Since the low levels reached 2 years ago, the yield on 10-year Canada bonds has more than doubled from 0.95% to 2.42%, but still remains below the lowest yield experienced during the Great Financial Crisis. Since the crisis, bond yields were pushed to historically low levels by extraordinary monetary policies of global central banks. These policies included zero or near zero short term interest rates and, in several cases, massive government bond purchases known as quantitative easing (QE). With growth finally recovering, the period of extraordinary stimulus is coming to an end. The Bank of Canada and the Fed have implemented several rate increases, with more expected to follow, and the Fed has begun to reduce its holdings of U.S. Treasuries and mortgage-backed securities. In the upcoming quarter, and subsequent ones, the Fed’s holdings will shrink by $50 billion per month, or an eye-catching $600 billion per annum. The accelerated reduction of holdings comes as U.S. fiscal deficits are growing sharply and more U.S. Treasuries will be issued to fund them. The combination should push U.S. bond yields higher. In addition, the European Central Bank is expected to end its QE programme in December, which should also reduce any downward pressure on yields. However, the ECB is moving very tentatively to reduce its monetary stimulus and will not raise interest rates before next summer. Still, the global reduction in QE should lead to rising bond yields. We are keeping the portfolio durations shorter than benchmark levels to reduce the impact of rising yields on valuations.

At present, 2-year Canada bonds yield 2.21%, while 30-year Canada’s yield 2.42%, a difference of only 21 basis points. The flatness of the yield curve suggests that the market is not anticipating further rate increases by the Bank of Canada, which we think is incorrect. The slope of the yield curve is also being affected by demand for long duration bonds by pension funds and life insurance companies that is not being satiated by new issue supply. 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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