INTEREST RATES AND BONDS – 4TH QUARTER 2016 FIXED INCOME COMMENTARY

“Last year we said, 'Things can't go on like this', and they didn't, they got worse.” ~ Will Rogers

Interest Rates and Bonds: After peaking in the summer, the bond market’s direction has decidedly deteriorated. In December the US Federal Reserve started its widely expected tightening by raising the Fed Funds rate 0.25% to 0.50%. Further interest rate hikes will likely proceed at a moderate pace as dictated by economic conditions. According to the commentary emanating from Federal Reserve governors and other pundits indicates that the consensus view is that historical interest rate lows are behind us.

interest rates bond market direction deterioated

Interest Rates and Bonds – After peaking in the summer, the bond market’s direction has decidedly deteriorated.

Mr. Trump's unexpected election win is causing some uncertainty as to the economic agenda going forward. His promises of corporate and personal tax cuts, increased military spending and infrastructure investment will have to be funded through increased borrowing that would normally be expected to be inflationary. In addition, his penchant for random Tweeting has, and will likely continue to cause, turbulence in the markets.

European concerns continue. The Italian banks' need for recapitalization, the most notable being the insolvent Banca Monte Paschi di Siena (the world's oldest and Italy's third largest bank), has called into question the viability of the entire Italian banking system. As it stands, approximately 18% of Italian banks' loan portfolio is non-performing.

Italy’s problems dwarf those of Greece. Italy is the third largest economy in Europe. A banking crisis in Italy will require all the resources of the European Union. The strapped Italian government simply does not have the resources to recapitalize some, or all, of its banking sector. Questions as to the continued viability of the European Union are multiplying.

In 2017 elections will be taking place both in France and Germany. These two countries have been traumatized by terrorist attacks and they have been severely impacted by the immigration crisis. Nationalist sentiment and anti-immigrant rhetoric have exacerbated tensions.

Indications are that Canadian government borrowing and deficit spending will be of longer duration that originally indicated. Increased borrowing and similar spending policies in the US should keep the interest rate differentials, and hence the exchange rates, between the two countries in a relatively tight range, unless Mr. Trump's policies result in significantly increased economic growth and job creation in that country.

The total return performance of the bond market as measured by the FTSE TMX Canada Universe Bond Index for the fourth quarter was a decline of 3.4%. 91-day Treasury bills returned 0.1% over the same period. The benchmark ten-year Government of Canada bond yield increased 0.72% over the course of the quarter to end with a 1.72% yield at year-end. Over the course of the quarter the Canadian dollar depreciated by 1.7 cents from 76.2 cents US to 74.5 cents US.

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