Continuing the up-down-up monthly pattern that has occurred since mid-year, the Canadian bond market rebounded from the decline of September and enjoyed its best monthly performance of the year during October. Weaker economic data and a more dovish outlook for the Bank of Canada allowed investors to ignore higher U.S. bond yields. As well, concerns about the NAFTA renegotiations and tighter mortgage lending rules made investors more pessimistic about Canada’s economic outlook, which encouraged buying of safe-haven bonds. The FTSE TMX Canada Universe Bond index gained 1.64% in October.

Canadian economic data received during October was mixed but, on balance, reinforced the consensus view that the economy was growing more slowly than the torrid pace of the first half of the year. Of particular note, retail sales in August showed an unexpected drop instead of increasing and, late in the month, GDP was shown to have declined slightly in August following no growth the previous month. The somewhat weaker news did not mean that the Canadian economy was in serious trouble, though. Unemployment held steady at 6.2% (the lowest rate in nine years), housing starts remained robust and manufacturing sales were stronger than expected. The Bank of Canada left interest rates unchanged at its October meeting. However, the Bank’s accompanying statement hinted that further rate increases would occur very gradually, and that contributed to the 3.2% decline in the Canadian dollar versus its U.S. counterpart during October.

U.S. economic data, while still somewhat jumbled by the hurricanes, was quite positive. Indeed, U.S. GDP growth during the third quarter, at 3.0%, was stronger than expected and little changed from the second quarter pace of 3.1%. The unemployment rate fell to 4.2%, the lowest rate in 17 years. As a result, consumer confidence was the highest in 17 years. Businesses were also optimistic, as capital spending increased faster than expected. Overall inflation accelerated to 2.2% from 1.9%, although core inflation held steady at 1.7%. As expected, the U.S. Federal Reserve left interest rates unchanged at its October meeting.

The European Central Bank announced that it would be extending, but scaling back, its quantitative easing programme. The ECB’s bond purchases were scheduled to end in December, but it was widely expected that the programme would continue into 2018. Starting in January, the monthly purchases will drop to €30 billion from the current €60 billion. The purchases will continue at least until September 2018. We believe the ECB’s quantitative easing has been a significant factor in the decline in Canadian bond yields in the last several years as investors switched from low-yielding European issues to Canadian bonds as a higher yielding alternative. Over the long term, the end of the ECB QE should allow Canadian yields to rise to more “normal” levels. In the short run, however, the ECB’s announcement should have little discernable impact on the Canadian bond market.

The Canadian yield curve declined in a near parallel fashion in the month, with yields of all maturities dropping by 13 to 16 basis points. In a departure from the usual relationship, Canadian yields did not take their lead from U.S. yields. U.S. yields actually rose during October, with the largest increases occurring at shorter terms. Since September 8th, when 2-year Canada Bonds yielded 22 basis points more than 2-year U.S. Treasuries, Canadian yields have drifted lower while U.S. ones climbed higher. By the end of October, Canadian 2-year yields were 22 basis points below their U.S. counterparts. The growing negative spread between Canadian and U.S. bond yields likely contributed to the weaker Canadian exchange rate.

The federal sector earned 1.07% in October. The provincial sector returned 2.33%, as the longer average duration meant larger gains as yields declined. In addition, returns were boosted as provincial yield spreads narrowed 4 basis points on average. The narrower yield spreads reflected international buying of provincial bonds and an absence of new long term issues. The corporate sector gained 1.55% in the month, as corporate yield spreads narrowed an average of 3 basis points. During October, there were $8.4 billion of new investment grade corporate issues in October that included $2.0 billion of Maple bonds (Walt Disney and Goldman Sachs), and $1.1 billion of floating rate notes. There were also $765 million of new high yield bonds issued in the month. Returns on non-investment grade issues, at 1.08%, trailed their higher quality counterparts. Real Return Bonds earned 2.26% in the period, but on a duration-equivalent basis they lagged nominal issues. Preferred shares returned 1.97% in October.

1 2