As this is being written, President Trump has nominated Jerome Powell to replace Fed Chair Janet Yellen when her term ends next February. While Powell has been a Fed Governor since 2012 and never dissented from the majority decisions, it should not be assumed that his choice was simply a matter of maintaining the status quo. Unlike his predecessors, Powell is not an economist, so he is more likely to rely on staff forecasts than directing their development. As well, his ability to steer Fed policy during an economic crisis is untested. For the short term, however, his appointment should have little impact on monetary policy and on the bond market.

In the near term, the bond market is likely to be in a holding pattern. Barring a large economic surprise or a major geopolitical event, investors appear to be focussing on the December 13th announcement by the Fed. At that time, we anticipate the U.S. central bank will raise its interest rate targets by 25 basis points, as it continues to gradually remove the extraordinary monetary stimulus that remains in place. We believe that the Bank of Canada will wait until early next year (perhaps its March 7th announcement date) before following the Fed’s increase. The Bank of Canada has indicated that it is closely monitoring economic data to determine when to make its next move. The recent slowing of Canadian growth makes it more likely that the Bank will be cautious about raising rates again.

Notwithstanding favourable economic growth, demand for bonds remains good. In part, the demand appears to be fueled by concerns about a possible equity pullback, given the length of that bull market and the seemingly stretched stock valuations. Long term bond issues are particularly well bid, as the recent supply of new issues has been too low to satisfy demand. Yield spreads of long term provincial and corporate bonds have narrowed sharply in the last four or five weeks as investors compete to lock in the higher yields of these issues. We suspect that issuers will return to the long end of the market, however, and that would cap the recent rally.

Strategically, we are maintaining the portfolio durations shorter than benchmarks because we believe that the economic situation in both Canada and the United States no longer warrants the extraordinary monetary stimulus that current administered rates imply. As well, with the Fed now unwinding its massive bond holdings, there will be increasing upward pressure in bond yields. From a sector allocation aspect, we are looking to gradually reduce the corporate bond overweight because yield spreads have compressed to levels that are not as attractive.

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