The Canadian bond market enjoyed a very good month in January. Remarkable declines in yields resulted in substantial price gains, and total bond returns for the month were better than those of many years. The FTSE TMX Canada Universe Bond index earned 4.63% in the period, while the FTSE TMX Canada Long Term Bond index surged 8.17%.

The strength of the bond market was primarily due to a flight-to-safety bid as investors sought secure investments. The price of oil continued to plunge, falling from over US$53 to under US$45, and casting a sense of impending doom on the global economy. Concerns about anemic economic growth, possible deflation, and a breakup of the European Union prompted lower European yields that spilled over into North America. As well, a dramatic shift in policy by the Bank of Canada pushed Canadian bond yields lower and their prices higher. International buying of Canadian bonds appeared to be quite strong, notwithstanding a falling Canadian exchange rate, as negative yields in several countries made our yields look attractive by comparison.

The Bank of Canada surprised the market on January 21st by lowering its overnight target interest rate by 25 basis points. (According to the Bloomberg news service, zero of 22 economists surveyed expected the rate reduction.) The Bank stated that the move was “insurance” against the negative impact of falling oil prices on the Canadian economy. It revised its estimate of Canadian GDP growth in 2015 lower by half a percent to 1.9%. However, the Bank forecast that both economic growth and inflation would rebound in 2016. The impact of the surprise rate cut was immediate and significant. Canadian bond yields fell sharply and prices rose, while the Canadian exchange rate weakened significantly. Moreover, the Bank’s rhetoric suggested that another rate reduction could occur as early as March or April if oil prices remained at current levels. As a result, the market priced in the potential for another reduction by moving yields even lower and prices higher. The effectiveness of the Bank’s “insurance” remains to be seen, however, as Canadian banks lowered their prime lending rates by only 15 basis points. In addition, the large reductions in capital spending in the energy sector that have been announced are unlikely to be reversed by a small decrease in interest rates; the price of oil is a far more important consideration.

Canadian economic data continued to show moderate growth, with little apparent impact yet from the oil price decline. Job creation remained erratic, but the unemployment rate held steady at 6.6%. Housing starts slowed somewhat but remained within their recent range, while retail sales were stronger than expected. The overall annual rate of inflation declined to 1.5% from 2.0% a month earlier, primarily due to the drop in gasoline prices. The core rate of inflation, which excludes some of the more volatile items, actually rose to 2.2% from 2.1%. In the past, the Bank of Canada used the core rate as an indicator of underlying inflationary pressures, although more recently the Bank has been somewhat inconsistent about which inflation measure it focuses on. For the next few months, though, the Bank will be focussed on stimulating economic activity and less concerned about inflation.

U.S. economic growth remained robust. Unemployment fell to 5.6% from 5.8%, as job creation remained quite strong. The improved labour situation in turn helped lift consumer sentiment to an 11-year high. The strength in the economy was a principal reason for the U.S. dollar continuing to rise against almost all other currencies. The rise in the value of the dollar, though, was thought to increasingly be a challenge for U.S. exporters’ competitiveness. The Federal Reserve left rates unchanged at its rate review meeting in January. The Fed upgraded its assessment of both U.S. economic growth and the labour situation, and left the door open for a rate increase in June. Normally, the Fed’s focus is solely on domestic U.S. conditions, but in its January statement it indicated that it was monitoring international developments. Unfortunately, it was not clear whether that referred to weak economic growth and deflation risks in Europe or to the significant appreciation in the U.S. dollar that may be negatively impacting U.S. exporters.

In Europe, there were a number of significant developments. In one, the Swiss National Bank (SNB) surprised the foreign exchange market as it stopped trying to cap the value of the Swiss Franc versus the Euro. For the last three years, the SNB had spent hundreds of billions of Euros in the foreign exchange market in an effort to protect Swiss exporters, but it was forced to give up the cap, because the continued decline in the Euro’s value made it too difficult. The Swiss Franc closed roughly 18% stronger versus the Euro as a result of the SNB’s decision. More importantly, the SNB’s decision reminded investors that central banks do not always keep their commitments.

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