François Dupuis Vice-President and Chief Economist. Mathieu D Anjou, CFA Senior Economist. The Yield Curve January

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1 January 8, Bond yields will continue to rise in Highlights Federal Reserve (Fed) leaders announced in December the first reduction to their securities purchases. The Fed should announce at each meeting that it will further reduce its securities purchases. However, to make these decisions, it will continue to closely monitor economic and financial conditions. Now that the jobless rate is closer to normal, it would be logical for the Fed to focus on other variables. In the short run, we can assume that the Fed will closely monitor changes to the personal consumption expenditure deflator. In Canada, eventual key rate cuts have not been ruled out should inflation stay well below the lower target (%) for an extended period of time. A key rate cut is nonetheless highly unlikely. The bond market s solid performance at the start of the year could suggest that the bond market correction is over. That is not our opinion. Accelerating global economy, with the United States at the head of the pack, should put upside pressure on yields over the coming quarters. Editorial A year ago, we predicted that could very well be a watershed year, as the long bond bull market would finally end and yields would begin to climb gradually. While the first part of our forecast was confirmed, yields rose more violently than we had anticipated. Last spring, the first signs that the Federal Reserve (Fed) was planning to taper its asset purchases caused U.S. real rates to return to positive territory almost immediately (graph ). Graph U.S. -year yields suddenly returned to positive territory in spring In % In % U.S. federal bonds Nominal -year yield Expected inflation according to TIPS* Real -year yield * Treasury Inflation Protected Securities. Contents Editorial... Monetary Policy Federal Reserve... Bank of Canada... Overseas central bank... Bond market United States... Canada...7 Provinces...8 Tables After causing some surprise by opting for the status quo last September, the Fed finally decided to begin reducing its purchases at its December 8 meeting. Encouraging economic figures from the United States and the budget agreement in Washington to prevent further federal spending cuts increased Fed leaders confidence that labour market gains will continue. The monthly pace of purchases went from US$8B per month to US$7B in January. The markets understood the Fed s message that highly stimulating monetary policy would remain appropriate despite this modest tapering and responded well to this announcement, although most analysts had not expected it. François Dupuis Yves St-Maurice -8- or 8 8-7, ext. Vice-President and Chief Economist Senior Director and Deputy Chief Economist desjardins.economics@desjardins.com Mathieu D Anjou Benoit P. Durocher Francis Généreux Jimmy Jean Hendrix Vachon Senior Economist Senior Economist Senior Economist Senior Economist Senior Economist Note to readers: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively. Important: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright, Desjardins Group. All rights reserved.

2 The Yield Curve January Reflecting the Fed s decision and, to a greater extent, the growing optimism about the economy, U.S. year yield ended at.%, up points from the end of. Very disappointing job creation for December and renewed fears about emerging countries then brought this yields to around.7%. The jobless rate may have less influence on Fed decisions Given its double mandate of stable prices and maximum employment, the Fed has always paid close attention to the job market. By deciding to commit to keeping its key rate unchanged until the jobless rate hits.%, the Fed placed even more emphasis on this economic variable Graph Inflation pressures remain quite weak in the United States Ann. var. in % Ann. var. in % Personal consumption expenditure deflator Sources: Bureau of Economic Analysis and Desjardins, Economic Studies Federal Reserve target Core deflator Despite weak job creation in December, the U.S. jobless rate fell to.7%. The Fed is therefore in a tough spot, as its pledge not to tighten its monetary policy before the jobless rate falls to.% no longer really means anything. The Bank of England is in the same situation. A first option for the Fed would be to use a lower threshold for the jobless rate, for example.% or.%. This option was not completely dismissed, but the Fed s latest statements imply that most leaders seem more inclined to return to using more qualitative indicators to signal future monetary policy direction. In its December statement, the Fed therefore used the following phrase: [...] it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below -/ percent, especially if projected inflation continues to run below the Committee s percent longer-run goal. We have always thought that linking monetary policy to the jobless rate was inappropriate and it is especially difficult now, as several structural factors seem to be impacting this variable. Now that the jobless rate is closer to normal, it would be logical for the Fed to focus on other variables, which give a clearer indication of how healthy the U.S. economy is. In the short run, if the general outlook for the U.S. economy does not change much, we can assume that the Fed will closely monitor the personal consumption expenditure deflator, which is currently well below the central bank s target (graph ). market correction is over. That is not our opinion. Bond yields remain historically very low and the accelerating global economy, with the United States at the head of the pack, should put upside pressure on yields over the coming quarters. If we try to imagine the situation at the end of, the most likely scenario is that the Fed will have ended its quantitative easing program, fears of deflation will have eased, and investors will be starting to prepare for a key rate hike in the second half of. We therefore expect to end with year yields at.% for the United States and.% for Canada. What s more, wild adjustments in the bond market could still surprise us. François Dupuis Vice-President and Chief Economist Mathieu D Anjou, CFA Senior Economist Bonds can be expected to retreat again The bond market s solid performance at the start of the year, especially in Canada where the Bank of Canada kept the door open to key rate cuts, could suggest that the bond Desjardins, Economic Studies, Economic Viewpoint, "Tying monetary policy to unemployment: Is the game worth the candle?" August,, vue_economique/pv8.pdf.

