The Canadian yield curve steepened modestly in January as yields for 2, 5, and 10-year Canada bonds fell roughly 10 basis points, while 30-year yields declined half that amount. Interestingly, U.S. bond yields did not decline as much as Canadian ones, even though the U.S. central bank surprised the market by indicating that it would not be moving interest rates for several months. Yields of 5 and 10-year Treasuries dropped 5 basis points, while 2 and 30-year yields closed down a single basis point from a month earlier.

As a result of the decline in yields, federal bonds enjoyed modest price gains and returned 0.69% in the month. Provincial bonds returned 1.74%, as they benefitted from a longer average duration with yields falling. In addition, in January’s risk-on environment, provincial yield spreads narrowed by an average 8 basis points resulting in further gains. The yield spread of investment grade corporate bonds narrowed by 13 basis points, which helped them return an average 1.68%. With inflation stronger than expected, Real Return Bonds earned 1.34% in January. Non-investment grade bonds didn’t keep pace with higher quality corporates and returned only 1.03% in the period. Preferred shares failed to benefit from the risk-on environment; new issue supply led to slightly lower prices producing average returns of -0.50%.

We believe current economic conditions are good, and the impact of the U.S.-China trade war is not likely to cause a recession. We anticipate that growth in both Canada and the United States will be slower in 2019 than in 2018 but will remain positive. We expect the Canadian economy will grow by 1.5% to 2.0% and the U.S. by 2.0% to 2.5% in 2019. If last year’s NAFTA renegotiations are any indication the trade talks between the U.S. and China will be protracted, which means the resultant drag on global growth will persist for the next several months. However, we think it likely that the U.S. steel and aluminum tariffs and the retaliatory tariffs imposed by other countries (including Canada) may be lifted in the near future, which would be positive for growth. Combined with inflation rates that are stable around 2.0%, neither the Bank of Canada nor the Fed are likely to raise interest rates more than once this year.

While the central banks are going to be less aggressive and more patient this year, they are unlikely to need to reduce rates. However, with yields of most Canada bonds only slightly higher than the Bank of Canada’s overnight target of 1.75%, the bond market appears to be discounting that possibility. In our opinion, as growth proceeds to stay positive and possibly accelerate somewhat, bond yields should rise from current levels. Accordingly, we have set portfolio durations slightly shorter than the respective benchmarks as a defensive strategy.

The widening of corporate yield spreads in the fourth quarter of last year made most issues relatively cheap and attractive. The spread narrowing that occurred in January reversed only a fraction of the fourth quarter move and we believe that corporates deserve to be overweighted in portfolios in the current environment.

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