The Canadian bond market enjoyed good gains in September, the result of a strong rally in the first half of the month. Weak job creation for the second consecutive month led to a rise in the unemployment rate and sparked speculation that the Bank of Canada would resume lowering interest rates. Bond yields declined and prices rose as investors anticipated a 25 basis point rate cut. On September 17th, the Bank delivered the expected reduction, and Canadian bonds held their gains over the balance of the month. Also on September 17th, the U.S. Federal Reserve lowered its interest rates by 25 basis points, its first reduction since last December. The FTSE Canada Universe Bond index rose 1.89% in September.

Shortly after Labour Day, we learned the Canadian unemployment rate had risen to 7.1% from 6.9% the previous month despite a decline in the number of Canadians working or looking for work (i.e. the participation rate). The higher unemployment rate was due to the net loss of 65,500 jobs in August, which followed a drop of 40,800 positions in July. Bond yields fell in reaction to the labour data and inflationary pressures that were not bad enough to stop the Bank of Canada from lowering rates. At 1.9% headline CPI inflation was benign and core inflation remained just above 3.0% but gave no indication of worsening. Under the circumstances, the Bank made a precautionary interest rate cut, although it believed a recession was unlikely. Subsequent data on Canadian GDP showed better than expected monthly growth although the year-over-year change was roughly half Canada’s potential growth rate.

In other news, the United States initiated the renegotiation of the CUSMA free trade agreement between Canada, U.S., and Mexico. Canada and Mexico subsequently started their own respective domestic consultations regarding the agreement. It was scheduled for review by July 2026, so the start of the renegotiation process was not a big surprise. What remains to be seen is what changes the U.S. wants given Trump’s erratic efforts to stimulate U.S. manufacturing and his willingness to apply sectoral tariffs contrary to the free trade agreement. Also in September, the federal government announced that on November 4th it would release its first budget since April 2024. The fourth quarter borrowing plans of the federal government showed a significant increase in net issuance of bonds that led some observers to predict that the federal budget deficit may balloon to $75 billion.

In the United States, the unemployment rate edged up to the still low rate of 4.3% due to higher participation and disappointing job creation. The weak labour report sparked a rally in U.S. bonds. More surprising a few days later was a revision to the estimate of job creation between April 2024 and March 2025 that showed 911,000 fewer jobs being created than previously thought. The revision slashed the average job creation from 150,000 per month to only 75,000 positions and raised questions about the ability of the U.S. economy to grow. The usefulness of the labour market data was already being challenged by the politicization of the Bureau of Labor Statistics, as well as the more stringent enforcement of U.S. immigration laws. In addition, the shutdown of the U.S. government that began as this is being written means statistics such as the unemployment rate, job creation, and Consumer Price Index will be temporarily unavailable.

The weak labour market data and the Bank of Canada rate reduction caused Canadian bond yields across all maturities to decline in September. The yield curve flattened slightly as 2-year yields fell 17 basis points while 10-year and 30-year yields declined 21 basis points. In the United States, there was more mixed reaction to the Fed’s rate move. Yields of 2-year Treasuries were unchanged at 3.62%, well below the Fed’s new 4.00% to 4.25% range, as investors had already anticipated multiple rate cuts. In contrast, the yields of long term Treasuries fell 19 basis points in September on concerns that U.S. economic growth was slowing.

The decline in Canadian yields caused bond prices to rise and propelled the federal sector to a return of 1.53% in the month. The provincial sector, which has relatively more long term bonds, earned 2.55% in the period. In addition to their longer average duration, provincial bonds also benefitted from a small narrowing of their yield spreads versus Canada bonds. The corporate sector gained 1.62% in September as strong investor demand pushed short and mid term corporate spreads tighter by 13 and 10 basis points, respectively. The decline in spreads came despite record new issue supply of $21.5billion in the month. It seems that with declining interest rates investors want any possible extra yield and are not sensitive to the risk/reward trade-off. Non-investment grade corporate bonds, though, earned only 1.09% in the period. Real Return bonds gained 1.75%, which lagged the results of duration-equivalent nominal bonds. Preferred shares had another good month, but trailed bond returns earning only 0.80%.

The Bank of Canada and the Fed will each announce their next interest rate decisions on October 29th. We believe both central banks will probably leave their respective rates unchanged but signal that they may lower their rates again in December. The Bank said that its decision to lower rates in September was a close one because it noted strong household spending and inflation that was not yet under control. With its overnight target rate already marginally stimulative, the Bank is likely to continue to move cautiously. As we noted in September, the Bank may wish to keep its powder dry and leave more room for easing in case economic activity slows substantially more. The Fed’s target interest rates, in contrast, remain somewhat restrictive. However, the U.S. economy continues to grow at a satisfactory pace, the inflationary impact of tariffs has not yet been fully felt, and the lack of key economic indicators due to the government shutdown may cause the Fed to be more cautious.

The trend to lower administered rates, even if it is at a gentle pace, leads us to maintain portfolio durations somewhat longer than the benchmarks. However, the massive fiscal deficits and resultant need for governments issue bonds poses a significant risk to the bond market. The Canadian government has announced plans to raise $53 billion of new bonds (net of maturities) in the fourth quarter alone, and any reluctance by investors will result in higher yields. If, on the other hand, Canada and the United States arrive at an agreement regarding trade and tariffs, we may see the Canadian bond market rally because the federal and provincial governments may be able to reduce spending on programmes to offset the negative effects of the U.S. tariffs.

The narrowing of corporate yield spreads in September reversed the previous month’s widening and left them at historically tight levels. Given the economic uncertainty, we do not believe the current level of spreads is properly compensating investors for risk. Accordingly, we are cautious regarding corporates and continue to look for opportunities to reduce credit risk.