In Europe, bond markets awaited details of the European Central Bank’s planned quantitative easing programme. Bond yields edged lower, in many cases, moving to greater negative levels. The negative yields reflect tremendous uncertainty about European growth, possible deflation, a breakup of the Euro due to the Greek debt crisis, and the growing conflict in eastern Ukraine. Negative government bond yields suggest preservation of capital, rather than return of capital, is paramount in many investors’minds. It also suggests that investors do not fully trust the creditworthiness of European banks that offer positive yields on savings. A total of nine European countries had negative yields on at least some of the government bonds (viz. Switzerland, Denmark, Germany, Sweden, Austria, Belgium, France, Netherlands, and Finland). By comparison, yields of Canada and U.S. Treasury bonds offer better yields and have been attracting international buying.

5-Year Bond Yields

The Canadian yield curve edged higher in February, with yields of 2 and 30-year Canada bonds moving up by 8 and 7 basis points, respectively. Yields of mid-term isues rose slightly more, as investors reacted to the Bank of Canada’s U-turn. The rise in yields resulted in the federal sector returning -0.35% in the month. Provincial bonds declined only 0.11%, as the impact of their longer average durations was offset by mid and long term provincial yield spreads narrowing an average 4 basis points. We believe the narrowing occurred because domestic and international investors were attracted to the incremental yields on provincial issues when absolute Canada bond yelds had fallen so low. The corporate sector gained 0.13% in the period, with corporate yield spreads edging tighter as the economic pessimism of January abated somewhat. New issue supply rebounded in February as $11 billion of fixed rate issues came to market, including the largest ever deposit note, a $2.25 billion 7-year issue from Royal Bank. The rise in Canadian gasoline prices during February apparently caught investors’ attention, as Real Return Bonds earned 0.72%. Non-investment grade bonds gained 1.30%, with energy related issues helped by oil prices stabilizing.

Fundamental economic factors cannot justify current bond yields that are near all-time lows. Canadian economic growth, although slowing, remains positive, and the strength of its largest trading partner, the United States, is robust. Extraordinarily easy monetary policy, in Canada and globally, is causing substantial distortions to bond markets. As well, the European concerns about possible deflation as well as the uncertainties stemming from the conflict in Ukraine and from the Greek debt renegotiations are resulting in a very strong flight-to-safety bid for bonds. Market conditions are somewhat more volatile than normal, due to investor uncertainty and reduced liquidity.

Unfortunately, monetary policy in Canada has become much less predictable. A month ago, the Bank of Canada’s surprise interest rate reduction appeared to be a game-changer. However, the Bank’s subsequent backtracking on the need for additional rate cuts has led us to re-evaluate that view. In part, the Bank’s recent change of direction was due to their surprise at the market reaction to their January move. It is worrisome that the Bank did not anticipate the bond market to act the way that it did. It is also concerning that the Bank flip-flopped so rapidly. Nor was that the only example of a 180-degree shift by the Bank. Last October, Stephen Poloz, the Governor, spoke about the Bank’s plans to avoid giving forward guidance. However, in February, Poloz clearly provided forward guidance regarding the likelihood of an early March rate increase.

In the United States, the economy no longer needs zero interest rates, but the Fed is not under pressure to move quickly with inflation temporarily depressed by the drop in energy prices. A rate increase may come as soon as June, but easily could be put off until September or later. When the Fed does finally act, there may be a significant reaction in the U.S. bond market. Yields of shorter term bonds, such as those maturing in 2 years, will likely rise the most, but longer term yields will probably move higher too. Given the historical correlation between the U.S. and Canadian bond markets, we would anticipate higher U.S. bond yields to cause Canadian yields to move higher as well.

1 2 3