In recent years, the longstanding correlation between the price of oil and the Canadian exchange rate appeared to weaken. This year, though, the correlation has again become very apparent. The weakness in the exchange rate has not been a Canadian phenomenon, as the U.S. dollar has gained in value against almost every other currency in recent months. Since mid-year, as the Loonie has fallen 6.5%, the Pound has fallen 8.5%, the Euro 9.1%, and the Yen 14.6%. Only the Chinese Renminbi has gained versus the U.S. unit. It seems the currency markets are paying more attention to relative economic strength than the bond markets.

Canadian Exchange Rate and Oil Price

The Canadian yield curve flattened in November as 2-year Canada bond yields declined 4 basis points while the yields of bonds maturing in 5 years and longer dropped 17 to 20 basis points. Remarkably, the monthly changes in Canadian bond yields were greater than the declines in U.S. bond yields, an event which rarely occurs. The decline in yields propelled federal bonds to a monthly return of 1.18%. Provincial bonds, which have significantly longer durations on average, gained 2.28%. Provincial returns were also helped by their yield spreads narrowing 2 basis points versus benchmark Canada bonds. Corporate bonds fared little better than federal issues, returning 1.22%. On average, corporate yield spreads widened marginally versus Canada bonds, led by bank subordinated debt spreads that increased by up to 10 basis points as investors re-evaluated the relative risks of that class of bank capital. New corporate issuance in November was fairly active at $9.0 billion. Non-investment grade bonds markedly underperformed investment grade issues, returning -0.73% in the month. The decline in Canadian high yield bond prices closely followed the drop in U.S. high yield bonds.Real Return Bonds earned only 1.66% in November, thereby lagging nominal bonds with similar durations. Apparently, investors focussed less on actual inflation than the potential impact of falling oil prices on future inflation.

There is an axiom in the investment business that “the market is never wrong”. That may be true, but it appeared that global bond markets were at least defying gravity in November. While Eurozone economies continue to stagnate and Japan struggles to break free of deflation, growth in countries such as the United States, Great Britain and Canada has been satisfactory. The need for extraordinarily low interest rates has long past, and cautious central bankers will finally start raising rates in 2015. The bond market does not appear to recognize that likelihood, however. In Canada, every Government of Canada bond maturing in the next 20 years yields less than inflation, which begs the question “Why would anyone buy those bonds?” With the economy performing reasonably well and a relatively stable stock market, there hasn’t been a flight-to-safety bid for bonds that could account for the low yields. Instead, there simply seems to be too much money chasing too few bonds. Given the amount of bonds issued by all levels of governments to fund their respective budget deficits since the crisis, that really reflects the incredible amount of monetary stimulus that has been provided. While consumer inflation has been relatively contained so far, there clearly has been inflation in the prices of financial assets such as bonds, stocks, and even real estate.

We believe that current yields are not attractive and prefer to keep portfolio durations below benchmark levels to protect from potential increases in yields. However, we recognize that the current bond market rally may extend a little further, and with liquidity declining during the holiday season, we are cautious about potential volatility. With regard to the different market sectors, we continue to emphasise corporate bonds. At this stage of the economic cycle, corporate profitability remains good and the additional yield available on corporate bonds is appealing. With regard to individual issuers, we maintain our longstanding aversion to commodity exposure, so we continue to hold no oil & gas companies.

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