Among the various sectors in the Canadian bond market, provincial government issues had the strongest performance in October, gaining 0.45%. The yield spread between provincial and benchmark Canada bonds narrowed 5 basis points, on average, as demand from both international and domestic investors for provincial bonds was strong enough to offset $5.0 billion of new issue supply. Corporate bonds were the second strongest sector in the month, earning an average 0.30% return, as their yield spreads narrowed 3 basis points. New corporate issues totalled $5.6 billion, with three large subordinated debenture issues from Canadian banks accounting for $4.0 billion of that. Canada bonds earned only 0.06% in the period, and were thus the worst performing sector.

The weak returns of Canada bonds reflected the steepening of the yield curve in the month. Yields on shorter term bonds declined slightly (e.g. 2-year yields declined by a basis point), but those of longer term issues rose modestly (30-year yields climbed 9 basis points) which resulted in price declines. The steepening of the Canadian yield curve was a more muted version of U.S. bond market activity that saw 2-year yields decline 8 basis points and 30-year yields jump 31 basis points. The rise in long term U.S. Treasury yields reflected twin concerns that the new quantitative easing programme would not target longer term bond purchases, but would ultimately cause inflation to rise excessively.

The implementation of another round of quantitative easing by the Fed will have three objectives. First, it will try to elevate asset prices; not just bonds, but also equities (because of better economic prospects) and housing (through greater consumer confidence and faster economic growth). Higher asset prices, it is hoped, will lead to some acceleration in inflation and the avoidance of deflation. As well, it is hoped that rising stock and house prices will create a wealth effect that will stimulate consumer spending. Second, QE2 will try to stimulate borrowing (and spending) by reducing the cost of credit. Thirdly, QE2 will likely result in the depreciation of the U.S. dollar, which will make U.S. businesses more competitive. How successful it is in achieving these objectives will me a major focus of the markets for the next few months.

We believe that the first objective of QE2 will be successful, with equity and U.S. bond prices generally moving higher. However, the impact on Canadian bond prices is less clear. Should the pace of foreign investment in Canada slow significantly, Canadian bond prices will probably decline somewhat. As well, a significant stock market rally would likely draw investors away from the bond market and that would also depress bond prices. With regard to the objective of easing credit conditions, we are concerned that the Fed may be entering the realm of “pushing on a string.” Consumers are in the process of paying down debt and repairing their balance sheets; lower interest rates are unlikely to reverse that trend. Only when businesses begin hiring more rapidly will consumer spending appreciate meaningfully. Businesses, on the other hand, have already re-built their balance sheets and are holding record amounts of cash. As a result, they have less need to borrow and lower interest costs will have little effect. However, as the economy and business confidence improve in conjunction with monetary stimulus, the corporate cash should find its way into business spending and hiring. The third objective, U.S. dollar devaluation, will likely occur, but with unpredictable consequences. With the U.S./Chinese exchange rate kept from changing significantly, the impact of the dollar depreciating will be felt more strongly on those currencies that are allowed to float. Already, a number of countries, including Brazil and South Korea, are considering implementation of capital controls as a method of avoiding rapid appreciation of their respective currencies. Indeed, should the implementation of QE2 by the U.S. lead to a more overt series of competitive devaluations or trade restrictions, we would anticipate increased volatility in the markets.

While the Bank of Canada is unlikely to raise interest rates again before the first quarter of next year, we believe that the path for rates is eventually higher. Current bond valuations offer little protection from higher rates, however. We also believe that the U.S. economy will accelerate in the coming quarters resulting in a gradual reduction in unemployment. Economic sentiment, in our opinion, is quite pessimistic and we think that any indications of acceleration have the potential to cause significant pullbacks. In the improving economic environment, we continue to favour corporate and provincial bonds over the lower yielding Canada bond alternatives.

1 2