Canada : Good for the economy, bad for bonds

Good for the economy, bad for bonds 
A significant sell-off has taken hold of the U.S. bond market since mid-October. The yield of 10-year
Treasuries climbed from 2.38% on October 8 to 3.48% at the close December 14. Their return over the period was a negative 7.88%. The sell-off gained momentum from President Obama’s compromise tax plan, which would add about $900 billion to the federal debt over the next two years if approved by Congress in its
original form. Bond traders got shivers down the spine from the impact of Mr. Obama’s proposal on borrowing requirements and from the lack of any medium-term plan to get the U.S. fiscal house on a sustainable longterm path. Furthermore, a stronger economic growth outlook was also pushing up long-term real rates.

Since November 3, when the FOMC announced the details of QE2, the real yield to maturity of 10-year
Treasury Inflation Protected Securities (TIPS) has risen 80 basis points at this writing compared to 90 basis
points for nominal bonds.

Given the amplitude of the correction, we do not exclude the possibility that the 10-year yield has gotten ahead of itself. But while some short-run consolidation cannot be ruled out, on the back of the Fed potentially buying up to $63 billion of Treasuries between December 16 end year-end, our fair-value model suggests that
investors should be cautious.

We are confident that the combination of the fiscal stimulus Congress is likely to adopt and Fed monetary
stimulus will lead to significant improvement in the U.S. labour market in the coming months. We now expect
economic growth of roughly 3% in 2011 and slightly more than that in 2012. If we are right, the fear that the

U.S. will find itself on the deflation path followed by Japan will be replaced in 2011 by renewed talk of
whether the FOMC will get its exit strategy right. The yield curve is being shifted up not only by expectations
of stronger GDP growth but also by a 2011 borrowing requirement that could be roughly $300 billion higher
than was expected back in November.

According to the Flow of Funds Accounts, outstanding Treasury securities increased $1.4 trillion over the 12-
month period ending in Q3 2010. A look at who financed the U.S. deficit shows that households provided 32% of the Treasury borrowing, a significant increase over the previous year. Foreigners were also large lenders but accounted for a smaller share than last year.

Looking forward, the Fed with its planned purchase of $600 billion in Treasuries will be a significant source of
funds. On the other hand, if economic momentum remains supportive of higher interest rates in 2011, it
can be questioned whether household appetite for Treasuries will be as strong next year as it has been
recently. The same could be true for pension and retirement funds. Further, if European leaders agree to
change the European Union treaties to create a permanent financial rescue system for the euro zone,
the U.S. dollar could resume its downtrend, making Treasury holdings less appealing to foreigners.

Bottom line:  Although when QE2 was introduced it seemed large enough to make a significant dent in the
10-year yield, the proposed fiscal stimulus means that borrowing requirements are likely to be considerably
larger than market participants assumed at the time.

Meanwhile, the economic and inflation outlook will become less supportive of low interest rates. When

these considerations are factored in, our fair-value model suggests that 10-year Treasuries will be trading
around 3.48% in Q1 2011 and heading to 4.17% by the end of 2011. In other words, the Treasury may not find it as easy to tap the pool of private funds as it did in 2010. We expect increased volatility around auction

… and in Canada 
In December the Bank of Canada kept its overnight rate unchanged at 1%. It is true that the Canadian
recovery appeared slightly weaker than expected and that U.S. domestic demand was picking up only slowly.
But a dominant reason for not raising the policy rate was increased risk to global financial stability from
sovereign debt concerns. Not only was this risk noted in the rate-setting statement, but the December 2010
issue of the Bank’s Financial System Review put it at the top of the list of risks to the Canadian financial
system. Also identified as contributing to overall risk was a growing vulnerability of households due to rapid
expansion of credit in an environment of low interest rates. The Bank could have leaned against personal
credit expansion by raising its target rate. It chose instead to keep considerable monetary stimulus in place. The choice showed which systemic risks really keep Mr. Carney awake at night.

