December was a seesaw month for the Canadian bond market. Bond prices fell and rallied back, fell again, and rallied once more to eventually finish higher than a month ago. As investors established their desired year end portfolio positions, trading volumes fell. As a consequence, liquidity was reduced and volatility increased, resulting in significant day-to-day price swings. Investor focus swung back and forth between favourable economic data in North America and concerns about slowing global growth, falling oil prices, a reappearance of the European sovereign debt crisis, and a collapse in the Russian ruble. The FTSE TMX Canada Bond Universe earned 0.56% in the month.

Canadian economic data was mixed in the month, as the Canadian economy continued its “Goldilocks: not too hot, not too cold” performance. On the plus side, Canadian GDP grew more than expected in the most recent month, leaving the year over year increase at a moderate 2.3%. In addition, capacity utilization rose to its highest rate in over 8 years, housing starts rebounded from a one month slowdown, and retail sales were somewhat stronger than expected. Less positively, unemployment edged higher to 6.6%, as 10,700 jobs disappeared following two months of robust growth. Lower gasoline prices caused the inflation rate to slow to 2.0% from 2.4%, and many observers anticipated that the recent plunge in oil prices would lead to further slowing of inflation. The Bank of Canada left interest rates unchanged, but acknowledged that recent economic growth had been better than it had forecast and the output gap might be smaller than it previously thought. However, the Bank also referred to potential risks to the Canadian economy arising from the drop in oil prices. The market consensus continued to be that the Bank would not raise interest rates in this country until well after the U.S. Federal Reserve started raising rates in the United States.

U.S. economic news in December was generally better than expected. Unemployment held steady at 5.8%, but the pace of job growth accelerated to the best in three years. In addition, the number of job openings rose to the second highest level in 14 years as businesses wanted to add workers to meet increased demand. The estimated GDP growth rate during the third quarter was revised sharply higher to +5.0%, the fastest since 2003. Stronger personal consumption was a significant factor, as better labour market conditions and sharply lower gasoline prices spurred spending. Retail sales, construction spending, industrial production, and vehicle sales all exceeded expectations in the month. The only disappointing sector was housing, which has shown little growth in over a year. Tight credit restrictions for first time buyers are thought to be a major stumbling block. The Federal Reserve left rates unchanged and issued a confusing statement following the announcement that acknowledged the better than expected growth but did not suggest interest rate increases were imminent. The market interpreted the Fed’s statement, though, to mean that rate increases were likely in the first half of 2015.

The price of oil continued to plunge in December. The West Texas Intermediate grade fell from US$66.15/barrel at the end of November to US$53.27/barrel at the end of December, leaving it down more than 50% from its peak in June. Outside of the energy sector, the drop in oil prices is like a large, broadly based tax cut. Consumers will have more money to spend on other things, and businesses that use a lot of oil, such as airlines, will have improved profitability. However, in December, markets seem to focus more on the potential negative impacts on energy producers, their suppliers, and governments that depend on energy-related royalties and taxes. As well, some observers believed that the falling oil price reflected weak demand and that caused forecasts of future economic growth to be revised lower. As a result, significant daily drops in the oil price generally meant higher government bond prices and lower yields. In the corporate sector, bonds issued by energy producers experienced wider yield spreads and lower prices. This was particularly apparent in the high yield market, which has a preponderance of oil and gas producers that may have less ability to withstand a prolonged drop in revenue. In investment grade corporates, energy related companies including pipelines experienced wider yield spreads. Even bank securities were affected, as investors were concerned about potential losses in their loans to the energy sector. In the provincial sector, Alberta bonds underperformed, because of that province’s reliance on oil royalties.

The drop in oil prices was also responsible for a further decline in the Canadian exchange rate in the month. The Loonie lost 1.8% in December, falling to US$0.86 at month end. The Canadian dollar was not alone, however, as other oil exporting countries, such as Norway, also saw their exchange rates weaken. Nowhere was the impact more apparent, however, than with the Russian ruble as it collapsed 18.5% in the month. Russia appeared destined for recession as the combination of sanctions regarding Ukraine and the plunge in oil prices slowed its economy. The Russian central bank had been trying to support the ruble, but was forced to abandon that effort after depleting its foreign exchange reserves by more than US$ 80 billion. In addition, a significant Russian bank that faced large loan losses as a result of the slower growth had to be rescued through an arranged merger with a stronger bank.

The Russian situation exacerbated concerns about weak European growth. As a significant trade partner with Europe and borrower form European banks, a potential Russian recession would have a negative impact on already slow growth in the Eurozone. Unfortunately, European governments were reluctant to apply more stimulative fiscal policies to revive their economies. Instead, they preferred to wait for the European Central Bank to initiate a quantitative easing programme (i.e. purchases of European government bonds) to see if that would be sufficient. Both the head of the ECB, Mario Draghi, and ourselves are doubtful that quantitative easing on its own will turn European economies around. Adding to European woes was a re-emergence of the European sovereign debt crisis as Greek politics forced a snap election call for January 25th with an anti-austerity party leading in the polls. If the party was to gain control of the government, investors were concerned that it would abrogate the rescue package and potentially cause a breakup of the Euro. The consequence of the European developments was a flight-to-safety bid for North American bonds in December.

The Canadian yield curve flattened slightly in December as 2-year Canada bond yields rose 2 basis points, while 30-year yields declined 7 basis points versus month earlier levels. The relatively small month over month yield changes belie the wide ranges in which yields moved during the period. For example, 5-year Canada yields fluctuated in a 24-basis point range, while 30-year Canada yields had a 26 basis point range. On a price basis, long term Canada bonds moved in a wide range of more than 6 points. In contrast with the 9 basis points of flattening in Canada, the U.S. yield curve flattened a much larger 34 basis points. Yields of 2 and 5-year U.S. Treasuries rose 19 and 17 basis points, respectively, in reaction to the Fed’s potential interest rate increases in the first half of 2015. Yields of 30-year Treasuries, however, fell 15 basis points as investors adjusted their economic and inflation expectations as a result of the declining oil price. In addition, liability-driven purchases by insurance companies and pension funds prior to year end in illiquid conditions pushed long term bond prices higher and yields lower.

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