The new year began with U.S. President Trump dominating the headlines and generating uncertainty that led to volatility in financial markets. Geopolitically, January began with the U.S. seizing the President of Venezuela and his wife on drug trafficking charges. Trump then turned his attention to Greenland demanding Denmark surrender ownership. Initially, military force was not ruled out, raising concerns about the durability of NATO, but then Trump chose to threaten additional tariffs on eight European countries that supported Denmark. While Trump eventually backed down following sharp declines in U.S. bond and stock markets, the event left international investors wondering about the prudence of investing in an unreliable ally. Trump finished the month by nominating a successor to Jerome Powell, the Chairman of the U.S. Federal Reserve, to mixed reaction in financial markets.

In addition to the geopolitical developments, Canadian bond investors had to deal with relatively weak economic data and robust new issue supply in both the provincial and corporate sectors. While benchmark Canada bonds experienced only small changes in yields in the month, the demand for the additional yield of provincial and corporate bonds caused their respective yield spreads to tighten to the narrowest levels since the Great Financial Crisis of 2008-2009. The FTSE Canada Universe Bond index earned 0.58% in January.

Data received during January showed the Canadian economy was continuing to struggle with the effects of an uncertain U.S. trade policy. Canadian GDP failed to grow at all in the most recent month (November) and had increased by only 0.6% in the most recent 12-month period. The unemployment rate rose to 6.8% from a revised 6.6% the previous month, although most of the increase was due to an increase in the participation rate. StatsCan estimated the working age population grew by 10,000, but the number of people working or looking for work (the labour force) jumped by 78,000. With only 8,200 net new jobs created in the month, the number of unemployed persons rose by roughly 70,000 leading to the increase in the unemployment rate. Inflation data was mixed with the annual rate rising to 2.4% from 2.2%, but the core measures of inflation improved to 2.6% from 2.8%.

The constant shifting of U.S. trade policy, with tariffs threatened, sometimes applied, sometimes not implemented, has resulted in considerable volatility in Canada’s trade balance. In November, it was estimated that the trade deficit was $2.2 billion, following a much smaller deficit in October and the surprise surplus of September. That volatility is likely to continue at least until the CUSMA trade agreement is renegotiated. But the shift away from the U.S. as our dominant trading partner has begun. A year ago, 76% of Canada’s exports went to our southern neighbour. The most recent figures show the U.S. share has dropped to 68%, with exports to other countries filling the gap.

The Bank of Canada, as widely expected, left interest rates unchanged at its January 28th meeting. Most economists expect the Bank will make few, if any, changes to interest rates in 2026, given the current low level of rates offsetting relatively weak economic growth. In discussing the decision to leave interest rates unchanged, Bank Governor Tiff Macklem noted that “elevated uncertainty makes it difficult to predict the timing or direction of the next change in the policy rate.” For now, we assume that interest rates will probably not change in the next few quarters.

U.S. economic data continued to work through distortions caused by the 43-day federal government shutdown, but in general showed that that economy was performing well. The estimate for GDP growth in the third quarter was revised up to 4.4%, the unemployment rate declined to 4.4% from 4.5% the previous month, and retail sales were stronger than expected. Importantly for the Fed, inflation failed to improve with the all-items and core rates holding at 2.7% and 2.6%, respectively. Following three consecutive reductions of 25 basis points, the Fed decided to leave its interest rates unchanged at its January 28th announcement.

A day after the Fed’s meeting, Kevin Warsh was nominated to succeed Jerome Powell as Chairman of the Board of Governors of the Federal Reserve when Powell’s term ends in May. Warsh has experience at the Fed, having served as a Governor from 2006 to 2011. The initial market reaction to the announcement saw the U.S. yield curve steepening with short term yields going down and longer term yields increasing. Short term yields declined because it is widely assumed Warsh will accede to Trump’s wishes for lower interest rates. Longer term yields rose because Warsh is expected to try to sharply reduce the size of the Fed’s balance sheet and avoid using it to lower long term yields. Warsh resigned as Governor in 2011 because he disagreed with the Fed initiating another round of bond purchases known as Quantitative Easing (QE). The prices of precious metals such as gold and silver, often seen as hedges against inflation, dropped very sharply on the news of Warsh’s nomination because he is also perceived to be an inflation hawk.

Warsh’s ability to lower interest rates will be somewhat limited because it is the Federal Open Market Committee (FOMC) that sets them, and he has only one of the twelve votes. In addition, Warsh will be taking the Governor position of Stephen Miran, a dovish Trump appointee who only joined the Fed a few months ago. Also, Jerome Powell’s term as Governor does not end when he ceases to be Chairman but continues until 2028.

Internationally, the biggest story was not about central banks’ actions, as no major monetary authority changed its interest rates in the month. Rather, volatility in the Japanese bond market caught investors’ attention because of the size of that market (roughly USD$7 trillion) and the scale of international holdings of Japanese investors. On January 20th, the yields of 30-year and 40-year Japanese Government Bonds (JGBs) soared more than 25 basis points, a day after yields had risen 11 basis points. The yield on 40-year JGBs moved above 4.00% for the first time since they were first issued in 2007. The catalyst for the sharp selloff was concern about election promises causing fiscal strain on the already heavily indebted country. While JGBs recovered some of their losses over the balance of the month, their higher yields left them more competitive internationally and raised concerns that Japanese investors would sell international bonds to repatriate and invest in JGBs. We note that the volatility of January 20th was exacerbated by the relative illiquidity of the Japanese bond market as less than USD$300 million of the benchmark 30 and 40-year JGBs traded on January 20th.

The Canadian yield curve steepened slightly in January as 2-year Canada bond yields declined 2 basis points while 30-year yields rose 3 basis points. In the U.S., yields of all Treasury terms increased slightly, with mid term yields rising more than short and long term yields.

The federal sector returned 0.34% as the impact of slightly lower short term yields more than offset the effect of higher long term yields. The provincial sector, despite its much longer duration, fared better than the federal sector, earning 0.74% in the month. Very strong demand for long term provincial issues caused their yield spread versus Canada bonds to narrow 5 basis points in the month, more than offsetting the small rise in benchmark Canada yields. Demand for investment grade corporate bonds was also very strong with mid and long term corporate yield spreads tightening by 7 basis points despite $16.5 billion of new issues, a record for January. The tighter spreads propelled the sector to a return of 0.80% in the month. High yield (i.e. non-investment grade) corporates returned 0.75% and Real Return Bonds gained 0.52% to start the new year. Preferred shares earned 0.39% in the month.

We believe the Bank of Canada is likely on hold for the next few quarters unless the economy weakens further. As a result, we anticipate the bond market will be in a trading range for the next few months. As there is very little chance of the Bank raising interest rates, we prefer to keep portfolio durations a little longer than benchmarks as a hedge against unexpected economic deterioration. The current differential between short term and long term yields, otherwise referred to as the steepness of the yield curve, seems at an appropriate level to us, so we have adjusted the structure of the portfolio to remove the steepening bias that prevailed last year.

The narrowing of provincial and corporate yield spreads to multi-decade tight levels means there is less additional return for increased risk. The recent trend to very tight yield spreads is reminiscent of the 2004-2006 period, which illustrated that spreads can remain very tight for an extended period. Accordingly, we are reluctant to move to substantially underweight the sectors, but we are looking for ways to structure the portfolios more defensively. An example of that is to upgrade the credit quality of the holdings, which we have been gradually undertaking for the last few months.