Canadian bond prices surged higher in May, driving yields of longer term bonds to all-time lows. In part, the bond rally had been expected due to the anticipated index duration extensions that will occur in the first half of June. However, renewed concerns about European sovereign debt and about the strength of the U.S. economy, as well as weak equity markets, also caused a flight-to-safety bid for bonds. The broad DEX Universe Bond Index gained 2.11% in the period, while the DEX Long Term Bond Index jumped 4.09%.

In Europe, the focus was primarily on the Greek election. Greece needed to ratify various austerity measures in order to qualify for continued financial support from the European Union and the International Monetary Fund, but its election failed to produce a viable coalition capable of governing, or ratifying the austerity programmes. As a result, Greece will hold another election on June 17th. In the event that it does not ratify the measures, it may be forced to leave the EU with attendant losses to European banks and collapse of the Greek banking sector. Some observers even predicted the disintegration of the Euro if Greece exits. Notwithstanding the possible dire consequences of rejecting the austerity measures, a significant segment of the Greek population had become weary of further restraint and the result of the June election remained in doubt. In addition to the Greek drama, Spain struggled in May to shore up the finances of both its regional governments and its banks. Already suffering from 25% unemployment, Spain’s ability to support these sectors was uncertain and the risk premium on its bonds widened as investors became increasingly nervous.

Globally, economic growth prospects dimmed in May. Europe remained mired in a recession, with little hope of growth restating. Lower demand from Europe combined with earlier monetary tightening has reduced Chinese growth modestly. Data from India indicated a marked reduction in growth. Commodity prices fell as investors anticipated reduced demand, with copper, aluminum and oil all experiencing sharp declines. This, in turn, led to a selloff in “commodity” currencies, including the Canadian dollar.

There is an old saying that financial markets are driven by only two emotions, fear and greed. In May investors very much succumbed to the former rather than the latter. Equity markets, including the S&P/TSX, the S&P 500, and major indices in Europe, all fell roughly 6% in the month as investors grew concerned about deteriorating prospects for global growth and a possible credit crisis developing in Europe. The financial stability of banks was also a concern as Spain bailed out a large bank in that country and JPMorgan in the United States reported a massive, unexpected trading loss. For many investors, the primary objective became protection of capital, with potential returns all but ignored. That led to some remarkable activity in the markets. Swiss and German T-Bills, for example, briefly traded with negative yields! Investors in essence paid those governments to hold their money. In longer term instruments, the German government during May issued €5 billion 2-year bonds with a 0.0% coupon. In other words, investors did not want any return on their investment; they simply wanted to know their funds were safe for the next two years. Notwithstanding already low yields, Canadian government bonds benefitted in this environment, because of this country’s perceived financial strength and relatively good fiscal situation. Canadian investment dealers reported significant foreign buying of Canadian bonds during the month.

In the United States, the economic data was quite mixed during May. Some reports, such as industrial production and housing starts, showed continued economic strength. However, other data suggested that growth might be slowing. Retail sales and job creation were both lower than forecast, regional manufacturing surveys were weaker, and consumer confidence fell. On balance, the news was generally more negative, as indicated in the Citigroup Economic Surprise Index. This index compares economic data in the last three months with forecasts to determine whether economic activity is accelerating or decelerating. Positive values indicate a higher number of positive surprises than negative ones. The generally negative economic tone in May contributed to the bond market rally, because it suggested that interest rates would need to stay lower for longer. As well, the weaker data worried equity investors and contributed to a shift out of stocks and into bonds.

Economic Surprise Index

In Canada, the economic news was somewhat more positive. Job creation was robust for the second straight month, and that led to a rise in the labour force participation rate, which caused a tick up in the unemployment rate. Manufacturing sales and retail sales rebounded from weakness earlier in the year and housing starts jumped to the highest level in over four years. In large part, though, the good Canadian economic data was ignored as investors focussed on diminished prospects for U.S. and global economic growth.

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