The Canadian bond market experienced a see-saw month that saw small increases in yields and modest returns as interest income more than offset small price declines. Canadian yields rose sharply in early June and then trended lower in a noisy pattern the rest of the month. The rally in Canadian bonds appeared to be a reaction to slight softening of U.S. economic expectations, as well as a rally in Eurozone bonds spurred by speculation of quantitative easing by the European Central Bank and turmoil in Iraq. The FTSE TMX Canada Universe Bond index returned 0.25% in the month.

Canadian economic data in June was generally positive. Retail sales and wholesale sales were much stronger than expected. Housing starts were better than forecast and manufacturing sales increased at a healthy 5.7% clip during the last 12 months. Unemployment rose to 7.0% from 6.9% a month earlier, but the increase was due to an increase in the participation rate. Job creation was robust at 25,800 new jobs, although the strength was entirely in part time positions as full time jobs fell. Early in the month, the Bank of Canada left interest rates unchanged and reiterated that it was concerned about downside risks to inflation. Subsequently, the inflation rate actually rose, as CPI jumped to +2.3% from +2.0% a month earlier. The large increase led many observers to speculate that the Bank would soon need to alter its rhetoric about low inflation.

U.S. economic news was mixed in June, with stronger data more prevalent early in the month and weaker data later in the month contributing to the rally during that period. Car sales hit their highest level in seven years, new home sales were stronger than expected, and industrial production rose more than forecasts. Less positively, housing starts were below expectations and personal spending unexpectedly slowed. U.S. CPI rose to +2.1% from +2.0%. The U.S. Federal Reserve continued to taper its monthly bond purchases, lowering them as expected to $35 billion.

One of the more interesting U.S. economic releases during June was a revision to the estimated pace of growth during the first three months of 2014. Initially, U.S. GDP had been estimated to have grown at a rate of +0.1%, but that was subsequently revised to -1.0%. In June, the estimate was revised a second time to -2.9%, making it one of the weakest quarters ever outside of a recession. Much of the downward adjustment was due to lower estimates of healthcare spending and slower inventory building. In many ways the sharp drop in GDP appeared to be an outlier, though, as job creation and industrial production in the first quarter accelerated from the second half of last year, and consumer confidence and new home sales each hit their highest levels since the financial crisis. Interestingly, neither the Fed nor the stock market gave any indication of concern regarding the weak GDP data. In many ways, the GDP revision was viewed as “old news”, giving little indication of the current economic situation.

In the Eurozone, weak economic activity and very low inflation prompted the European Central Bank to increase its monetary stimulus. One of the more notable ECB moves was to impose negative interest rates on bank deposits to encourage banks to lend rather than hold on to the money. The ECB also indicated that it would consider more unconventional measures to boost inflation and economic activity. That prompted European bond yields to fall and made Canadian bonds look attractive by comparison. International buying of Canadian bonds appeared to increase, leading to lower yields and higher prices.

In the following chart, it can be seen that the yield on 5-year Canada Bonds has fallen below those of U.S. Treasuries and U.K. gilts this year, whereas they previously enjoyed a significantly better yield. The lower relative yield currently is likely a contributing factor behind lower international demand for Canadian bonds over the last several months. Versus Eurozone bonds, however, Canadian bonds remain attractive. Yields on German Bunds, for example, have fallen faster in 2014 than Canadian bond yields. During June, in particular, European bond yields fell as the European Central Bank increased its monetary stimulus and the rally prompted some investors to sell and reinvest in Canadian bonds.June14-1

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