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October was an eventful month, with the U.S. federal government shutting down, Canada – U.S. trade negotiations temporarily paused following an Ontario TV ad featuring Ronald Reagan, and a truce agreed by China and the United States re their trade disputes. After trading sideways in the first week, bond yields dropped sharply when China and the U.S. ratchetted up their trade restrictions on each other. Also, bond investors were anticipating interest rate cuts later in the month. However, by the end of the month, Xi and Trump met and agreed to a yearlong truce in their trade dispute. Both the Bank of Canada and the U.S. Federal Reserve lowered their respective interest rates by 25 basis points on October 29th, in line with market expectations, but bond yields moved higher following the announcements. The FTSE Canada Bond Universe index rose 0.69%in October.
When the Bank of Canada and the Fed lowered their interest rates, the central banks tried to manage expectations regarding another rate cut at their next meetings scheduled for December 10th. The Bank stated that, if inflation and economic activity evolve broadly in line with its expectations, it “sees the current policy rate at about the right level.” In other words, the Bank did not expect to need to adjust interest rates again in the near term. Bank of Canada Governor Tiff Macklem also noted that some of the sectors that have suffered the greatest negative impact from the trade war are less interest rate sensitive, making monetary policy responses less useful. Bond yields had anticipated the possibility of another rate reduction in December, so the Bank’s announcement led bond yields to move somewhat higher as that speculation unwound. If, on the other hand, the Bank feels compelled to act because inflation or economic activity is substantially different than expectations, we would expect multiple rate moves rather than a single 25 basis point adjustment.
The Fed’s decision to lower its interest rates by 25 basis points was not unanimous. One voter wanted a larger reduction, while another voter preferred no cut. At the press conference following the rate announcement, Fed Chair Jerome Powell hinted at the amount of disagreement regarding the decision when he said “A further reduction in the policy rate at the December meeting is not a foregone conclusion. Far from it.” As had happened in Canada earlier in the day, bond yields moved higher as speculation about additional rate cuts was dampened, in this case by Powell’s comment.
Data received in October showed that the Canadian economy was continuing to struggle with the negative effects of the trade war. In August, Canadian GDP unexpectedly shrank 0.3%, versus forecasts that it would be unchanged. As a result, year over year growth slowed further to 0.7% from 0.9% the previous month. The negative news was somewhat improved by analysis that showed one-off items, such as the Air Canada strike and drought conditions reducing power generation by Hydro Quebec, were responsible for some of the weakness. More positively, the unemployment rate held steady at 7.1% as robust job creation offset a rise in the participation rate. Of concern, though, inflation was more rapid than expected as the year over year increase in CPI jumped to 2.4% from 1.9% the previous month. In addition, core measures of inflation that were already slightly above 3.0% edged higher still.
In the United States, the federal government shut down on October 1st as the Republicans and Democrats failed to agree on plans for spending. As a result of the shutdown, most economic data series were unavailable, making evaluating current economic conditions more difficult. Privately collected data on consumers suggested confidence was weaker based on the outlook for the economy and for the labour market. However, while hiring appeared to be weak, there was no evidence that the labour market was deteriorating. We note, though, the aggressive enforcement of immigration policies is making labour market analysis less straight forward. In other news, U.S. CPI inflation edged up to 3.0%, matching core measures of inflation, and giving no relief to the Fed that wants inflation to slow to 2.0%.
The Canadian yield curve shifted slightly lower in October with the yields of benchmark bonds of all maturities declining by 4 to 6 basis points. Yields had been lower prior to the Bank’s rate announcement on October 29th, but the “about the right level” comment caused them to jump roughly 8 basis points over the balance of the period. The U.S. yield curve underwent a similar shift in the month, with Treasury bond yields down between 2 and 7 basis points depending on term. Yields had been as much as 21 basis points lower prior to the Fed’s October 29th rate cut and Powell’s suggestion that a December reduction may not occur.
The federal sector returned 0.50% as lower yields produced small gains in bond prices. The provincial sector gained 0.92% in the month, as its longer average duration resulted in larger price gains. The provincial sector also benefitted from long term yield spreads narrowing 2 basis points. The corporate sector earned 0.70% as it too experienced a 2 basis point narrowing of long term spreads. Non-investment grade corporate bonds returned 0.63% in October and Real Return Bonds earned 0.39% on average. Preferred shares once again outperformed bonds this month, rising 2.24%.
Since July 2020, Canadian banks have been issuing Limited Recourse Capital Notes (LRCNs), a subordinated form of debt that is convertible into equity should the bank encounter severe financial difficulty. Approximately $40 billion LRCNs have been issued in the last five years, with the proceeds often used to redeem traditional $25 par preferred shares. Recently, we started seeing the original LRCN issues being redeemed by CIBC, Royal Bank, and National Bank as yield spreads have compressed and refinancing the LRCNs made more sense than extending them. Refinancing has meant new LRCNs have been issued with lower reset spreads and greater extension risk.
As this is being written, the federal government has released its long awaited budget. The deficit was projected to rise to $78 billion, much larger than the previous $42 billion forecast, but at the lower end of the $70 billion to $100 billion range of recent economists’ forecasts. Bonds initially rallied on the news that the deficit was not as bad as feared. Interestingly, the federal government does not expect to increase its bond issuance to finance the large deficit. In terms of economic impact, it will take a few quarters to properly evaluate the budget’s effect, but the increased spending as well as the previously announced reduction in income taxes may offer enough stimulus that the Bank of Canada is not compelled to cut interest rates again.
Barring a sharp, unexpected deterioration in economic activity, we believe the Bank of Canada and the Fed will leave their respective interest rates unchanged at their next scheduled announcements on December 10th. Consequently, we do not expect shorter term bonds to rally much from current levels. Longer term yields may fall temporarily as we approach December 1st when bond index durations typically extend.
Given the economic uncertainty, we continue to believe the current level of spreads is not properly compensating investors for risk. Accordingly, we are cautious regarding corporates and continue to look for opportunities to reduce credit risk.