Bond Market Update, July 6, 2006
Is the Fed done? After seventeen consecutive increases of 25
basis points spanning over two years, we believe that the Fed
has done enough and can head for a summer holiday awaiting
the next series of economic data. Monetary policy has a long
lead time, and with the US housing market now weakening and
consumer spending and confidence next to go, it is prudent for
the Fed to pause here rather than risk an overshoot and thus
heighten the risks of a recession. So far, the latest hike in the
Fed Funds rate and the somewhat dovish remarks that
accompanied it have buoyed market sentiment. The US yield
curve has flatlined; from overnight rates to 30 year bonds,
everything is trading within hailing distance of 5.25%.
Importantly, corporate spreads have begun to widen as the
specter of economic slowdown becomes visible.
In Canada, it is all sweetness and light. The Bank of Canada
says it is on hold despite a series of strong economic releases.
Our view is that our Central Bank will take the summer off
and then review the situation. By then, we expect that there
will be clear evidence of deceleration in North American
economies under the weight of cumulative monetary tightening
to date plus the deflationary impact of the spike in oil prices.
OUTLOOK
In Canada, two year Canadas are trading 20 basis points
above the Bank Rate, signaling that the market has a small
conviction of another rate hike on July 11.
As to the market, long term bonds are deeply oversold and
thus, some kind of dead cat bounce is likely but any such rally
will be limited by ongoing concerns re inflation. Any serious
rally will await clearer signs that the Central Banks in North
America are finished and that monetary easing is in sight.
The Canadian dollar will continue to benefit from our triple
surpluses, merger activity and strong resource sector
conditions. We continue to believe that parity is in sight for our
currency.
Elsewhere, it seems likely that the European Central Bank and
the Bank of Japan will be raising rates. A worrisome trend for
the US bond market is the marked reduction in purchases of
US Treasury bonds by foreign investors, another factor
inhibiting any rally.
STRATEGY
We favour a strategy of extending duration, especially given
the flat nature of the yield curve. A decline of 50 basis points in
long term yields over the next six to twelve months will
produce above average returns.