The Bank of Canada’s rate cut was, in our opinion, a game changer. It substantially lessened the likelihood of rate increases for the next 18 months, thereby reducing potential market risk for bond purchasers. As a result, it encouraged and facilitated the flight-to-safety bid for Canadian bonds. In addition, the bond market is already discounting another rate cut this spring, because the price of oil is well below the Bank’s assumed level of US$60 per barrel. The Bank’s move helped lower the value of the Canadian dollar by close to 9% in the month, which might help Canadian exporters competitively. However, the Bank revealed in some discussions with us that the non-energy export sector has shrunk its productive capacity in recent years, so there may not be a quick improvement in Canada’s trade balance as a result of the currency depreciation. We are concerned, however, that the swift decline in the Loonie will lead to higher import prices (and not just for iTunes). We suspect Canadian inflation will prove far stickier than many observers expect and not fall that far.

We are skeptical that the ECB’s quantitative easing programme will be successful in reinvigorating economic growth, for a few reasons. First, the U.S. experience with three successive rounds of quantitative easing was that long term bond yields fell in advance of a quantitative easing programme being announced, and then yields actually rose while the buying programme was operating. The reason for this was that investors bought bonds in anticipation of the Fed launching quantitative easing, which forced yields lower.

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However, when the Fed was buying bonds, there were more offers than it needed and the price of the bonds slipped. We believe that there has been substantial buying of sovereign European bonds in advance of the ECB’s announcement, and if those bonds are offered to the ECB it may cause bond prices to move lower. As a result, yields would rise rather than fall as the ECB hopes.
A second reason that the European quantitative easing may be unsuccessful is that there simply may not be enough demand for new loans. With European economic growth close to zero, businesses may choose not to invest in additional capacity until demand picks up. A third concern with the ECB’s quantitative easing is that ECB debt purchases will be made in line with the individual countries’ share of ECB equity, so the benefit to the weaker countries’ debt will be limited. In addition, in the programme, the individual national central banks have to assume the risks rather than the ECB, which recognizes the non-zero possibility of a default or break up of the European Monetary Union. What is needed to spur growth more than lower interest rates are structural reforms, including less restrictive labour laws that discourage hiring.

We have shifted portfolio durations close to benchmark levels, because of the Bank of Canada’s surprise policy change as well as the current market volatility. Although economic growth in Canada has slowed, it is expected to remain positive, yet bond yields are at unprecedented levels. Until we observe stronger growth in Europe or some stabilizing in the price of oil, we prefer to stay close to the benchmark.

We have been adding to provincial holdings because of the potential that yield-hungry international investors will shift their attention to that sector. While absolute yields have fallen, provincial yield spreads are little changed and in some cases that spread makes up more than half of the bond yield. Some international investors have been concentrating on federal issues, but we think they may be enticed by the relatively wide spreads that provincial bonds offer. Liquidity in the corporate sector has declined as investors lower their economic expectations. Corporate yield spreads may continue to drift wider. We are monitoring the corporate sector both for opportunities to take profits and to add attractively priced issues, as we believe that valuations and credit worthiness of individual issuers will be subject to much greater variation.

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