The nature of pain trades is that they usually end with a blow-off as investors capitulate, cover their losing positions, and in the process cause an final outsized market move. In some regards, the bond market move in May resembled the required capitulation trade. In the U.S. bond futures market, for example, investors moved from a longstanding net short position to a long position in May. Anecdotally, investment dealers have also reported some short covering bond purchases. However, it may take a few more weeks to determine if the pain trade has finished.

Fundamentally, the U.S. economy looks like it is staging a strong rebound in the second quarter. Indeed, a number of economists have revised their forecasts of second quarter growth in U.S. GDP to over 4%. The crucial question, though, will be whether growth will remain robust over the balance of the year. We believe that it will slow somewhat, but not enough to deter the Fed from ending its quantitative easing by October. A key indicator of the economy’s staying power will be job creation; if it remains high, that bodes well for increased consumption and eventually business investment. We believe that the Fed will have sufficient confidence in the U.S. economy to begin moving away from extraordinarily low interest rates in early 2015. Past experience suggests that the bond market will start discounting the Fed’s rate moves months in advance. We also believe that net issuance of U.S. Treasuries will increase in the second half of this year, which supply will weigh on the market.

The Canadian economy is unlikely to continue outperforming the U.S. one. High debt levels are discouraging consumption and business investment has been disappointing. The trade situation has improved from substantial deficits to small surpluses and that has been beneficial to economic growth. But the improvement in the trade balance has been dependent solely on energy exports, as non-energy exports have failed to rebound from the lows of the financial crisis. As a result, the improvement in Canada’s trade balance is not broadly based and is at risk of growing U.S. self-sufficiency in energy. Any benefit from the weaker exchange rate has been minor so far. Canada’s growth will also be depressed by fiscal austerity that is looming in its two largest provinces, Quebec and Ontario. The Bank of Canada is unlikely to risk an unwanted rise in our exchange rate, and will not increase interest rates before the Fed. Our bonds, though, will continue to be led by the U.S. bond market, and that suggests higher yields over the balance of the year. Accordingly, we are defensive regarding duration, and looking for opportunities to reduce it further.

On June 2nd, as a result of coupon payments and large government issues no longer qualifying for the respective indices, the durations of various indices were expected to increase noticeably. The FTSE TMX Universe Bond index duration was projected to increase 0.12 years. More significant changes were expected for some of the sub-indices; the FTSE TMX Canada Mid and Long Term Bond indices’ durations were forecast to rise 0.30 and 0.37 years, respectively. While index funds will adjust their portfolios to match those changes, our clients’ liabilities will not have changes nor will the bond market necessarily be more attractive as a result of the index duration extensions. Accordingly, we do not plan to adjust portfolio durations and the differentials versus benchmarks will increase as a result.

The economic environment remains favourable for corporate issuers and we continue to over-weight the sector. However, the yield spreads have tightened to the lowest levels since the financial crisis and the risk/reward trade-off is no longer as favourable as it once was. We are looking, therefore, for opportunities to modestly reduce the corporate sector allocation.

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