Global bond markets enjoyed very strong rallies in November, led by sharp declines in yields in both Canada and the United States. The rallies were extensions of moves begun in October and were fueled by lower inflation, slightly weaker economic data, and less hawkish comments from central bankers. As well, the rallies were exacerbated by some investors jumping on the bandwagon as they sensed the cyclical peak in yields had been reached in October. The large drops in yields from the October peaks also reflected the very sharp increases in yields that had occurred in September. The Bloomberg Canada Aggregate and the FTSE Canada Universe indices returned 4.30% and 4.29%, respectively, in November. Monthly returns greater than 4.00% are rare, having occurred only two or three times since 1980.

Canadian economic data received in November was mixed but on balance slightly negative. Canadian GDP was estimated to have shrunk at a 1.1% annual rate in the third quarter, much worse than expected. However, the second quarter GDP estimate was revised substantially from -0.2% to +1.4%, and StatsCan’s initial estimate for the month October was a relatively strong +0.2%. The unemployment rate rose to 5.7% from 5.5% as rapid population growth from immigration more than offset strong job creation. In the housing sector, existing home sales were weak, but starts of new homes were strong. Importantly, the inflation rate dropped to 3.1% from 3.8% as strong price gains in October 2022 were dropped from the calculation. Bonds rallied on the inflation news as investors knew the Bank of Canada would not begin lowering interest rates until inflation was back under control and close to the Bank’s 2% target.

The Bank of Canada did not have a rate setting meeting in the month, but the federal government released its Fall Economic Statement (FES) on November 21st. In it, the government projected higher deficits for the next few years that will require significantly more borrowing in the form of both bonds and Treasury Bills. The bond market did not immediately react to the projection of higher deficits, but the increased supply may become a headwind to lower yields in the coming months and quarters.

The government also tried to clear up the confusion caused by two aspects of its Budget last March. The first was a decision to not cancel the Canada Mortgage Bond (CMB) programme. Instead, the government surprised the market with the announcement that it will purchase up to $30 billion of CMBs a year, with the emphasis on 10-year maturities to benefit construction of new multi-family rental properties. That announcement prompted the yield spreads on CMBs to quickly tighten 5 basis points as it meant there would be fewer CMBs for the public to invest in. (You may recall that the government recently revised the expected CMB issuance from $40 billion to $60 billion per year.) The second area of uncertainty was the taxation of preferred shares held by financial institutions. The Budget had proposed that preferred share dividends received by banks and insurance companies would be taxed as regular income, but the FES reversed this, stating that the dividends would continue to receive preferential tax treatment. This led to additional strong gains in preferred shares that were already recovering from being deeply oversold.

U.S. economic data received in November was also mixed. In addition, U.S. data, particularly for the manufacturing sector, was distorted by the auto strikes in October, making it more difficult to discern underlying trends. The unemployment rate ticked up to 3.9% from 3.8% when job creation disappointed, but the labour market remained relatively tight as initial claims for unemployment benefits remained low and the number of job openings climbed higher. The inflation rate declined to 3.2% from 3.7%, but the core rate remained elevated at 4.0%. However, inflation expectations moved higher and consumer surveys suggested uncertainty, but retail sales were better than expected. The Federal Reserve left its interest rates unchanged at the start of the month and reiterated that it was prepared to raise rates again if required. However, subsequent Fed speakers implied that further rate increases might not be necessary, which led bullish bond investors to bring forward their estimates of the first rate cuts. At the end of October, the market was not expecting the Fed to cut rates before the second half of next year. A month later, the market consensus was for rate reductions to begin as soon as next May and total at least 100 basis points in 2024.

Internationally, the only major central bank to adjust monetary policy in November was the Reserve Bank of Australia, which raised its rates by 25 basis points for its first increase since June. Global bond markets, though, enjoyed declining yields as disappointing growth spurred speculation of future rate cuts. The yields of 10-year government bonds, for example, fell 36 basis points in Germany, 34 basis points in Great Britain, and 45 basis points in Australia.

Optimism that the Bank of Canada would begin cutting interest rates sooner than previously thought propelled a nearly parallel shift downward in the Canadian yield curve in November. The yields of 5, 10, and 30-year Canada bonds plunged 48 to 50 basis points, while 2-year yields fell only 42 basis points. The shift in the Canadian yield curve mirrored the changes in the U.S. yield curve where 5, 10, and 30-year Treasury yields dropped 50 to 52 basis points in the month. Interestingly, the Canadian yield curve remains much more inverted than the U.S. one, with 2-year Canada bond yields 80 basis points higher than 30-year yields. In the United States, the differential is only 15 basis points, reflecting concerns about financing the massive U.S. fiscal deficit as well as a more optimistic economic outlook.

Federal bonds gained 3.37% in November as the steep decline in yields generated good gains in bond prices. The provincial sector, which has a significantly longer average duration, returned 5.71% in the month. Provincial bond returns were also helped by their yield spreads narrowing by an average 6 basis points on strong investor demand. Investment grade corporate bonds earned 3.81% in the period, helped by an average 10 basis point narrowing of their yield spreads versus benchmark Canada bonds. It appeared investors believed any economic softness would lead to a soft landing rather than a serious recession. Non-investment grade bond returns of 2.85% trailed those of higher quality issues, primarily because of their shorter durations. The Real Return Bond index rose 6.84%, which was significantly less than what nominal bonds of similarly long durations earned. The large decline in the annual inflation rate reduced demand for RRBs. Preferred shares, as noted above, rebounded from a severely oversold position and gained a remarkable 9.47% in November.

As much as we like good returns, we are concerned that the November bond rally may have gone too far. We are not convinced that inflation will continue to quickly fall towards the 2% target, in part because the comparison with price moves last year will be more challenging in November and December. As well, the recent sharp drop in bond yields has loosened financial conditions markedly, which means there is less pressure on the Bank of Canada to reduce interest rates. We also believe investors have not yet focused on how much (or how little) the Bank will lower rates when it does begin to loosen monetary conditions. The Bank has suggested that its estimate of the neutral rate, which is neither stimulative nor restrictive, may be revised higher. If the Bank ultimately only lowers its overnight target rate to 3.00%, it is difficult to see great value in long term Canada bonds yielding roughly 3.25%. Accordingly, we are keeping portfolio durations close to benchmarks as we await more information on the economy and inflation.

While we believe the rally may have gone too far too soon, we do not believe it is likely to fully reverse. The high yields seen in October may indeed prove to be the peak ones for this cycle. The yield curve remains steeply inverted between 1-year and 5-year bonds, and relatively flat for longer maturities. We continue to look for opportunities to lock in attractive yields by extending out of very short term bond holdings into 3-year to 5-year bonds.

Sector wise, we remain cautious about corporate bonds because of the need for interest rates to remain high for several more months. We believe the current level of yield spreads does not properly reflect the level of risk in the economy. We are particularly cautious regarding real estate issuers given their elevated leverage and the need to adjust cap rates to reflect current interest rates and bond yields. We also note the dichotomy in equities, particularly in the U.S. S&P500 where seven massive tech stocks are dominating the price performance of the other 493 index constituents. We believe any correction in equities will cause corporate yield spreads to widen noticeably.