For some time, the market consensus has been that the Fed would not raise interest rates at its June meeting. In part, this reflected investors’ views that the weak U.S. growth in the first quarter would lead the central bank to be cautious. In addition, the British referendum to stay in the European Union or leave has the potential to cause significant volatility and the Fed might want to avoid exacerbating it. So it was a surprise that during May several Fed officials reminded markets that a rate increase in June remained a real possibility. This “Fedspeak” was probably more responsible for the rise in U.S. bond yields than the positive economic data.

Canadian 10yr yields vs oil

The federal sector returned 0.96% in the month, buoyed by the decline in yields. The provincial sector earned 1.05% as its longer average duration offset the impact of yield spreads widening an average of 5 basis points. Corporate yield spreads also widened by 5 basis points, but the lower average duration of corporate bonds meant they enjoyed smaller price gains as overall yields fell. The investment grade corporate sector gained 0.66% in the month. New issue volume of $7.2 billion was average, and the widening of spreads seemed to reflect the unwinding of demand following the GE Capital redemptions in April. Junk bonds (i.e. non-investment grade corporates) returned 1.82% in May as yield-hungry investors bid up bond prices, particularly for energy issuers. Real Return Bonds returned 1.38% in the period and trailed the duration equivalent nominal bond returns. Preferred shares earned 0.52%, as weak returns on rate reset issues lowered the index average.
The disappointing economic data received in May, plus the prospect of the Canadian economy shrinking in the second quarter as a result of the Fort McMurray wildfires, caused Canadian bond yields of all maturities to decline in the month. The largest move came in 10-year Canada Bond yields, which fell 19 basis points. Interestingly, the decline in yields came even as oil prices continued to recover. Over the last year, Canadian bond yields and the price of oil have been closely correlated, but they diverged in May. In contrast with Canadian bonds, U.S. short and mid-term bond yields edged higher in May in response to the increased potential for a June rate hike by the Fed.

As this is being written, surprisingly weak U.S. labour data confirms our existing view that the Fed is unlikely to increase its administered rates at its next scheduled date, June 15th. Since the financial crisis, the Fed has increased rates exactly once, and we do not expect that it will suddenly become more aggressive in tightening monetary policy. Notwithstanding the ineffectiveness of zero or near-zero interest rates, we do not believe that the Fed will raise rates before September at the earliest. As a result, U.S. bond yields are likely to remain range bound for the next few months and, thus, will not put any upward pressure on Canadian yields. In Canada, we expect investors will look through very weak second quarter economic data and begin to anticipate an economic rebound in the third quarter. The Bank of Canada appears unlikely to change its trend-setting interest rates for the next year, given the slow but generally positive economic growth in this country. Accordingly, we believe that the Canadian bond market will also remain range bound and we will look to reduce duration when bond prices approach the upward limit of their range and add duration when the lower bound is approached.

When we look at the yield curve, 5-year bonds appear overvalued. The yield of 5-year Canada Bonds is only 12 basis points higher than that of 2-year Canada’s and 3-month Treasury Bills. Beyond 5 year, the yield curve provides increasing returns for longer maturities. Given the low yields of 2 to 5 year bonds, we are holding relatively fewer short term bonds and more cash equivalents. Among the sectors, we remain over-weight in the corporate sector, but have capacity to add if yield spreads widen to more attractive levels.

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