Market Commentary
The “magazine cover indicator” is a contrarian measure of market sentiment. Because editorial coverage often follows an established trend, prominent magazine headlines can coincide with periods when consensus expectations are approaching an inflection point. The Economist’s recent focus on risks in the bond market is noteworthy in this context.
While no single sentiment indicator determines an investment decision, several market developments support a constructive view of government bonds.
Strong equity performance and declining bond prices during the third quarter created allocation imbalances for investors managing portfolios against policy targets. Rebalancing could therefore support incremental demand for fixed income. One market estimate suggests U.S. pension funds alone may need to purchase approximately US$33 billion of bonds, with additional potential demand from other institutional and private investors. Government bond prices in Canada and the United States also showed signs of stabilizing in early October.
On a relative valuation basis, government bonds also appear increasingly attractive compared with equities, providing a further potential catalyst for investor reallocation.
Implementation of the U.S. Treasury’s proposed “Treasury Twist” has been limited to date. Although the reasons for the measured pace remain uncertain, the Treasury has policy tools available to influence issuance and market conditions. An anticipated reduction in issuance of longer-dated Treasury securities (20 years and beyond) could alleviate supply pressures at the long end of the curve. Additional Federal Reserve balance-sheet support is theoretically possible, subject to independent monetary policy decisions. However, the recent improvement in bond-market conditions may reduce the need for more extensive intervention.
Although U.S. deficits have attracted considerable attention, France faces its own significant fiscal challenges. Social expenditures and overall government spending account for a substantially higher share of gross domestic product (GDP) than in the United States. Long-standing pension and social programme commitments constrain fiscal flexibility, while efforts to reform these arrangements have encountered substantial political and public resistance.
As a member of the euro area, France cannot independently lower policy rates or devalue a national currency to mitigate fiscal pressures or restore competitiveness. Monetary policy is determined by the European Central Bank for the currency union as a whole. Consequently, fiscal adjustment may be more difficult, particularly if the euro remains elevated relative to France’s underlying economic conditions.
The 2009–2013 European sovereign-debt crisis provides a historical point of reference. Should French fiscal pressures intensify, European institutions and potentially the International Monetary Fund could become involved in a support programme requiring significant fiscal consolidation. Without independent monetary and exchange-rate mechanisms, such adjustments could carry meaningful economic and political costs.
Canadian labour-market data continue to signal deteriorating economic momentum. Employment declined by 68,300 in September, compared with expectations for an increase of 9,200. Combined with August’s loss of 41,700 positions, employment fell by approximately 110,000 over the two-month period.
Weakness extended across both full-time and part-time employment:
• Full-time employment: Down 35,400.
• Part-time employment: Down 32,900.
• Unemployment rate: Increased to 6.5%, from 6.4%.
• Participation rate: Declined to 64.8%, from 65.0%.
Declining labour-force participation alongside rising unemployment reinforces concerns about the underlying strength of the Canadian economy. A sustained slowdown, with elevated recession risk, would be supportive of long-duration Government of Canada bonds.
Renewed tensions in the Middle East supported higher crude prices and contributed to upward pressure on Canadian government bond yields during September. The long bond yield rose from 4.14% to 4.30%, while the two-year yield increased from 3.01% to 3.37%.
Despite the increase in yields, the Canadian yield curve flattened. The two-year to 30-year spread narrowed by 21 basis points, from 1.14% at the end of August to 0.93% at September month-end. Further flattening remains possible as economic conditions weaken.
The Canadian long bond outperformed its U.S. counterpart by 16 basis points on a relative-yield basis in September, with the yield differential widening from -1.10% to -1.26%. The Fund continues to favour long-dated Government of Canada bonds, both within the domestic yield curve and relative to U.S. long bonds, reflecting Canada’s comparatively stronger fiscal position.
The U.S. dollar appreciated against the Canadian dollar during September, with USD/CAD rising from 1.3854 to 1.4228.
The Canadian economy faces pressure from labour-market weakness, fiscal and trade uncertainty, and subdued domestic demand. Should slowing growth prompt the Bank of Canada to reduce policy rates, continued downward pressure on longer-term yields could support further yield-curve flattening. Such an environment would present capital appreciation potential for the Fund’s long-duration Government of Canada bond exposure.
Fund Performance and Positioning
The Tactical Sovereign Bond Fund maintains exposure to 30-year Government of Canada bonds, consistent with expectations for weaker domestic economic growth and lower long-term yields. Active management of the position has improved its average cost. At the end of September, the Fund’s duration was 6.9 years.
The rise in USD/CAD created substantially overbought technical conditions. The Fund resumed tactical long-U.S.-dollar trading while avoiding sustained exposure at elevated levels.
Series F returned -0.9% for the month, outperforming the benchmark by 28 basis points. Through the third quarter, Series F declined 2.8%, underperforming the benchmark by 30 basis points. Year-to-date the fund has declined 10 basis points, outperforming its benchmark by approximately 56 basis points.
Chart of the Month
Consistent with the contrarian sentiment framework discussed earlier, the Government of Canada long bond has exhibited a bullish technical price breakout, reversing September’s decline. Sustained follow-through would provide additional confirmation of improving price momentum.
Government of Canada 3.50% due December 2057 | Daily
Source: Bloomberg