Looking ahead, we anticipate elevated volatility in the bond market in December. In part, that is due to declining liquidity that occurs every year as investors reduce activity in advance of the holidays. This year, though, central bank activity has the potential to unsettle markets. Already, the European Central Bank has disappointed investors anticipating more aggressive actions to stimulate that region’s growth. Even more important than the ECB decision will be the Fed’s meeting on December 16th. Most likely, the Fed will increase interest rates at that time, but take great pains to explain that further rate increases will be very gradual so as to not upset economic growth.

As the central bank of the world’s largest economy, the Fed’s move, if it does raise rates, will have repercussions globally. Zero interest rate policies over the last several years have encouraged speculation and leverage. An increase in U.S. interest rates could well trigger massive unwinding of those positions. As a result, equity, currency, and foreign exchange markets could experience significant volatility that would cause, at least initially, a flight to safety bid for bonds. On a longer term basis, we would expect U.S. bond yields to move somewhat higher as a result of the Fed starting to raise rates, but the expected pace of subsequent moves will determine the size of the adjustment in the bond market. We believe longer term Canadian bond yields will follow U.S. yields higher, if and when that eventually occurs. We are, however, keeping portfolio durations close to benchmarks until the Fed makes its announcement. One reason for this is that the Fed’s rate increase is probable, but not a certainty. Numerous times in the last few years the Fed has appeared to give similar hints, but has not acted. A second reason for our caution is the potential volatility that a Fed rate increase could cause. We would prefer to shorten durations after the risk of a flight to safety bid for bonds dissipates.

Corporate yield spreads are relatively wide from an historical perspective. Indeed, the corporate sector of the bond market appears to be anticipating a serious recession, given the risk premiums that are built into the spreads. We do not believe that a serious recession is at hand though and corporate bonds are, therefore, quite attractive. We anticipate adding to the corporate holdings to take advantage of the wide spreads, but we are monitoring the new issue activity to determine when new issue concessions are no longer repricing existing issues.

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