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The Canadian bond market fluctuated significantly in October, as it adjusted to the impact of the U.S. government shutdown, as well as changes in tone from both the Bank of Canada and the U.S. Federal Reserve. Yields rose steadily in the two weeks of October, but sharply reversed course over the balance of the period to finish lower on the month as a whole. The DEX Universe Bond index returned 1.05% in October.
Canadian economic news during October was generally good, but not great. Growth in Canadian GDP was slightly stronger than expected but, at 2.0%, the year-over-year increase was too slow to make much of a dent in Canada’s output gap. Unemployment fell to 6.9% from 7.1%, but the improvement was due mainly to a drop in the participation rate to 11 year lows as 21,400 workers aged 15 to 24 left the labour force. Retail sales grew modestly and the housing sector remained stable. Inflation was steady at 1.1%, near the bottom of the Bank of Canada’s target range. A key development in the month came when the central bank announced it was not changing interest rates from the levels established three years ago. That was not a surprise, but in its statement the Bank of Canada removed mention of the likelihood that rates would eventually move higher. The Bank also revised lower its forecasts of Canadian growth and indicated that it was concerned that inflation was staying so low. Investors reacted to the Bank’s statement by revising their expectations for interest rates to remain lower for longer, resulting in a rally in bonds, particularly for short and mid-term maturities.
In the United States, substantial disagreements between Republicans and Democrats on the federal budget deficit led to a 17-day partial government shutdown and threatened a default by the U.S. Treasury. While the shutdown ended with a temporary funding measure that will last until early 2014, its economic impact is difficult to assess. As a result, it is more difficult than normal to determine the underlying strength of the economy and how that will affect monetary policy. Even before October 1st, some businesses and consumers reduced spending as precautionary measures. During the shutdown, some 800,000 federal civil servants plus uncounted private sector employees were on furlough, not earning a paycheque. In addition, suppliers to the federal government were not paid during the shutdown. As a result, economic measures are expected to show weakness for the month of October, although the severity is difficult to quantify. The experience of past shutdowns suggests, however, that any weakness will be short-lived, and the effects eliminated within a quarter.
The impact in the bond market of the shutdown and the risk of default was not entirely consistent. During September, the acrimonious fiscal debate had been one of the reasons that the bond market rallied, because investors anticipated economic weakness and also there was a perverse flight to quality. Oddly, some investors bought U.S. Treasuries because they feared the chaos that would result if those same Treasuries defaulted. Subsequently, in the first half of October, bond prices declined because more focus was given to the potential for default than for economic weakness. Threatened default apparently caused some investors to delay buying U.S. Treasuries. When the default was averted, that sparked a buying spree primarily by international investors that pushed bond prices higher over the balance of the month.
One of the reasons that the pace of economic growth was so closely watched in October was that it was likely to determine when the Fed would begin to taper its bond purchases. At its September meeting, the Fed had delayed tapering because it was concerned that underlying economic growth was not yet self-sustaining. Until growth improved, investors believed that the Fed was likely to leave its bond purchases unchanged. A consensus soon developed that the Fed was unlikely to start tapering before March. However, at its October 30th meeting, the Fed’s statement of its policy was less dovish than expected and bond prices began to decline again as investors discounted the possibility that tapering could begin as soon as December.
The Canadian yield curve steepened slightly during October as 2-year Canada Bond yields fell 9 basis points, while 30-year yields declined 6 basis points. Mid-term bond yields experienced the greatest volatility in the month, with both 5 and 10-year Canada Bond yields fluctuating in wide 24 basis point ranges. Eventually, 5-year yields finished 15 basis points lower on the month, as the lower for longer view of interest rates made the bonds appear attractive. Declining yields across the curve helped propel federal bonds to an average return of 0.84% in the period. Provincial bonds earned 1.19%, as their longer average durations resulted in larger price gains as yields fell. Provincial yield spreads were marginally tighter in short and mid-term maturities and marginally wider for long term issues. Corporate issues returned 1.19%, benefitting from good investor demand that caused their yield spreads to tighten by 3 basis points. BBB-rated issues returned 1.49%, thereby outperforming both higher rated issues and lower rated ones. High yield bonds lagged investment grade issues, earning only 0.71% in the month. Corporate new issue supply was fairly strong at $8 billion, with banks, REITs, and infrastructure companies raising most of the financing. Real Return Bonds earned 2.48% in the month, as bargain hunting appeared to occur as well as new demand from foreign central banks. The year-to-date return of RRB’s is still awful at -9.59%.
We believe that the bond market is establishing a trading range as investors await a clearer picture of economic growth, particularly in the U.S. The Fed has indicated that it is data-dependent regarding changes to its quantitative easing programme, but with the next month’s supply of economic news likely to be distorted by the partial government shutdown, a clear picture of underlying economic strength may not emerge until December. Until then, we anticipate that bond prices may drift lower as any signs of weakness will likely be attributed to the shutdown, while stronger than expected data will be attributed to the underlying strength of the economy, which should have more influence on the timing of the Fed’s tapering. Portfolio durations are currently shorter than the benchmarks in anticipation of potential weakness. However, as noted above, we believe the market is now in a trading range and we will look to use the expected weakness to move closer to benchmark durations. We are also mindful of the bond market’s seasonality; November and December often experience bond market rallies as liability driven investors try to adjust their portfolios prior to year-end and index followers need to add duration to match index duration extensions that occur every December. (This December, the DEX Universe is forecasted to extend approximately 0.15 years.)
Looking at relative value along the yield curve, we believe the rally in shorter term bonds that was driven by the Bank of Canada’s more dovish outlook is overdone. The removal of the warning about higher rates in the future was long overdue inasmuch as it had appeared in over two dozen consecutive statements. In addition, for some time, we have believed that Canadian economic growth has been tepid and would only grow more rapidly if external demand results in greater exports. In other words, we need the U.S. to grow faster if we are to improve. Fortunately, the underlying pace of economic growth, excluding the fiscal headwinds, we believe is about 3.5% per annum. That should be sufficient to generate increased demand for Canadian goods. In addition, global growth appears to be turning gradually better: China’s growth has stabilized at approximately +7.5%, Europe is tentatively emerging from recession, and a number of emerging market economies are accelerating. Better global growth should bode well for Canada. As a result, we believe that shorter term yields will begin to move higher again, and we are shifting to better values in mid-term maturities.
At this stage in the economic cycle, corporate creditworthiness is generally good. With yield spreads at relatively attractive levels, corporate bonds are our preferred sector. However, we are monitoring individual issuers’ creditworthiness carefully and remain cautious regarding the Canadian housing market as well as Europe.