The U.S. data last month reinforced our view that the world’s largest economy is experiencing robust growth that will ensure the Fed ends its bond purchase programme by October and begins raising interest rates within the next 12 months. As the first of what will be series of rate hikes approaches, we believe there will be a risk of a significant bond market selloff occurring in advance of the Fed’s first move. At the moment, the bond market is not focussed on the potential for a number of rate increases, but we think that will eventually occur. With regard to the impact on the rest of the world, we do not believe that the Fed will deviate from its historic emphasis of focussing solely on U.S. economic circumstances.

We also believe that the Canadian economy will benefit from the stronger U.S. growth, but the pace of growth in this country will allow the Bank of Canada to stay on the sidelines until well after the Fed begins to raise rates. Canadian bond yields will likely follow U.S. yields higher in the event of a major selloff in that market. The timing of the move to higher yields is difficult to predict with great accuracy, however. The massive monetary stimulus from many global central banks since the financial crisis is creating demand for bonds and other investible assets that seems insatiable. However, we are convinced that a shift in investor attitudes is likely as the U.S. economy powers ahead. In light of the growing risk within the bond market, we are keeping portfolio durations shorter than their benchmarks to reduce the impact of yield increases.

We continue to favour corporate bonds in light of the improving economic environment. However, yield spreads have compressed a long way from the extremes of the financial crisis, and the relative attractiveness of corporate issues has declined somewhat. As a result, we are looking at selectively reducing corporate sector exposure. We are also increasing exposure to Real Return Bonds as a hedge that the Bank of Canada has misjudged the inflationary pressure in Canada.

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