The differential between short and long term Canada bond yields increased in December, resulting in the yield curve steepening. Yields of 2-year Canada bonds declined 5 basis points, while 30-year Canada yields increased 4 basis points in the month. The rise in long term yields reversed much of the decline the previous month that was caused by investors anticipating increases in index durations in early December. The U.S. Treasury yield curve experienced a similar steepening in December with lower short term bond yields and higher long term yields.

During December, federal bonds earned only 0.04% as lower long term bond prices offset gains in short term bonds. The provincial sector gained 0.40% in the month. Provincial returns were helped by an average 5 basis point narrowing of their yield spreads but hurt by their longer average durations. Investment grade corporate bonds gained 0.73% in the month as yield spreads tightened by 9 basis points on average reflecting optimism that vaccinations would end the pandemic. High yield bonds earned 1.30% in December and Real Return Bonds returned 0.34%. Preferred shares had another strong month, earning 2.42% as their high yields and expectations of reduced supply encouraged investors.

The start of vaccinations against COVID-19 was great news in a year that had little to cheer about. The successful use of multiple vaccines to counter the pandemic is very positive news for the medium term economic outlook, but not without risks. As we noted last month, the coronavirus has been mutating and it is not certain how well the vaccines will perform against each strain. It is also not yet known how long the immunity will last after receiving a vaccination. However, the vaccines should mean social distancing and lockdown measures will become unnecessary once a sufficient percentage of the population has been inoculated. That will likely take until at least the end of the second quarter of 2021 in most countries, including Canada.

In the next couple of quarters, though, there remain significant economic challenges. The second wave of the pandemic is resulting in record numbers of infections and hospitalizations that are forcing many jurisdictions in Canada and other countries to reimpose significant social distancing restrictions which will curtail economic activity. The first quarter of 2021 looks like it will be particularly weak, as lockdowns are extended. Rising unemployment and increased bankruptcies are probable. Government fiscal stimulus to mitigate the economic weakness will mean budget deficits will remain high as will bond issuance to fund the deficits.

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