For much of September, bond prices moved lower and yields rose as the bond market consolidated its gains of the last four months. However, a rally late in the month, driven by speculation of additional bond purchases by the U.S. Federal Reserve as well as duration hedging by Canadian insurance companies, erased most of the losses and left the broad market with positive returns. The DEX Universe returned 0.65% in the month.

In Canada, the Bank of Canada raised its overnight target interest rate by 25 basis points on its September 8th Fixed Announcement Date, the third consecutive increase since the central bank started its monetary tightening programme. In its accompanying statement, the Bank stated that it believed financial conditions remained extraordinarily stimulative. That prompted many investors to re-evaluate their expectation that the Bank would soon pause, and bond yields rose as a result. Canadian labour market data was also supportive of higher yields. While the unemployment rate rose to 8.1% from 8.0%, that occurred because the labour force surged by even more than the number of new jobs. In addition, the number of new full time positions, at 79,900, exceeded the 44,100 lower-paying part time jobs that were lost. Over the balance of the month, though, economic data tended to come in below expectations, and that led to concerns about the future pace of Canadian economic growth. In particular, the trade deficit widened sharply as exports to the United States slowed, and it was revealed that the Canadian economy actually shrank by 0.1% in July. The weaker growth trajectory, ongoing concerns about global economic conditions, and worries about the elevated levels of household debt in Canada, led the Bank of Canada late in the month to backtrack from its earlier comments and hint at a pause in its tightening cycle.

In the United States, economic data was similarly mixed. Crucially, though, unemployment remained stubbornly high and inflation quite low. This combination prompted the U.S. Federal Reserve to hint at potentially initiating another round of monetary stimulus. With short term interest rates already as low as possible, additional stimulus would have to come in the form of quantitative easing in which the Fed would try to force longer term yields lower. While the U.S. central bank didn’t provide details, many investors assumed the Fed would purchase outstanding U.S. Treasuries and that led to a sharp rally over the balance of the month, with bond prices rising and yields falling. Interestingly, not all investors were pessimistic about future economic growth and the need for further monetary stimulus; the S&P 500 stock index had one of its strongest Septembers on record as it surged 8.9% in the month.

The Canadian yield curve flattened noticeably in September. Yields on 2-year Canada bonds rose 17 basis points in reaction to the Bank of Canada’s rate increase, while 5-year bond yields also increased a small amount. In contrast, yields on longer term Canada bonds fell, with 30-year yields declining 9 basis points. While a strong rally in the U.S. bond market in the second half of the month contributed to the strength of Canadian long term bonds, a major factor behind the move appeared to be Canadian life insurers purchasing substantial long term holdings to better match their liabilities ahead of quarter-end.

In the United States, the yield curve actually steepened as shorter term bond yields fell slightly, while 30-year U.S. Treasury yields rose 16 basis points. The relatively small yield changes belied the volatility in U.S. bond market during September. A sharp selloff early in the month was followed by a strong rally as the market became increasingly fixated on the possibility of bond purchases by the Federal Reserve. As an indication of the volatility, the price of 30-year Treasuries fluctuated in a remarkable 8-point range during September.

Provincial bonds were the best performing sector in the month, returning 1.23%. In large part, the strong performance reflected the longer average duration of provincial bonds combined with the decline in longer term yields. However, provincial bonds also benefitted from an average 4 basis point narrowing of their yield spreads. Investor demand for provincial bonds was robust and the spread narrowing occurred even though $5.5 billion of provincial bonds were issued in the month. Corporate bonds were the second best sector in the month, returning 0.68%. Strong investor demand absorbed $5.4 billion of new corporate bond issues and corporate bond yield spreads still narrowed 3 basis points. Canada bonds were the worst performing sector as they returned only 0.31% in the period. The lower yield and shorter duration of federal bonds held back their returns this month.

In his first inaugural speech in 1933, U.S. President F.D. Roosevelt famously stated that “The only thing we have to fear is fear itself.” Just as excessive fear was an impediment to a recovery during the Great Depression, excessive caution in the current economic environment is slowing the recovery and distorting valuations in various markets. The bond market, in particular, has been driven in large part by fears that the American economy may fall back into recession, with the Canadian economy likely to suffer from a knock-on effect. Mid term Canada bond yields are currently hovering around the lowest levels seen in the depths of the recent recession in late 2008, while long term Canada yields have actually fallen to their lowest levels in over 50 years.

In our opinion, these yields are too low given the current economic environment and the likely path for future growth. The Canadian economy is neither in recession nor likely to soon re-enter one. Indeed, all of the production and jobs lost in the recent recession have been recovered. In the United States, the recession was deeper and the recovery has been slower, but economic growth remains positive. Unfortunately, the typical consumer is still rebuilding his or her balance sheet. In addition, mid-term election politics are preventing any legislative attempt to stimulate the economy. The housing sector remains depressed as the overhanging inventory of foreclosed homes depresses new home building and price appreciation. However, the sector has been stabilizing for a number of months and is much more likely to grow than shrink from current levels. Pent-up demand for new homes continues to grow. In addition, other cyclical sectors of the U.S. economy, such as manufacturing, are steadily improving. Capital spending on equipment and machinery is strong and, we believe, will soon lead to increased hiring as businesses need more employees to run the new equipment.

Another source of strength in the bond market over the last few months has been unprecedented levels of foreign buying of Canadian bonds. The last time that foreign investors were such an important factor in the Canadian market was 2003-2004, when Asian central banks were attempting either to manage their exchange rate or to diversify away from the U.S. dollar. Then, as now, it was impossible to predict exactly when the buying would stop. However, it was clear, as it is now, that it would not continue indefinitely. This time, when the buying stops, the demand/supply balance will shift and we expect that bond prices will decline.

A third reason for our cautious view of the bond market is the potential for a prolonged stock market rally to draw investors away from the safety of fixed income and back into risky asset classes. Corporate profitability has been improving and many firms are adding to already high levels of cash, which suggests stock valuations are increasingly attractive. At the margin, we would expect a shift toward stocks and away from bonds as the recovery proceeds.
In light of our concerns about current bond market levels, we have taken a number of steps to structure the bond portfolio. One of these steps was to reduce the duration of the portfolio to reduce the impact of rising yields. We anticipate using any market rallies in the coming weeks to further reduce the portfolio duration. Another step has been to structure the portfolio with substantial holdings of short term securities to protect from the impact of further rate increases from the Bank of Canada. While the Bank may choose to pause at its next Fixed Announcement Date on October 19th, we believe that it will ultimately raise rates several more times over the next year. The timing of those increases will depend on economic data, and we believe that the fourth quarter of 2010 will see acceleration in growth from the second and third quarters. A third way in which we are positioning the portfolio defensively is in its sector mix. We have de-emphasized low-yielding Government of Canada bonds in favour of higher-yielding corporate issues. In addition to the higher income from corporate bonds, their yield spreads remain wide by historical standards and thus offer potential for relative price gains. As well, with corporate credit conditions relatively favourable, an economic recovery characterized by moderate inflation, gradually rising yields, and a steepening yield curve generally leads to tighter corporate yield spreads. In the short run, some of these moves may modestly reduce returns, but in the long run they should help protect capital and position the portfolio to benefit from higher yields.