Globally, the European sovereign debt crisis continued with no resolution. Politicians failed to develop a consensus on how to resolve Greece’s funding needs and the repeated delays led to substantial volatility in European equities, especially bank shares, as investors anticipated the potential impact of a Greek restructuring. Fears that some European banks might suffer substantial losses caused substantial volatility in global bank stocks and raised concerns about another credit crisis developing as investors increasingly shun lending to any bank that might have direct or indirect exposure to the weak European debtors. Weakness in bank shares led global equity markets to substantial losses in September. As well, austerity measures introduced by virtually every European country will slow economic growth in the region and, in some cases, result in recessions and this realization led to further equity losses. The S&P/TSX fell 8.7%, while the S&P 500 dropped 7.0%.

During September, in addition to the prospect of European austerity measures dampening economic growth, markets were concerned about the potential of a “hard landing” in the Chinese economy. In efforts to reduce inflation and dampen real estate speculation, Chinese authorities have been gradually raising interest rates and bank reserve requirements this year, and recent economic data suggested that the measures might finally be working. With China estimated to have produced 38% of the world’s growth so far in 2011, investors worried that the tightening programme might lead to a sharp slowdown in growth in that country that would materially impact global economic activity.

The Canadian dollar fell 7% against its American counterpart in September. The value of the Loonie has historically been correlated to commodity prices, so the decline in prices for most commodities in the month led to a sharp selloff in the exchange rate. Canadian Exchange RateShould the current level hold for the Loonie, it would be stimulative for Canada’s export sector, but put some upward pressure on inflation because of higher import prices.

The Fed’s Operation Twist announcement capped a remarkable rally in 30-year U.S. Treasuries in September. Prices of the longest term Treasuries finished 13.5% higher than a month earlier, and their yields dropped an astonishing 67 basis points. Volatility was quite high, with at least three days experiencing price swings of 4 points or more. Yields of 10-year Treasuries declined a more muted 28 basis points, while 2 and 5-year yields rose slightly. Thus, the Fed enjoyed almost instant gratification in its quest for a flatter yield curve and lower long term yields. In Canada, long term bonds followed the lead of U.S. bonds, although the price and yield changes were more subdued; yields on 30-year Canada bonds fell 33 basis points in the month. In contrast with the U.S. experience, though, yields on 5 and 10-year Canada bonds fell by a similar amount to the shift in long term yields, as investors sought the perceived safety of fixed income of any duration. Yields on 2-year Canada bonds declined only 20 basis points, as the Bank of Canada’s overnight target acted as an anchor to shorter term yields.

The large drop in long term yields was exacerbated by the reaction of mismatched pension funds and life insurance companies. The drop in long term yields meant, if it was not reversed, that the present value of future liabilities had risen and surpluses had shrunk. As a result, there was a scramble to add duration during September and avoid further losses. In some cases, the duration was added through bond purchases. In other cases, the funds and insurance companies used interest rate swaps, because they were reluctant to sell assets such as equities that had declined in value. The demand to receive fixed payments on long term interest rate swaps was so strong that the spread over Canada bond yields briefly declined to negative. In other words, the investor was willing to receive less than the yield on Canada bonds for the same term. Given that swaps involve counterparty risk, the use of the swaps meant higher risk and lower returns than government bonds, suggesting a measure of desperation on the part of the participants.

Provincial bonds had the best returns as a sector, gaining 2.56% in the month. The strength of those gains was due to the longer average duration of provincial bonds combined with the sharp drop in long term bond yields. The gains were, in fact, tempered by yield spreads for mid and long term provincial issues widening by an average 8 basis points as investors sought to reduce risk of any sort including provincial credit risk. Federal bonds were the top-performing sector on a duration-adjusted basis, earning 1.73% in September. Of particular note, long term Canada bonds returned 4.81% in the period. The corporate sector lagged both government sectors, returning only 1.19% in the month. Corporate yield spreads increased as investors concerns about a possible credit crisis and potential recession. Mid term corporate yield spreads rose 17 basis points on average, while long term yield spreads increased only 9 basis points. Overall, the widening in spreads was led by financial issues, because they were thought most likely to be adversely affected by a credit crisis; the relative lack of longer term financial issues accounted for the smaller shift in longer term spreads. For some less liquid, higher risk segments such as U.S. banks and investment dealers, the spread widening was much greater. Issuance of new corporate bonds, at $2.7 billion, was down 65% from the $7.8 billion raised in September 2010 as investors and issuers adjusted to wider spreads and the market volatility. Real Return Bonds earned 1.65% in the month, only slightly less than the nominal DEX Universe returns. However, on a duration-adjusted basis, RRB’s failed to keep pace with nominal bonds because expectations of slower growth led to reduced inflationary concerns.

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