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For much of February, Canadian bond yields drifted higher in reaction to better U.S. economic data. However, late in the month, Canadian bonds participated in a strong global bond rally which was sparked by Italian election results that renewed concerns about the European debt crisis. As well, the approach of the automatic U.S. federal spending cuts, known as the sequester, raised concerns about the U.S. economy faltering and that prompted a flight-to-safety bid for bonds. Canadian bond yields were also affected by weaker Canadian growth and robust international demand. The DEX Universe gained 1.00% in February.
Canadian economic data released in February showed that the economy slowed at the end of 2012 and that the deceleration continued in early 2013. The weakness was evident in both business and consumer spending. Manufacturing sales in December fell 3.1%, as 16 of 21 industries experienced declining sales. Retail sales also dropped 2.1% in the final month of 2012. January housing starts fell sharply, with single-family homes dropping 10.5% and multi-family units plunging 29%.
Although other housing data failed to confirm the weakness (existing home sales actually increased and prices were higher year over year in all cities other than Vancouver), the housing starts news prompted many observers to wonder if the long-predicted housing correction had finally commenced. One positive economic development during February was a decline in the unemployment rate to 7.0%, the lowest level since December 2008. However, this news was discounted because 21,900 jobs were lost and only an even larger fall in the size of the labour force accounted for the decline in the unemployment rate. Inflation fell to only 0.5%.
The weaker Canadian economic data, combined with the Bank of Canada’s hints in January that rate hikes were unlikely this year, contributed to a steady drop in the value of the Canadian dollar. During February, the Loonie lost over 3% of its value against the U.S. dollar. Paradoxically, the fall in the Canadian exchange rate occurred at the same time as investment dealers reported substantial buying of Canadian bonds by foreign investors. That buying should have resulted in demand for Canadian dollars, but was clearly offset but other selling.
The impact of the falling exchange rate on Canadian bonds, if it continues, will be twofold. By making Canadian exporters more competitive, it will be stimulative for Canadian growth, reducing the need for additional stimulus from the Bank of Canada. A significant decline in the exchange rate would also lead to higher import prices, thereby increasing inflationary pressures and potentially causing the Bank to lessen its monetary stimulus.
In contrast with Canadian data, the U.S. data received in February tended to be stronger than expected. Consumer and business confidence increased and this translated into increased activity. Business capital spending jumped higher and retail sales edged slightly higher even though payroll taxes had increased at the start of the year. Although unemployment increased to 7.9%, job creation was satisfactory following the late-2012 surge. As well, the housing recovery continued with the most single-family starts and new home sales since July 2008. In addition, home prices continued to accelerate, which should prompt further increases in construction and also should give consumers greater confidence to spend through the wealth effect. The wealth effect will also be felt through higher equity prices as U.S. stock markets rose to near pre-crisis highs. The only dark cloud for the U.S. economy in February was the looming federal spending cuts that were to commence on March 1st. With no political agreement to delay the sequester, federal spending cuts of $85 billion were mandated to begin. Economists’ estimates of the impact of the cuts will be to shave 0.5% off the U.S. growth rate this year.
