The Canadian market enjoyed another strong monthly return, with the DEX Universe index gaining 1.81% in September. Ongoing uncertainty emanating from the European debt crisis and concerns about slowing global economic growth prompted investors to shift from risky asset classes, such as equities, to more secure ones, such as bonds. As well, the U.S. Federal Reserve announced another monetary stimulus programme, nicknamed Operation Twist, that triggered a substantial rally in longer term U.S. Treasury bonds and caused longer term Canadian bond prices to also rise.
Canadian economic data was mixed. Unemployment ticked up to 7.3% from 7.2% as job creation was weak. Inflation reversed the previous month’s decline, rising to 3.1% from 2.7%. On the positive side, Canadian GDP grew 0.3% in July, following a small decline in economic activity during the second quarter that was thought due to temporary factors. At its rate setting meeting, the Bank of Canada left its overnight target interest rate unchanged at 1.00%. In light of the deteriorating global economic outlook, the Bank felt there was less need to withdraw monetary stimulus (i.e. raise interest rates).

U.S. economic data was also mixed, but on balance was more positive than expected given the steep declines in confidence the month before. Industrial production grew more rapidly than forecast, with particular strength in the manufacturing sector. Investment by businesses in new plant and equipment was strong. Retail sales grew in August, notwithstanding the sharp drop in consumer sentiment surveys. Indeed, the consumer surveys rebounded slightly from the steep drops the previous month. As well, there was some indication that consumers were no longer as focussed on paying down debt, because consumer credit grew by the fastest rate since April 2008. If the deleveraging process is, in fact, ending, it suggests that consumption should start to increase, which would be positive for U.S. economic growth. Less positive data showed that job creation stalled during the uncertainty of August, although the unemployment rate held steady at 9.1%. Also, the housing sector remained weak.

With rising concerns that global growth was slowing and no prospect of further fiscal stimulus given the political deadlock in Washington, the U.S. Federal Reserve decided to try to stimulate economic activity by lowering long term borrowing costs. To do this, they announced that they would sell $400 billion of their short term U.S. Treasuries (i.e. issues with less than 3 years remaining to maturity) and reinvest the proceeds in longer term Treasury Bonds. It was hoped that the large scale purchases of longer term bonds would increase their prices and lower their yields. Nicknamed Operation Twist after a similar plan fifty years ago, the scheme had been rumoured for weeks with considerable speculation about the term of the bonds that the Fed would buy. In the event, the Fed surprised the market by announcing that almost 30% of the purchases would be of 30-year bonds. Most observers had expected much fewer 30-year purchases and the Fed’s plan caused a sharp rally in long term bonds.

In implementing Operation Twist, the Fed chose to ignore some of its potential negative consequences. The first potential problem is that lowering long term yields would cause the yield curve to flatten. That will likely put downward pressure on the U.S. banking sector which typically borrows short and lends long. A steep yield curve generally increases U.S. bank profitability, while a flatter curve diminishes it. At a time of rising concerns about a potential credit crisis, reducing bank profitability is not a good thing. The second potential problem arising from Operation Twist is that it puts considerable strain on pension funds, because by lowering long term yields it raises the present value of the funds’ liabilities. With equity holdings losing money this year, pension funds will have considerable strain on their surpluses as liabilities rise. To fund the rising pension liabilities, corporate sponsors may have to reduce their spending in other areas including capital spending and hiring.

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