The Canadian bond market treaded water in June. Initially, bond prices jumped higher, but they subsided later in the period. U.S. economic growth slowed, while Europe remained mired in recession and China’s economic data was, at best, mixed. For bond investors, the positive impact on bond prices of weaker economic activity was offset by optimism about the European debt crisis. In the end, slightly lower long term bond prices offset interest income and the DEX Universe Bond index closed with a meagre 0.01% gain on the month.

In Canada, the economic news was mixed. The unemployment rate held steady at 7.3%, although job creation slowed from the robust pace of the previous two months. Reduced spending on cars, gasoline, and clothing caused an unexpected fall in retail sales, but GDP growth remained satisfactory at 2.0% versus a year ago. Lower gasoline prices led to inflation dropping to 1.2% from 2.0% the previous month. The Bank of Canada left interest rates unchanged, but said it may raise them if domestic growth occurs as forecast, even if global risks increase. Investors, though, observed softening growth of Canada’s trading partners, particularly in the United States, and discounted the Bank’s rhetoric.

The unusually warm weather last winter has made interpreting U.S. economic data since then more challenging than usual. The better than normal weather early in the year encouraged economic activity, such as construction, to occur sooner and the strength of the first quarter potentially borrowed from the second quarter. As a result, the weaker growth that occurred during the spring season may simply have reflected the effect of the warm winter. However, the longer that growth remains slow, the more likely that there has been a fundamental weakening of the economy. The economic data in June suggested that the U.S. economy had indeed slowed. The manufacturing sector, in particular, appeared to slow as reduced demand from Europe and greater consumer caution slowed buying. Less optimistic businesses led to reduced hiring, and the unemployment rate edged up to 8.2% from 8.1%. The weaker labour situation, plus worries about the fallout from the European crisis, caused consumer sentiment to fall to its lowest level since December. As a consequence, retail sales fell slightly. On the positive side, the U.S. housing sector showed continued improvement: housing starts were up 26% compared to year ago levels, homebuilder confidence was at 5-year highs, and home prices showed further evidence of stabilizing.

The generally weaker than expected data in the United States prompted talk of further monetary stimulus by the U.S. Federal Reserve. Indeed, the central bank did extend its bond buying programme, nicknamed Operation Twist, to the end of 2012. It had been previously scheduled to wind up in June. The Fed also revised down its expectations for near term growth in the American economy.

In Europe, there was an alternating series of negative and positive developments regarding the debt crisis in that region. Spain was forced to seek international aid to bolster its banks, which had been hard hit by the collapse of property values. In addition, Cyprus became the fifth member nation to ask for a bailout from the European Union. More positively, the second Greek election in as many months produced a government committed to complying with most of its bailout terms. As well, late in the month, yet another European summit produced an agreement that was hoped to resolve the crisis. The agreement would centralize the regulation of European banks and, if necessary, bail them out directly rather than funneling loans through already over-burdened governments. The agreement also sought to reduce the borrowing costs for Italy and Spain, reduce the demands for budget cuts for countries seeking bailouts, and yet provide greater fiscal discipline and coordination. The initial market reaction to the agreement was optimistic, but given that this has been the 19th summit and announcement since the crisis began, we remain cautious about its prospects for success.

The price of oil continued to fall in June, reaching levels that could have a number of economic impacts. As a result of the fall in oil, the Canadian exchange rate, which is often linked to commodity prices, dipped to its lowest level in 7 months. If the exchange rate holds at that level, it would make Canada’s export sector more competitive, providing stimulus to our economy. As well, falling gasoline prices benefit consumers, leading to increased spending for other goods and services. Less positively, the drop in the price of oil makes the oil sands megaprojects less attractive and could lead to reduced capital spending in one of the hottest sectors of the Canadian economy.

CAD exchange rate & oil prices

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