For the second month in a row, global bond markets experienced falling prices and rising yields. The Canadian bond market was no exception, with significant volatility occurring on a number of days. Investor concerns about potential reduction in monetary stimulus from central banks sparked the global selloff. The U.S. Federal Reserve, in particular, gave indications that it might begin reducing, or tapering, its purchases of U.S. government bonds later this year, and that prompted significant selling of bonds. The potential reduction of Fed purchases seemed to have an outsized impact and, in part, that reflected so-called “crowded trades”, in which too many investors who had assumed that monetary stimulus would remain in place indefinitely had to unwind their positions at the same time. As a result, liquidity declined and the price impact was increased. The turmoil was not confined to fixed income markets; global equity markets declined in June, with emerging markets suffering some of the largest losses. Interestingly, economic data received during June was generally weaker than expected and did not support the concept of central banks needing to reduce monetary stimulus. The DEX Universe Bond index fell 2.03% in the month.

A significant catalyst for the market volatility occurred on June 19th when the Fed released its monetary policy statement. The statement was more hawkish than expected and included a more optimistic forecast of U.S. economic growth in the second half of 2013 and 2014. In addition, Chairman Bernanke, in his post meeting press conference, was less dovish than many observers had anticipated. Indeed, Bernanke stated that it was possible that the Fed could start tapering before the end of this year. While he gave no indication that the Fed would actually raise interest rates before 2015, many investors interpreted Bernanke’s remarks to mean that the Fed would soon cease its monetary stimulus. Both bond and stock markets fell in reaction as fixed income investors anticipated higher yields and equity investors worried about faltering economic growth without the central bank’s support. Globally, concerns about U.S. growth slowing were compounded by fears that Chinese growth might also slow. The Chinese monetary authorities, in an effort to restrict rampant credit growth, sparked an interbank liquidity and credit crisis that had the potential to significantly constrain the world’s second largest economy. Prospects of decelerating global growth caused some industrial commodities such as copper and nickel to fall in value in the month and that, in turn, led “commodity” currencies such as the Canadian and Australian dollars to fall in value.Canadian Exchange Rate drops in June

In the years since the financial crisis, investors have become accustomed to extraordinarily low interest rates, and many have formulated their investment strategies on the presumption that rates would remain low indefinitely. In many cases, riskier assets have been acquired with low-cost leverage. However, with the Fed’s warning that it might soon start reducing its monetary stimulus, those strategies needed to be re-evaluated and potentially unwound. While difficult to quantify, the shedding of risk carry trades in June clearly exacerbated the volatility. As well, retail investors, convinced that the 30-year bull market in bonds was over, began to sell fixed income mutual funds and exchange traded funds in record quantities.

Canadian economic data was mixed in June and provided no incentive for the Bank of Canada to adjust monetary policy in the near term. Growth in Canadian GDP was only 0.1% in the most recent month and over the last 12 months the Canadian economy expanded by just 1.4%. Canadian consumers appeared cautious, with retail sales showing little growth. On the business side, manufacturing sales fell for the fourth month in the last five, with 13 of 21 industries reporting weaker sales. One of the few bright spots in the Canadian data was the labour market, as unemployment fell to 7.1% from 7.2% on the strength of a remarkable 95,000 new jobs in May.

As noted above, U.S. economic data failed to provide a smoking gun that would cause the Fed to raise rates soon. Construction spending was weaker than expected, as were manufacturing surveys and new factory orders. Industrial production was flat as decreased output from utilities offset gains in mining and manufacturing. The unemployment rate rose slightly to 7.6%. In addition, the estimate of economic growth in the first three months of the year was substantially lowered to 1.8% from 2.4% on weaker consumer spending. Even the housing sector, which experienced good sales and price increases, saw housing starts fall short of expectations.

