We believe, for a couple of reasons, that the bond markets over-reacted to the potential tapering of the Fed’s quantitative easing programme. First, economic growth appears to have slowed in the second quarter from the surprisingly strong first three months of the year. If the soft patch in the economy is prolonged, job growth will likely falter. Slower economic growth and lower job creation means the Fed may not start tapering its bond purchases for at least several months. The second reason we believe the May selloff may have been an over-reaction is that the impact of the Fed’s quantitative easing programmes may have been overstated. Notwithstanding a massive increase in the Fed’s holdings of Treasuries in the quantitative easing programmes known as QE2 (October 2010 to June 2011) and QE3 (September 2012 to the present), long term US Treasury yields actually rose. Even during Operation Twist, when the Fed extended the term of its Treasury holdings between September 2011 and December 2012, yields were little changed. If quantitative easing was not as effective as hoped, perhaps slowing or stopping it will not have much effect either.The Effects of QE on Yields

If we are correct in our assessment regarding the over-reaction to Fed tapering, the bond market may be due for a bounce in prices. When that occurs, we will look to reduce portfolio durations from neutral to more defensive levels. Our economic outlook remains one of modest growth in Canada with greater than normal dependence on the U.S. export market. In the United States, we believe growth will accelerate slightly in the second half of the year, but not enough to prompt the Fed to begin tapering its bond purchases before the end of the year. Neither the Bank of Canada nor the Fed are likely to raise interest rates before 2014. Corporate bonds remain our preferred sector, although potential spread tightening is likely to be slower than in recent months.

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