The Canadian yield curve steepened in September as longer term yields rose more than short term ones. Yields of 2-year Canada bonds rose 2 basis points, while 5 and 30-year yields increased 11 basis points. The largest increase was for 10-year maturities, which increased 16 basis points. The pattern and size of yield changes was very similar to those that occurred in the U.S. bond market. The federal sector returned -0.54% as a result of the rise in yields and consequent declines in bond prices. The provincial sector fell -0.87%; provincial yield spreads were unchanged, but their longer average durations resulted in larger price declines. The corporate sector earned -0.49% in the period, as corporate yield spreads moved a few basis points wider. High yield bonds returned +0.44%, as they bounced back from weakness in the previous two months. Real Return Bonds fell 2.11% in September, as their very long durations resulted in larger price drops as yields rose.

We believe that the bond market may have set the low yields for the year at the end of August. With the Fed widely anticipated to end its bond purchases at its October 29th meeting, market attention will increasingly shift to the timing of the first rate increase in the United States. Fed officials have stated the obvious, that the timing of the rate decision will be dependent on the strength of the economy over the next few months. Stronger growth will result in an earlier move on interest rates, while slower growth will cause the Fed to delay rate increases. We anticipate that U.S. growth will remain strong, with GDP increasing by 3.0% or more for the next few quarters. As a result, we believe the Fed will begin to raise interest rates at either its March or June meetings next year. However, given the large market reaction to its musings about reducing quantitative easing last year, the Fed will likely avoid discussing rate increases as long as possible.

While the Bank of Canada will probably wait for the Fed to raise rates a couple of times before considering interest rate increases in this country, the Canadian bond market will continue to take direction from its U.S. counterpart. We, therefore, believe it prudent to position bond portfolios defensively, with durations sorter than their respective benchmarks. We are mindful, however, that the extraordinary monetary stimulus present in most developed countries is inflating the values of financial assets, including Canadian bonds. Demand for them remains strong because many central banks have overnight interest rates at close to 0.0%, and until at least some of the monetary stimulus is removed, we expect improving economic fundamentals will vie with easy money to determine the direction of bond prices and yields.

For much of 2014, we have emphasised mid-term maturities because they offered the best value along the yield curve. That strategy has benefitted the portfolios, but we are looking to reduce the overweighting of mid-term issues going forward. We are also selectively reducing the overweighting of the corporate sector, as yield spreads seem less likely to compress much further.

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