In Europe, the Italian election failed to result in a clear winner. Instead, most Italians appeared to cast an anti-austerity protest vote that left Italy’s path to curing its fiscal woes unclear. As a result, fears that the European Union would eventually suffer sovereign defaults flared up. Risky assets, such as stocks, sold off and bond prices globally surged higher. Yields of 10-year British Gilts, German Bunds, and U.S. Treasuries all fell 10 basis points following the election. Yields of 10-year Canada Bonds nearly kept pace, declining 8 basis points in the same period. Italian yields, on the other hand, spiked 40 basis points higher.

The late month rally in the Canadian bond market had the greatest impact on shorter term yields. The yield curve steepened as 2 and 5-year bond yields fell 20 basis points in February, while long term yields declined only 7 basis points. The large drop in shorter term yields reflected speculation by some investors that the Bank of Canada would need to lower rates later this year to counteract the weakness in the economy. Indeed, yields on 2-year Canada bonds traded below the Bank’s overnight target rate of 1.00%, as some investors believed money market rates would soon fall.

The decline in yields led federal bonds to gain 0.86% in February. Provincial bonds returned 1.05% in the period. Their yield spreads were unchanged, but the longer average duration of provincial issues meant they had relatively large price gains. Corporate yield spreads narrowed by an average 2 basis points and returned 1.14% as a result. Interestingly, corporate issuance was fairly light at $2.1 billion, so the lack of significant spread tightening may indicate that corporate demand and supply is becoming more balanced. Real Return Bonds were again laggards, losing an average 0.23% in the month. Low inflation reduced demand for RRB’s, but they remained expensive; inflation would need to accelerate to over 2% for them to yield more than nominal bonds.

Looking ahead, we believe the market may have overreacted to the Italian election and the weaker Canadian economic data. While the Italian political situation may take a month or more to sort out (especially if another election is required), we think it may lead to slower resolution of that country’s fiscal problems, but not a default. Canadian economic data has been weak in recent, but it is not clear that we are about to begin a recession.Canadian GDP Growth Declining We believe the housing starts data was not the start of a collapse, rather a volatile statistical result in a month subject to considerable seasonal adjustment. Certainly, there is a risk that a slower housing sector combined with reduced energy sector activity could cause the economy to contract. However, we believe the housing correction will be gradual, so its impact on the economy will be muted. In addition, the decline in the exchange rate, as well as growing demand from the U.S. and China, will provide an offsetting boost to our exports and the whole economy. Accordingly, we look to use the recent bounce in bond prices as a selling opportunity to further reduce portfolio durations and move to a more defensive structure. We will continue, of course, to monitor economic developments closely.

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