The Canadian yield curve steepened in June as 30-year Canada yields rose 27 basis points, while 2-year yields increased only 14 basis points. However, as occurred in May, mid-term bond yields rose even more, with 5 and 10-year yields jumping 31 and 37 basis points, respectively. While the increase in short term yields was relatively muted because the Bank of Canada was not expected to raise rates over the balance of 2013, investors in mid-term issues anticipated that rate increases would be substantial when they finally do occur. Of interest, the changes in the Canadian yield curve closely resembled those of the U.S. yield curve, which also experienced greater mid-term bond weakness.

The increase in Canadian yields across the maturity spectrum resulted in federal bonds declining 1.52% in the month. Provincial bonds fell 2.79% on average as their returns were negatively impacted by their longer average durations and a 3 basis point widening of yield spreads. Corporate bonds also underperformed federal issues, declining 1.91% in the period. Corporate yield spreads widened 7 basis points on average, although some industries experienced substantially worse spread performance. The telecommunications sector, for example, was hit by media reports that the U.S. wireless giant Verizon was considering operating in Canada. The threat of greater competition negatively impacting financial results caused BCE, Telus, and Rogers bonds to widen 30 to 35 basis points. Real estate bonds also widened as much as 35 basis points as investors grew more cautious about the impact of higher yields on the overall economy as well as specifically on real estate valuations. Real Return Bonds plunged 6.96% in June, as their long durations made them particularly susceptible to rising yields. As well, with Canadian inflation remaining below 1%, RRB prices adjusted as they were too expensive relative to nominal bonds.

As this is being written, it appears that global bond markets have stabilized somewhat. Given the moves of the last two months, it would make sense to see the markets consolidate around current levels. If the unwinding of crowded trades has indeed subsided, we would anticipate that bond prices move sideways for the balance of the summer months.

While investor sentiment shifts can drive the bond market for short periods, economic fundamentals ultimately will dictate the direction of prices and yields. Economic growth in Canada remains tepid. The housing market appears to be headed for a soft landing, but the real test will be in 2014 as current condominium projects are completed, new units come on the market, and construction employment falls. The recent drop in the exchange rate will be a modest boost for exporters’ competitiveness if it lasts, but the pace of global growth will be more crucial to an improvement in Canada’s trade balance. While our largest trading partner, the United States, looks to be in a sustained recovery, other areas of the global economy are sputtering. Europe remains mired in recession without a credible plan to boost growth. China appears to be targeting lower and more sustainable rates of growth, while trying to limit excessive speculation in housing and other areas of its economy. In Japan, the drive to eradicate deflation is far from a guaranteed success and risks adding even more debt to that already heavily indebted nation. With developed economies’ growth weak, emerging markets are unlikely to be strong.

Just as global central banks are waiting for more evidence of a sustainable recovery, our outlook for the bond market is data dependent. Should growth remain sub-par, it seems unlikely that the Bank of Canada will raise interest rates. In the United States, we expect the Fed will begin to taper its government bond purchases later this year, because there will be fewer government bonds to purchase. As a result of economic growth and a number of tax hikes, the U.S. federal deficit is expected to fall sharply. The Congressional Budget Office is predicting a deficit of only $642 billion in 2013, having been in excess of $1 trillion in each of President Obama’s first four years in office. A smaller deficit means fewer bonds will need to be issued, so it stands to reason that the Fed will slow its purchases. But it is important to remember that tapering is a different decision than raising interest rates, and we do not expect the Fed to raise rates before 2015. Thus, we do not anticipate central bank actions to negatively affect the bond market for the next few months. If we see further evidence of the market stabilizing, we will look to shift from the current defensive posture in the portfolios to take advantage of tactical opportunities.  However, if the bond market continues to adjust toward higher yields, we will look to reduce durations further. From a sector perspective, we continue to favour corporates and will look to rebuild the over-weight allocation if spreads stabilize. Our credit analysis will pay particular attention to the impact of the recent rate increases and the potential for disappointing economic growth in coming quarters.