The Canadian bond market was choppy in October with unusually wide daily swings in yields. Investors reacted to an array of competing factors, including a war in Israel that initially produced a flight to safety and lower yields. Economic data suggested the Canadian economy was slowing in response to the Bank of Canada’s series of interest rate increases and inflation unexpectedly declined. Conversely, the U.S. economy continued to show strength and U.S. bond yields, which often lead Canadian ones, moved sharply higher with the 30-year Treasury yield moving above 5.00% for the first time in 16 years. Equity markets also experienced volatility with the S&P/TSX Composite losing 3.2% and the S&P 500 declining 2.1%. The Bloomberg Canada Aggregate and the FTSE Canada Universe indices returned 0.36% and 0.37%, respectively, in October.

In Canada, the annual rate of inflation declined to 3.8% from 4.0%, and the monthly change in prices showed an unexpected decline of -0.1%. That prompted a rally in shorter term bonds as investors anticipated the Bank of Canada would not need to raise interest rates again this cycle. The rally was reinforced by subsequent data that showed Canadian GDP growth stalled in August. In addition, StatsCan’s flash estimate of growth for September was also flat, raising the possibility that Canada had slipped into a technical recession of two consecutive quarters of shrinking rather than growing. More positively, housing starts were much stronger than expectations and unemployment held steady at the relatively low rate of 5.5%. Job creation was strong, and the participation rate edged higher. As expected, the Bank of Canada left its interest rates unchanged as it wanted additional data before adjusting monetary conditions.

In the United States, the data indicated the economy was very resilient following the Federal Reserve’s rapid interest rate increases. U.S. GDP was estimated to have grown in the third quarter at a remarkable annual rate of 4.9%. American consumers, who are less exposed to interest rate increases than their Canadian counterparts, continued to spend. The unemployment rate held steady at the low 3.8% level and the number of job openings surged higher. Business investment spending appeared strong, although the data on the manufacturing sector was made more difficult to interpret by the six week automotive strikes. While the Fed was not expected to raise its rates at its November 1st announcement, the strength of the U.S. economy meant that additional rate hikes might still be needed. At a minimum, rates would need to stay higher for longer, which led to weakness in the prices of longer term bonds and higher yields. In addition, notwithstanding the very strong economy, the U.S. fiscal deficit appears out of control at a $1.7 trillion pace. Therefore, the U.S. Treasury has increased the amount of bonds it is issuing, and investors began demanding higher yields to compensate for the increased supply.

Internationally, the other major central banks left their administered interest rates unchanged as they waited for additional data on inflationary pressures. The Bank of Japan maintained its negative policy rate of -0.10% but adjusted its Yield Curve Control policy so that the previously announced cap of 1.00% on 10-year Japanese Government Bond yields would instead become a “reference” rate. In other words, the Bank of Japan would allow bond yields to rise somewhat higher than 1.00%. As domestic yields become more attractive, Japanese investors will have less reason to purchase foreign bonds, including Canadian ones.

Both the Canadian and American yield curves became less inverted in October, but in different ways. In Canada, short term bond yields declined as investors anticipated that the Bank of Canada was finished raising interest rates this cycle. The yields of 2-year and 5-year Canada bonds fell 22 and 13 basis points respectively, while longer term yields rose a few basis points. As a result, long term yields moved closer to the higher short term yields. In the United States, the yield of 2-year Treasuries edged higher by 2 basis points while 10 and 30-year Treasury yields shot up by 29 basis points. The rise in longer term yields was caused by concerns about financing the massive U.S. fiscal deficit. Notwithstanding the changes in October, the Canadian yield curve remained significantly inverted with 2-year yields higher than 30-year yields by 78 basis points. In contrast, the U.S. yield curve was only marginally inverted as the difference between 2-year and 30-year Treasury yields was a negligible 8 basis points.

The federal sector earned 0.48% in October as the decline in short term bond yields resulted in slightly higher prices. The provincial sector returned 0.22% in the month as the small increase in longer term yields had more impact. Investment grade corporate bonds gained 0.40% despite yield spreads widening an average 5 basis points in the period. Non-investment grade bonds lagged better quality ones, gaining 0.02% in October. Real Return Bonds returned -0.23% which was slightly better than the results of nominal bonds with similarly long durations. Preferred shares declined 2.80%, as investors continued to exit the asset class despite very attractive yields. Weakness in equity markets likely contributed to the decline in preferred shares.

While the decline in the inflation rate was good news, we believe caution is warranted before declaring the fight against inflation complete. Wage increases to compensate for past inflation are putting substantial pressure on employers to raise prices further. In addition, the recent slowing in Canadian economic activity is only partially due to higher interest rates. Weather, fires, and strikes have temporarily dampened activity, and some rebound from those events seems likely.

The sharp selloff in bonds in October, particularly in the U.S. market, followed by pauses by both the Bank of Canada and the Fed have set up the possibility of a relief rally. Accordingly, we are keeping portfolio durations close to benchmark levels as we await more information on current inflationary pressures. If we are correct in believing inflation is not yet under control, we will look for an opportunity to reduce durations to more defensive levels.

We also believe the risk of a recession remains elevated given the need for rates to stay higher for longer and the less than robust pace of recent growth. As a result, we are being cautious regarding portfolio allocations to corporate bonds.