The Canadian bond market rebounded in November from weakness the previous month. Bond investors had to digest several significant news events in the month, including the US elections, the change in Chinese leadership, slower Canadian growth, the unexpected departure of Bank of Canada Governor Mark Carney, and developments in the ongoing European sovereign debt crisis, but the market remained within the trading range first established in August. The DEX Universe gained 0.62% in the period.

In Canadian economic news, we learned that GDP grew at only a 0.6% annual pace during the third quarter. However, the disappointing rate of growth reflected a rapidly deteriorating trade balance more than soft domestic conditions. Weakness in net exports (the difference between exports and imports) removed a full 3.0% from GDP growth in the quarter. Other data, though, pointed to softer domestic conditions: job creation was anemic in the most recent month and retail sales were weaker than expected. While some data were more positive, such as higher exports in the most recent month, on balance the Canadian economy appeared to have entered a slow growth phase, putting little pressure on the Bank of Canada to raise interest rates for several months. This was supportive of modestly higher bond prices.

In a surprise move in November, it was announced that Mark Carney would become the next Governor of the Bank of England. Mr. Carney will remain in his post at the Bank of Canada until June 2013, before heading to England. He is highly regarded in both Canada and internationally, so his decision to leave is viewed as a loss, but is it problematic for Canada and for its bond market? We think not. Mr. Carney is often given credit for Canada’s enviable performance during and since the financial crisis, both in terms of economic growth and the strength of the Canadian banking sector. However, the foundations of both predated his arrival at the Bank of Canada in February 2008. As a result of housing policy and financial sector regulation, Canada did not suffer the property bust that forced many countries to bail out their respective banks. In addition, Canada’s banks have been required to keep higher capital levels than those in many other countries for several years, cushioning the impact of economic downturns. The Bank of Canada did cut rates aggressively and promise to keep them low for a year under Mr. Carney’s watch, an appropriate response to the economic downturn. However, when the Canadian economy was recovering, the Bank raised interest rates only a little before stopping. Given that Canadian household debt levels have been identified by many observers, including the Bank of Canada, as the greatest risk to Canadian economic wellbeing, it is puzzling that the Bank would leave interest rates at such stimulative levels and then complain that consumers were actually taking advantage of the low cost of credit. While Mr. Carney is clearly intelligent (and ambitious), we do not believe his departure will have substantial impact on Canadian markets.

In the United States, the elections finally occurred, with little significant change. Barak Obama was re-elected president, while the Democrats retained control of the Senate and the Republicans the House of Representatives. At the margin, the Republican Party lost seats in both the Senate and the House, as well as failing to gain the White House, but the net result was probably not enough to have substantial impact on the negotiations to avert the fiscal cliff that resumed shortly after the elections. The initial market reaction to the election results was a sharp selloff in equities caused by concerns about higher taxes and the need to realize capital gains before yearend. Bond prices rose as stock prices fell, but by mid-month equities began to recover and bonds fell back.

With regard to the American economy, the estimated pace of growth during the July to September quarter was increased to 2.7% from the earlier estimate of 2.0%. While seemingly good news, the sources of higher growth were less promising for future economic activity. Most of the increase came from government spending, mainly for military items, and companies stockpiling inventory. Consumer spending as well as business investment in equipment and software were less than originally thought. Data on the U.S. economy during the current quarter has been more difficult to interpret because of the disruption caused by Superstorm Sandy. Unemployment claims rose immediately after the storm, but quickly began to recede toward pre-storm levels. Retail sales and industrial production were also weaker in the aftermath of the storm, but it will take another month or two to determine whether the slowdown was a temporary one due to the storm or the start of wider spread economic weakness. On the positive side, the housing sector continued its grinding recovery. Housing starts climbed to the highest level in over four years, and home prices rose 3% on a year-over-year basis.

Internationally, the European Union continued to struggle to resolve the Greek debt crisis, without setting unwelcome precedents should other member countries, such as Spain, also need to be bailed out. The International Monetary Fund, which has been funding a third of the emergency funding to Greece, finally demanded that the current approach be amended to produce a more credible long term solution. In particular, the IMF wanted to see a plan to actually cut Greece’s debt levels to 120% of its GDP, which was viewed as a sustainable amount. To do that, European agencies including the European Central Bank would need to write off a portion of the Greek debts they held. In the end, an agreement was reached to extend the term of Greek loans and sharply reduce the interest rate charged. German Chancellor Angela Merkel even hinted at a new willingness to accept losses on some Greek debt. The focus on Greece during November meant there was little progress on trying to restart the European economy. Unemployment in the EU rose to new highs, as the recession in the region deepened. Canadian bonds once again benefitted from their safe haven status, as investors sought to diversify away from the seemingly intractable problems of Europe. International buying of Canadian bonds remained strong, with the most recent month’s data showing over $9 billion of net purchases.

Foreign Purchases of Canadian Bonds

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