The Canadian bond market enjoyed good returns in July, as investors focussed on geopolitical risks in Ukraine and the Middle East, plus the potential negative impact of these crises on the already struggling Eurozone economy. Many equity markets around the world fell in the month as investors sought to reduce their exposure to riskier assets. Demand for bonds as safer, less risky investments helped push Canadian bond prices higher and yields lower. More favourable economic news, particularly out of the United States, was by and large ignored in the risk-off environment. The FTSE TMX Canada Universe Bond index returned 0.63% in July.

Canadian economic growth remained tepid and uneven. While GDP grew more rapidly than expected in the most recent month and retail sales were stronger than forecast, labour market news was disappointing. The unemployment rate rose to 7.1% from 7.0%, as job creation stalled. Inflation rose to 2.4% from 2.1%, but the Bank of Canada dismissed the increase, believing it to be a temporary phenomenon. At its July rate-setting meeting, the Bank again left interest rates unchanged and, in the accompanying Monetary Policy Report, it spent considerable time defending its lack of response to higher than expected inflation. The Bank’s previous concerns that inflation was too low were not mentioned. Also during July, we received confirmation that international buying of Canadian bonds had accelerated significantly during May. We believe that the increased interest in Canadian bonds was due primarily to falling European yields at that time.

U.S. economic data during July was generally quite positive. The labour market had particularly good news as unemployment fell to 6.1% from 6.3%, job creation was robust, and the number of job openings rose to the highest level in seven years. (Curiously, the U.S. Federal Reserve chose to ignore the good labour news as it focused on the lack of wage inflation as one reason to leave interest rates at ultra-low levels.) The improved job situation was not ignored by consumers, however, as consumer borrowing and retail sales climbed and vehicle sales rose to the fastest pace since before the financial crisis. U.S. inflation held steady at 2.1%, while wage and benefit costs had the largest increase since the third quarter of 2008. The only area of weakness in the month was the housing sector. Housing starts and new home sales were weaker than expected, while existing home sales were flat. Home price increases continued to decelerate on a year-over-year basis, and actually declined on a monthly basis in several large cities. More stable prices might actually be a positive development, though, because it would improve affordability for first time buyers.

The Canadian yield curve flattened slightly in the month; yields of 2 and 5-year bonds were little changed while 10 and 30-year yields declined 7 to 8 basis points. The weak economic situation in Canada and the Bank of Canada’s inclination to retain very stimulative monetary policy appeared to encourage bond buyers, notwithstanding the very low yields available. In the U.S, the yield curve also flattened, but more because short term yields rose as investors anticipated that the strengthening economic activity would lead the Fed to raise interest rates sooner than previously thought.

The decline in yields during July helped lift federal bonds to a return of 0.50%. Provincial bonds, which have longer durations on average, gained 0.90% as yield spreads were little changed. Corporate bonds returned 0.50% in the month, with yield spreads edging marginally wider. New issue supply remained strong at $8.1 billion. Noteworthy among the new issues were $800 million of Maple bonds (viz. Morgan Stanley and Metropolitan Life) and the first ever Non-Viable Contingent Capital (NVCC) subordinated debt issue from Royal Bank. The NVCC issue contained provisions for forced conversion into common stock should the bank run into financial difficulties. Despite offering a higher yield than existing sub-debt issues, we declined to purchase the Royal Bank new issue because we preferred to know the proposed treatment of more senior-ranking debt securities prior to buying NVCC securities. The federal government’s policy on “bail-in” rules for deposit notes had been long promised but was not available until after the end of July. High yield bonds returned only 0.42% in the month, as the risk-off environment reduced demand for riskier bonds. Real Return Bonds surged 2.57% in the period, helped by their very long durations as yields declined and by increased demand for inflation protection as CPI remained above the Bank of Canada’s 2% target.

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