The shape of the Canadian yield curve was little changed in December, as yields at all maturities increased 8 to 10 basis points. In contrast, the U.S. yield curve steepened as short term yields were little changed but long term yields rose 15 basis points. In Canada, federal bonds declined 0.33% as the higher yields resulted in lower bond prices. Provincial bonds earned 0.00% in the month, helped by yield spreads narrowing an average of 6 basis points. Corporate bonds returned 0.01%, as yield spreads tightened an average of 5 basis points. Real Return Bonds fell 0.77%, as the decline in CPI hurt demand for RRB’s.

The partial agreement to avert the U.S. fiscal cliff that was achieved in the wee hours of New Year’s Day, dealt with raising tax rates for high income individuals and families, as well as extending a few spending programmes. It pushed off for two months decisions on scheduled automatic spending cuts, on increasing the U.S. debt ceiling, and on approving this year’s budget. We expect the negotiations over these items to be every bit as rancorous as the negotiations in December, perhaps more so. It is difficult to predict, therefore, whether the U.S. economy will avoid being pushed into a recession by the fiscal tightening. It is estimated that the New Year’s partial deal will reduce the pace of U.S. growth in 2013 by 1.5% and the outcome of the February negotiations will result in further slowing. With US economic growth trending around 3% and half that growth already eliminated, there will be little margin for error.

Outside the fiscal debate, certain areas of the U.S. economy appears poised to perform well in 2013. The housing recovery is fully underway, seven years after it initially collapsed. The housing and manufacturing sectors are the two main cyclical elements of the U.S. economy; and the slow recovery in the housing sector to date is a significant factor behind the United States’ tepid recovery from the recession. With home prices finally climbing, we believe that the housing sector will likely provide a multi-year boost to U.S. economic growth. We also believe that global growth will accelerate in 2013, led by a rebound in Chinese growth, and that will be positive for U.S. exporters.

Whether the United States falls into recession is important to Canadians because if it does, Canada will very likely fall into recession, too. Canada’s economic growth has already fallen behind that of the U.S., as consumers struggle to reduce excessive debt and the housing sector slows. In light of this factor and the near term uncertainty of U.S. politics, we anticipate that the Canadian bond market will remain within the trading range that it has travelled in since last August. While we recognize that record low yields are not especially attractive, we also realize that the factors that drove yields so low have not gone away. In particular, the U.S. fiscal cliff, slow economic growth and the possibility of recession, sovereign debt risk, financial repression and the desire for capital preservation have not faded away as we enter 2013. We also believe that the Canadian bond market will continue to attract foreign buying, particularly if we avoid recession.

Our current strategy, therefore, is to keep durations close to benchmark levels. We will, however, adjust duration tactically as the market moves within its trading range. Corporate bonds, which have been emphasised since the financial crisis, no longer offer as compelling value, so we have reduced the proportion of the portfolio held in that sector. Should a recession become more likely, we will reduce the corporate allocation further.

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