mid term yields above those of shorter term issues. Unless the Bank of Canada begins lowering interest rates soon, which we do not expect, mid term bond yields will face increasing upward pressure. Accordingly, we are shifting the portfolio yield curve exposure to reduce the expected impact of higher mid term yields.

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