Holiday related illiquidity, somewhat disappointing economic data, and a few surprises from central banks made for a volatile final month of the year in the Canadian bond market. Falling oil prices encouraged economic pessimism which translated into a risk-off investor sentiment that left equity markets lower and bond markets higher in December. With governments around the globe still avoiding fiscal or industrial policies to encourage growth, investors hoped that central banks would again ride to the rescue. Interestingly, investors chose to focus on what central bankers said, rather than what they did. The FTSE TMX Canada Universe Bond index returned 1.13% in the month.

On December 2nd, the Bank of Canada left its trend-setting interest rates unchanged. However, less than a week later, the Bank’s Governor, Stephen Poloz, gave a speech in which he outlined the Bank’s potential use of unconventional monetary tools in the event of another serious financial crisis. Although he prefaced his remarks by saying he did not expect them to be necessary, his discussion of the possible use of negative interest rates made headlines globally, and led many investors to conclude that the Bank was worried about the Canadian economy stalling and was considering another interest rate reduction in the near term. The Canadian dollar weakened roughly 2% over the balance of the month, and Canadian bond prices rallied.

Canadian economic data received during the month reinforced investors’ moribund impression of the economy. Canada’s GDP unexpectedly fell in the two most recent months, and the year-over-year change in GDP declined to -0.2% from +0.1% a month earlier. Unemployment rose to 7.1% from 7.0% as 35,700 jobs disappeared in a month. The unemployment rate would have moved even higher but for a drop in the participation rate to 65.8% from 66.0%. Wholesale trade and retail sales were well below forecasts and the trade deficit deteriorated as exports fell more rapidly than imports.

The negative consensus view of the Canadian economy was further reinforced by a drop in oil prices in the first three weeks of December. The weakness in oil prices has been closely linked to the slowdown in Canadian growth in 2015, so a further 16% drop in oil prices led to concerns that the Canadian economy would suffer even more. As can be seen in the graph below, daily swings in oil prices in early December led to revised expectations for Canadian growth and the need for further monetary stimulus. Canadian bond yields seemed to track oil prices closely.

The Correlation of Canadian Bond Yields with Oil Prices

U.S. data in December indicated below-trend economic growth. The manufacturing sector continued to struggle with the impact of the strong U.S. dollar, low oil prices (reducing demand for equipment), and weak emerging market economies. Unemployment, however, remained at the relatively low 5.0% level and the participation rate edged higher. As well, vehicle sales remained robust and construction spending was stronger than expected.

As widely expected, the Federal Reserve raised its interest rates by 0.25% in December. After more than seven years of economic recovery, the central bank finally felt confident enough about U.S. growth to move away from its zero interest rate policy. The need for extraordinary monetary stimulus no longer existed and the Fed began moving to more “normal” rates. Fed officials stressed that the adjustment process will be gradual, which many observers interpreted to mean four more rate hikes were expected in 2016. Market reaction to the rate increase, in both bonds and equities, was fairly muted, because the Fed had done a good job of managing expectations.

In Europe, economic growth remained disappointing. Of particular concern was the region’s low inflation, which actually edged lower to +0.1%. The European Central Bank lowered its deposit rate by 10 basis points to -0.30% and made other small tweaks to its quantitative easing programme, but the lack of more substantial stimulus disappointed some investors.

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