In China, the once-a-decade change in the country’s top leaders occurred in November. While there was much speculation about the likely policy initiatives to come from the new decision makers, it will take a few months to determine if there will be substantive changes in direction for the world’s second largest economy. For the time being, though, Chinese economic statistics during November suggested that the economy had stopped decelerating and the pace of growth was stabilizing. With a number of indicators, including industrial production, retail sales, and export growth actually surprising to the upside, it appeared that China might resume its role as a major engine of global growth. That would be positive for the Canadian economy given the direct trade links with China, but also from the indirect benefits for other trading partners. Stronger growth in Canada and globally would likely be negative for bonds.

The Canadian yield curve flattened somewhat in November. Yields of benchmark 2-year Canada bonds edged down by a basis point, while 10 and 30-year yields moved 9 basis points lower. International investors buying Canadian bond futures were a significant factor behind the strength of 10-year bonds, while domestic investors anticipating index duration extensions in December helped bolster 30-year bonds. The DEX Universe index duration was expected to lengthen 0.08 years as short issues fell out of the index, while the DEX Long Term Bond index duration was forecast to rise a more significant 0.22 years.

Federal bonds returned 0.53% in the month, benefitting from the decline in yields. The provincial sector earned 0.61% in November. The beneficial effect of longer average durations was offset by wider yield spreads brought about by relatively heavy issuance of $7.9 billion of provincial bonds in the month. In contrast, corporate bond issuance was relatively light at $3.9 billion. As a result, corporate yield spreads narrowed slightly, helping the sector to return 0.78% in the period.

Looking ahead, the negotiations regarding the U.S. fiscal cliff are likely to dominate the markets in December. We expect a long, painful decision process that will be followed by significant fiscal austerity in the United States. Some forecasters dismiss the economic damage from the cliff. In their view, it will be resolved at the last second and the markets will quickly realize it was a non-event. This ignores the fact that, unlike past brinkmanship moments, the cliff ends with significant fiscal tightening. Without any agreement, the scheduled tax hikes and spending cuts will reduce U.S. GDP in 2013 by roughly 5% and cause a serious recession. Any compromise, whether it is reached in December or in the New Year, will not totally eliminate austerity. Our best guestimate is that the fiscal drag from an agreement will amount to at least 2% of GDP, taking the U.S. economy close to, but not into, recession. However, one benefit of an agreement to limit the fiscal cliff would be to reduce the uncertainty that has been slowing job growth and capital investment by businesses. A pick up in hiring once the uncertainty of the fiscal situation is resolved would help underpin the housing recovery.

International headwinds and growing domestic fatigue will keep Canadian GDP growth below its trend rate through the end of the year and into early 2013. The prospects for the Canadian economy are tied in large part to events outside of its borders and will require at least a partial detour around the fiscal cliff in the United States, a continued stabilization across emerging market economies, and for the European sovereign debt crisis to remain more or less contained. The Bank of Canada, in our opinion, will not raise rates until at least the second half of 2013. In addition to the subpar pace of growth, the Bank will want to avoid causing the Canadian dollar to strengthen further and hurt the competitiveness of our export sector.

Canadian Exchange Rate vs Oil Prices

Barring a major surprise in the U.S. fiscal negotiations, we expect the Canadian bond market to remain in its trading range for at least another month or two. We will adjust duration tactically as bond prices move within that range. From a sector perspective, corporate bonds remain favoured, but we have reduced their allocation because the rally in yield spreads this year has made their valuations less compelling. Provincial yield spreads have not kept pace with corporate ones, so they have become relatively better value. The allocation to the provincial sector, which has already risen, will likely move higher still in the near term.

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