In light of the current economic strength in Canada and particularly in the United States, we believe the respective central banks will continue to raise interest rates. The Fed is expected to next raise its rates in December, while the Bank of Canada will probably wait until early 2019. Both central banks believe they are no longer providing extraordinary monetary stimulus but have to raise interest rates further to achieve a neutral monetary stance. As they approach interest rate levels deemed to be neutral, the pace of increases is likely to slow to prevent overshooting and causing an economic slowdown. We believe the Bank of Canada’s and the Fed’s deliberations will be complicated in 2019 by slightly slower economic growth than this year. At this time, we believe the Bank will raise rate twice in 2019, while the Fed will move three times. It appears that only a portion of the anticipated rate increases are built into current bond yields, so we would expect bond yields to move higher in the coming months.

In addition to coming rate increases by the central banks, bond yields are likely to be pushed higher by a supply/demand imbalance for U.S. Treasuries. The Fed is now unwinding its balance sheet by $50 billion per month (or $600 billion per annum) even as the size of every U.S. Treasury auction is being increased to fund the ballooning federal deficit. With the world’s largest buyer of Treasuries turning into a seller, the yield of U.S. bonds should move higher.

Our economic forecast does not anticipate a recession in 2019, but the outlook is murkier for 2020. The stimulus from the U.S. tax cut in December 2017 will have faded and lingering unanticipated consequences from the U.S.-initiated trade war will further slow growth. In Canada, we will still have to contend with a shortage of pipeline capacity that is hamstringing the energy sector. In 2020, we will also have to contend with home buyers from 2015 experiencing sticker shock as their mortgages renew at substantially higher rates. In light of the potential for slowing growth, we are gradually shifting to more defensive and higher quality corporate issues in the portfolio. We continue to believe that the current demand/supply imbalance of long duration bonds will eventually correct and long term yields will rise. In anticipation of that occurring, we have structured the portfolio to benefit from increasing term differentials (i.e. a steepening of the yield curve).

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