Global equity market volatility sparked a flight-to-safety bid for bonds early in August. The volatility was led by Japan’s Nikkei index which plunged almost 20% in the first three days of the month, but other stock markets also experienced sharp declines. A reversal of the yen carry trade following the Bank of Japan’s July 31st rate increase also pushed bond yields lower. However, as stocks began recovering bond investors began refocusing on the potential for interest rate cuts in September and subsequent months. In this country, the Bank of Canada was widely expected to make its third consecutive rate reduction at its next scheduled announcement on September 4th, while in the United States, the Federal Reserve was thought likely to finally start lowering rates at its September 18th meeting. Minutes of the Fed’s July 31st meeting and Fed speakers later in August confirmed that interest rate reductions were imminent. The prospect of lower interest rates prompted bond purchases that pushed their yields lower. The Bloomberg Canada Aggregate and FTSE Canada Universe indices earned 0.51% and 0.33%, respectively, in the month.

Canadian economic data received during August supported the belief that the Bank of Canada would continue to gradually lower interest rates. Canadian GDP grew at an annual pace of 2.1% in the second quarter, but StatsCan estimated that the economy stopped growing at the end of the quarter (June) and the start of the third quarter (July). The unemployment rate held steady at 6.4%, but that was due solely to a sharp drop in the participation rate as job creation faltered. In addition, retail sales declined for the fifth month in the last six as consumers struggled to deal with high interest rates and inflation. Importantly, the inflation rate slowed to 2.5% from 2.7% the previous month.

The Bank of Canada did not hold a rate-setting meeting in August. Minutes of the Bank’s July 24th meeting focussed on the downside risks to inflation, suggesting the Bank’s Governing Council was concerned about the increasing slack in the economy.

In the United States, the economic data was also supportive of monetary policy easing. The unemployment rate rose to 4.3% from 4.1% because of disappointing job creation and a slightly higher participation rate. Industrial production was weaker than expected, partly due the impact of Hurricane Beryl on Gulf Coast oil and gas production, and housing starts were also weaker than anticipated. As in Canada, U.S. inflation moved lower, with CPI declining to 2.9% from 3.0% the previous period. Minutes of the Fed’s July 31st meeting strongly suggested interest rate cuts were coming as several members of the Fed’s Open Market Committee thought a 25 basis point reduction would have been appropriate at that meeting and the vast majority of participants anticipated a rate reduction at the September 18th meeting. Late in the month, Fed Chair Jerome Powell confirmed that it was time for lower interest rates.

Internationally, the prospect of most central banks lowering interest rates while the Bank of Japan is expected to raise them caused many investors to unwind the so-called yen carry trade. The yen carry trade involves borrowing in yen at a low cost to invest in assets in other currencies offering higher yields. With yen borrowing costs rising and other major bond markets’ yields falling, the carry trade was becoming less attractive. In addition, the foreign exchange value of the yen has risen more than 10% from the lows hit in early July, further discouraging the carry trade. Unwinding it resulted in sales of the higher yielding securities, particularly U.S. Treasuries, which put upward pressure on yields. The Bank of England, the Reserve Bank of New Zealand and Sweden’s Riksbank each lowered their interest rates by 25 basis points in August. The European Central Bank was widely expected to join the Bank of Canada and the Fed in reducing their respective rates in September.

The rising expectation that the Fed would soon join other central banks in lowering interest rates caused the U.S. dollar to decline against most currencies in August. The Japanese yen, the Euro, the British pound and the Loonie all appreciated over 2% versus the U.S. dollar in the month. In Canada, the stronger exchange rate should result in slightly lower inflation due to reduced import costs.

The prospect of additional interest rate cuts caused the Canadian yield curve inversion to dissipate further in August as shorter term bond yields once again declined faster than longer term yields. The yield of 2-year Canada bonds fell 13 basis points, while the 30-year bond yield rose 4 basis points as a result of market weakness late in the period. By the end of the month, 2-year yields were only 7 basis points higher than 30-year yields, having been as much as 150 basis points higher just over a year ago. In the United States, the strong likelihood of the Fed beginning to lower interest rates in September also resulted in shorter term bond yields falling more than longer term yields, but the sizes of the moves were markedly larger than the Canadian changes. The yield of 2-year Treasuries fell 29 basis points, while the 30-year Treasury yield dropped 17 basis points. The U.S. bond market has enjoyed larger declines in yields than in Canada since late June when the differential between the two markets hit a record. Despite the U.S. outperformance since then, the Canadian market remains relatively expensive on an historical basis.

The federal sector returned 0.40% in August. The provincial sector gained 0.29%, as the increase in long term yields negatively impacted its results. Investment grade corporate bonds earned 0.26%, with the equity market volatility early in the period causing some widening of yield spreads which did not reverse over the balance of the month. Non-investment grade corporate bonds earned 0.75%. Real Return Bonds returned -1.19%, underperforming nominal bonds of similarly long durations following the decline in the annual rate of inflation. Preferred shares continued to benefit from redemptions and attractive yields as they earned 2.71% in the month.

The duration of the FTSE Canada Universe Bond Index was forecast to increase by slightly more than 0.09 years on September 3rd (following the Labour Day long weekend). The increase would be somewhat larger than previous Septembers and the result of coupon payments and bonds being removed from the index because they had less than a full year to maturity. Index extensions such as this one typically lead to significant buying of longer term bonds as indexed funds adjust their durations to match the index change.

As this is being written, the Bank of Canada has lowered its interest rates by 25 basis points, the third consecutive reduction. The Bank also indicated “If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further cuts in our policy rate.” Interestingly, the Bank noted that the recent increase in the unemployment rate was due to recent immigrants and youth having more difficulty securing jobs. So far, the rise in the unemployment rate has not been caused by layoffs, as has been the case in some previous cycles, which suggests the economy remains resilient. The Bank also suggested the higher numbers of recent immigrants and youth looking for jobs would help slow wage gains from the current inflationary pace. We have our doubts about the impact of immigrants and youth on average wages because of the potential mismatch of skills.

The Bank’s overnight target rate is now 4.25%, still well above the yields of Canada bonds that range from 2.85% to 3.15% and are clearly discounting several further rate cuts in the coming quarters. Many observers believe that the Bank will make additional 25 basis point cuts at its meetings on October 23rd and December 11th. Barring a significant reversal in inflation’s downward trend, we concur with that outlook. The key question, though, is the level at which the Bank stops. We believe the Bank is unlikely to lower its overnight rate to less than 2.50%, and may well stop at 3.00%, given that the economy is not in recession and the need to allow for the lagged effect of any monetary easing. In addition, the Bank’s estimate of the neutral rate of interest, that is neither stimulative nor restrictive, has increased from its previous 2.00% to 3.00% range, which suggests 2.50% may not be reached. If the endpoint in the Bank’s easing cycle is between 2.50% and 3.00%, we believe bonds are fully valued at current levels. As a result, we are more likely to reduce durations than to increase them.

We think the yield curve will continue to normalize, with short term yields moving below long term ones. Given our outlook for the general level of yields that may mean longer term yields need to rise while shorter term ones fall. We continue to favour the middle of the yield curve to take best advantage of the yield curve steepening. We also remain cautious regarding the corporate sector due to relatively narrow yield spreads and elevated equity volatility that may lead to sharply wider spreads.