Longer term bond yields, however, remained above the levels reached in February. Rising yields globally appear to have kept Canadian yields from declining too much. Yields of longer term bonds in the United States, Germany, and the U.K. are all higher than at the start of the year, thereby putting upward pressure on similar Canadian yields.

Rising yields globally have kept Canadian longer term yields from declining

The Canadian yield curve flattened in the month. The yields of 2 and 5-year Canada bonds fell 8 and 19 basis points respectively, while 10 and 30-year yields dropped 25 and 18 basis points, respectively. The U.S. yield curve also flattened as 30-year Treasury yields declined an identical 18 basis points and 2-year Treasury yields actually rose 5 basis points. The increase in short term U.S. yields reflected increased speculation that the Fed might raise rates in September.

The federal sector earned 1.28% in July, as lower yields resulted in higher bond prices. The provincial sector gained 2.09% in the month, because its longer average duration resulted in larger gains from the lower yields. Provincial yield spreads were unchanged in the period. Standard & Poors downgraded Ontario bonds from AA- to A+, but there was little impact on the market. The corporate sector earned only 0.87% in the month, as yield spreads widened 6 basis points on average and thereby muted the effect of falling benchmark yields. In part, the wider corporate spreads were caused by new issues that were priced at concessions (i.e. wider spreads) to existing bonds. Unfortunately, with many investors not wanting to add to their corporate holdings, the new issue concessions re-priced the existing bonds, forcing their spreads wider too. Three of the new issues were deposit notes from CIBC, Royal Bank, and TD Bank that each raised in excess of $1 billion. As well, poorly conducted selling of corporate bonds by a transition manager hurrying to complete its assignment also had the effect of widening spreads. Non-investment grade corporate bonds declined -1.06%, as a gloomier economic outlook and weakness in the U.S. high yield market weighed on Canadian high yield issues. Real Return Bonds earned 2.08% in the month, but failed to keep pace with nominal long term bonds.

The Canadian economy is not yet in a recession, even if the second quarter GDP shrinks as it did in the first quarter. The weakness is confined to the resource sector, while most other sectors are experiencing positive growth. That said, the Canadian economy is faltering and could benefit from some stimulus other than another Bank of Canada rate cut. Doug Porter, Bank of Montreal’s Chief Economist, said it best: “A deficit of a few billion dollars is no concern in a $2 trillion economy, and that Ottawa’s primary focus at a time of faltering resource prices should be on supporting growth, not aiming for a self-imposed budget target.” With the federal election campaign now underway, we should expect numerous suggestions from the various political parties for increased fiscal stimulus. Some of those suggestions may alarm the market, but we expect the impact to be temporary, given the uncertainty of both the election result and the willingness of the winning party to keep its election promises.

While the recent decline in oil prices suggests that more layoffs and reductions in capital spending are looming for the energy sector, we are hopeful that Canadian economic growth will accelerate in the second half of this year. Factors behind our optimism include satisfactory job creation in Canada, a rebound in U.S. growth, and improving economic activity in Europe. If we are correct, the Bank of Canada will not need to cut interest rates again in 2015. That should lead to a correction in shorter term bonds that have rallied too far in recent weeks. Longer term yields seem likely to take their lead from U.S. bonds. Canada 30-year bonds are relatively expensive to U.S. Treasuries, yielding roughly 80 basis points below the American equivalent. That is the greatest differential since World War II, and appears unlikely to increase. Should U.S. yields move higher, as we believe they will, Canadian yields are likely to follow. Accordingly, we are maintaining durations modestly below benchmark levels. In light of our economic forecast, we are comfortable over-weighting the corporate sector. The recent widening of yield spreads has simply made corporate bonds more attractive, and we will look for opportunities to take advantage of that situation.

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