If there is a single global benchmark bond, it would be the 10-year U.S. Treasury, due to the size and depth of the U.S. bond market and the status of the United States as the world’s largest economy. Virtually every sovereign issuer in the world issues bonds with 10-year maturities and the yields of each of these are invariably compared to that of the U.S. Treasury. The Canadian bond market is no exception, with the spread between 10-year Canada’s and U.S. Treasuries followed closely by many investors and investment dealers. The Treasury doesn’t always have the lowest yield, but its movement tends to have broad influence on global bond markets. So the fluctuations in the 10-year Treasury yield during October were noteworthy. At one point, the benchmark yield had fallen by roughly a quarter over a two week period that did not include major disasters or economic collapses. Other bond markets, including Canada’s, moved in sympathy with U.S. Treasuries, although the magnitude of the moves was often more muted. The magnitude of the U.S. move provided an indication of the uncertainty in investors’ minds regarding growth and monetary policy, but also suggested significant speculative activity.

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The Canadian yield curve shifted downward in a nearly parallel fashion in October. Yields of benchmark Canada bonds maturing from 2 to 30 years declined 8 to 11 basis points in the month. The decline in yields powered the federal sector, which returned 0.65% in the period. The provincial sector also returned 0.65%, as the benefits of longer durations was offset by provincial yield spreads widening by 4 basis points in the month. Corporate bonds gained only 0.38%, because their yield spreads widened an average of 7 basis points thereby offsetting most of the yield decline on benchmark Canada’s. New issue supply was subdued at only $5.8 billion, of which $5.0 billion was raised by Bank of Nova Scotia, CIBC, National Bank, and TD. In part, the reduced issuance reflected the nervousness of the markets. However, the banks’ October 31st yearends also played a part, because they were reluctant to add to positions that might have required additional capital. Real Return Bonds earned only 0.45%, as economic uncertainty dampened investor demand for inflation protection. Non-investment grade corporates fell 0.72% in the month, as investors sought to reduce risk within their portfolios. As a result of the October loss, high yield returns for the first ten months of 2014 trail those of investment grade corporates.

Looking ahead, we think October’s volatility will be followed by a period of consolidation as investors try to discern the path of economic growth and central bank policies. With quantitative easing finally finished, the focus for U.S. monetary policy will be the timing of the first interest rate increases. Fed officials are concerned about the durability of the U.S. expansion, but given that unemployment is below 6% and GDP growth has been averaging better than 3%, it makes little sense to leave interest rates close to 0%. We think the Fed will most likely wait until next June before starting a series of increases. An earlier start is possible, but unlikely unless U.S. growth accelerates significantly. The bond market, though, will anticipate the Fed’s first move by a few months. When that occurs, we would expect mid-term bond yields to be most affected.

The Bank of Canada is unlikely to raise Canadian interest rates until the Fed has raised its rates two or three times. Canadian growth is so slow that it is barely reducing the output gap that exists in this country. As well, the Bank wants to encourage exports, so it wants to avoid causing the exchange rate to strengthen. Rate increases in Canada are unlikely for at least twelve months.

Current yield levels offer little protection from a bond market selloff. Even though, the Bank of Canada is unlikely to raise rates for at least a year, we believe it is prudent to keep portfolio durations shorter than their benchmarks. A number of factors have driven yields to these levels including geopolitical concerns, fears of Ebola, equity market jitters, and pension fund rebalancing. As these factors fade in importance over time, previously ignored economic fundamentals may become more prominent. Should that occur, yields may drift higher well in advance of central bank moves.

The widening of corporate yield spreads in October had more to do with the impending fiscal year end of most investment dealers than a deterioration in creditworthiness. Most corporations are enjoying robust earnings and credit quality remains strong. That said, corporate yield spreads have narrowed substantially in the last few years and the risk/reward trade-off is no longer as compelling. Accordingly, we are being very selective about additions to the portfolios and looking for opportunities to take profits where appropriate.

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