The international buying of Canadian bonds was also a factor in the Canadian exchange rate strengthening during June. The Loonie gained 1.6% versus the U.S. dollar in the month and returned to levels last held in early January. The biggest move in the exchange rate during the month, however, followed the higher than expected inflation rate, as investors speculated that the Bank of Canada would need to revise its “too-low inflation” concerns and they revised their expectations for the timing of future rate increases.

The Canadian yield curve flattened modestly in June. Yields of 2-year Canada bonds rose 6 basis points, while yields of longer term bonds gained a basis point at most. The Canadian bond market outperformed the U.S. market in the month, as U.S. yields experienced modestly larger increases. Federal issues returned a meagre 0.11% in June as small declines in bond prices detracted from interest earned. Provincial issues, on average, returned 0.42%. Provincial yield spreads narrowed by 1 basis point and that, combined with longer average durations, led to modest price gains. The corporate sector earned 0.25% in the period. New issue supply was fairly robust at $9.8 billion, and that led to yield spreads widening 4 basis points on average. Banks were conspicuous issuers in the month as TD raised $1.5 billion of 6-year deposit notes, CIBC issued $1.0 billion of 5-year notes, and Bank of Nova Scotia sold $1.0 billion of 7-year notes. High yield issues earned 0.78% in the month. Real return bonds gained 0.55%.

For a few months, it appears that bond investors have been focussed on factors other than economic fundamentals. Unrest in Ukraine and Iraq, liability driven investing by pension funds, concerns about equity valuations, and central bankers musing about inflation being too low have helped drive bond prices higher and yields lower. We believe, however, that economic fundamentals will ultimately determine value in the bond market. Those fundamentals suggest that bond yields are too low and that they will rise over the next few quarters.

The key aspect of our forecast is that the U.S. economy has definitively turned the corner and no longer needs extraordinary monetary stimulus. With unemployment falling towards 6.0% and inflation above 2.0%, the Fed’s 0.25% overnight interest rate is not appropriate or necessary. Increases await the end of the Fed’s bond purchase programme, and we expect them to start in early 2015. The bond market will likely anticipate rate increases by several months.

The Canadian economy will benefit from stronger U.S. growth, but there is less pressure on the Bank of Canada to raise interest rates in this country. Concerns about inflation being too low seem misplaced when CPI is at +2.3% and we expect the Bank will modify its stance when it releases the latest Monetary Policy Report later in July. Canadian bond yields are likely to follow U.S. ones gradually higher. Accordingly, we are keeping portfolio durations shorter than the benchmarks.

In addition to improving economic activity and higher inflation, central bankers face increasingly pressure to raise rates from emergency levels because of concerns that those rates are having unintended, negative consequences. Specifically, a number of observers including the Bank for International Settlements (the central bank’s bank) have raised concerns that ultra-low interest rates are causing asset bubbles and complacency toward risk. Housing in several Canadian cities, for example, are potential asset bubbles as very cheap mortgage rates are encouraging buyers to pay higher and higher prices. In the U.K., there are also concerns about a housing bubble developing. As well, some observers are questioning record high equity market valuations and suggesting low interest rates are responsible. With regard to complacency, equity volatility measures are very low even as markets set record highs and there appears to be little concern that central banks will raise rates in the foreseeable future. In the bond market, complacency is apparent as non-investment grade bonds are at record low absolute yields and have tight yield spreads versus federal benchmarks. Risk taking is also being encouraged as leverage for investments is very cheap. However, buying investments with borrowed funds has the potential to magnify losses significantly if either the investment declines or interest rates rise. In the past, central banks, particularly the U.S. Federal Reserve, have been reluctant to prick asset bubbles by raising interest rates, but the current ultra-low rates have been in place for roughly five years and they are becoming harder to justify.

Corporate bonds remain our preferred sector. However, yield spreads have narrowed substantially and no longer offer as compelling value as they once did. Should yield spreads tighten further, we will look to selectively reduce the corporate sector allocation. With regard to Real Return Bonds, we are monitoring inflationary pressures and will increase the RRB holdings if inflation continues to rise.

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