In early December, according to the Financial Times, credit default swap prices were implying five-year
default risks for Greece, Ireland, Portugal and Spain of 54%, 38%, 31% and 23% respectively. In light of these odds and discussions among European leaders for a permanent mechanism for emergency funding to
countries facing liquidity problems, we expect that the odds of disruption of the global financial system will
fade as European finance ministers deliver on their commitments to fiscal responsibility. Such a development would allow the Bank of Canada to refocus on domestic factors in setting its target rate. In the meantime, the Bank is reaping the benefits of its well-established credibility on the inflation front. While waiting to see how the debt problems of the euro-zone periphery play out, the Bank has so far been able to keep its overnight rate below 12-month core inflation without creating undue pressure at the long end of the yield curve.

Back in October the Bank downgraded its 2011 growth projection for the Canadian economy to 2.3% from
2.9%. This revision reflected its expectations of a deceleration in household expenditures and of weak U.S.

demand for Canadian goods. At the time it had just cut its 2011 U.S. growth forecast to 2.3% from 3.0%. Since then, however, the U.S. political environment has evolved quite significantly. President Obama’s initiative on the fiscal front could force the Bank to reassess its policy stance.

The White House compromise with the Republicans, if approved by Congress, is likely to lift GDP growth by 0.5 to 0.7 percentage points in 2011. Moreover, the unwinding of fiscal stimulus in Canada is likely to be
somewhat more gradual than the Bank expected in October. Finance minister Jim Flaherty recently suggested that he will extend funding for nearly completed infrastructure projects beyond the original March 31 deadline.

It will take time to see how much lift the U.S. economy gets from QE2 and from Mr. Obama’s fiscal package. However, we think our trade balance will benefit and further withdrawal of monetary policy stimulus is likely to come sooner than we assumed a month ago. At this stage, we think the Bank will use its April Monetary Policy Report to set the stage for a resumption of rate hikes in May rather than in July as we previously forecast.

However, in an environment where large international imbalances persist, our central bank will have to keep an eye on international developments as it removes monetary stimulus. This suggests to us that along the way
to an higher overnight rate, the Bank is likely to take several pauses to assess economic and financial trends at home and abroad.

Although monetary policy normalization will be felt more strongly at the front end of the curve, long bonds will also feel some added pressure from a softer U.S. bond Provincial revenues got a boost from stronger-thanexpected GDP growth coming out of the last recession.

Quebec and Ontario each reported budget deficits about $1 billion lower than previously estimated for the fiscal year ended last March 31. This month we have revised up our Canadian GDP growth forecast for 2011. We now expect the economy to grow 2.8% from fourth quarter to fourth quarter, up from 2.1% previously. Much of the upgrade is due to upward revision of external demand. A decent economic outlook for next year leaves us confident that provincial public finances are generally likely to improve further. With current provincial spreads to Canadas still wide by historical standards, we think there is room for further spread compression.

Although corporate bonds significantly underperformed comparable Canadas during the second quarter of 2010, they have added value year to date. From December 31, 2009 to December 14, 2010, long corporates generated a total return of 10.58% compared to 8.64% for long Canadas. For maturities of 5 to 10 years, corporates have returned a total of 6.56%, or 122 basis points more than comparable Canadas. Though supply headwinds could arise from large refinancing needs around the world, our economic scenario and equity-market expectations remain supportive of the corporate bond market.

Bottom line: The North American economic outlook has evolved quite significantly since Mr Bernanke opened the door to QE2 back in August. We now expect that the combination of a second round of quantitative easing and fiscal policy stimulus will lead to a considerable improvement in the U.S. economy and labour market. The bond market may have turned around abruptly in the last two months, but the 10-year Treasury yield is still no  higher than it was when the economy was emerging from the great recession. Under these conditions we think interest rates across the yield curve will be higher 12 months from now. Given this outlook, we will seek opportunities to bring portfolio duration shorter than benchmark duration. Still, healthy financial positions and sustained economic growth argue for a continuing overweight position in corporate and provincial bonds.
Full report: Canada : Good for the economy, bad for bonds