3 The Yield Curve January Federal Reserve Tapering should continue at the same pace Federal Reserve (Fed) leaders announced in December the first reduction to their securities purchases. As of January, these purchases were at US$8B per month. In January, the amount dropped to US$7B US$B in Treasuries and US$B in mortgage-backed securities. This reduction came a bit earlier than expected, but improved economic conditions, the absence of any major obstacles to growth that could have been caused by the shutdown, and the bipartisan budget agreement reached on December created a window of opportunity for kicking off the process. The Fed should announce at each meeting that it will further reduce its securities purchases. However, to make these decisions, it will continue to closely monitor economic and financial conditions, especially inflation and the job market. In this last instance, December s results for the establishment survey could lead to some hesitation at the meeting in late January. Hires dropped to just 7,, a break with the recent average gains of around, new jobs per month (graph ). December s slide by the nonmanufacturing ISM and lower consumer confidence according to January s preliminary data are also raising some doubts. However, it seems that the weather is one of the main factors in this weakness. What s more, most of the other economic indicators are doing especially well. Growth was probably quite strong at the end of, and the outlook remains very positive for, as many of the factors that hurt the economy last year have dissipated. We expect real GDP to grow.9% in. At.7% in December, the jobless rate is nearing the.% threshold established by the Fed (graph ). However, much of this drop is due to the fact that fewer Americans are participating in the labour force. Consequently, the jobless rate might not be the best indicator of the job market s health and, sooner or later, the Fed will have to revise or abandon the threshold it set in and turn to other statistics that are more representative of how Americans are doing. For its part, inflation remains modest, especially with regard to the consumption expenditure deflator. However, we expect it to rise slowly over. Forecasts: The Fed should keep the pace on reducing its securities purchases. At each meeting, it should announce a US$B cut, and the program should wind up after the October meeting (graph ). As for key rates, no increase is anticipated prior to September Graph The U.S. jobless rate will continue to descend In % In % Sources: Bureau of Labor Statistics and Desjardins, Economic Studies.%.%.% Desjardins forecasts Graph Federal Reserve securities purchases will be tapered over most of the year In US$B Graph December s job creation was very disappointing in the United States Monthly var. in thousands Employment according to the establishment survey Sources: Bureau of Labor Statistics and Desjardins, Economic Studies Monthly securities purchases Monthly var. in thousands Desjardins forecasts In US$B Mortgage-backed securities Treasuries Sources: Federal Reserve and Desjardins, Economic Studies

4 The Yield Curve January Bank of Canada The expected inflation upswing should somewhat reduce concerns After rising an annualized.7% in the third quarter, Canada s real GDP looks to have performed fairly well again in Q. Real GDP by industry went up.% in October, yielding a carryover of at least.% for the fourth quarter as a whole (graph ). Under these conditions, our forecast for goes from.7% to.8%. Canada s economic growth should accelerate in (+.%) and (+.%). However, many uncertainties remain for both and. Among other things, exports are still not capitalizing on improved demand in the United States and the rest of the world. Note that many businesses are reporting some difficulty in capturing market share abroad due to fierce competition. A lot of hope rests on acceleration by exports and non-residential investment to support growth in the coming quarters. There are still some encouraging signs, however, as many businesses expect sales growth to pick up in the next months (graph 7). Total inflation will gradually climb towards the mid-point target (%) before the end of (graph 8). The downside risks to inflation are quite high, however, and the inflation forecasts were revised downwards throughout, as the effects of surplus production capacity and lively competition in retail trade had a greater impact than anticipated. Worries about the housing market s strength and household debt linger, despite some modest signs of improvement. In the end, the monetary authorities feel that, overall, the risks are currently balanced. Movement by the balance of risks will dictate monetary policy decisions over the coming quarters. Eventual key rate cuts have not been ruled out should inflation stay well below the lower target (%) for an extended period of time. In the short run, this possibility will continue to put downside pressure on the Canadian dollar. A key rate cut is nonetheless highly unlikely and everything suggests that the coming quarters will instead see the overnight rate somewhat stable. In 7 $B In 7 $B Real GDP by industry,,, Quarterly average,,9,9,8,8,7,7,,,,,,,,,,,,,, Jan. April July Oct. Jan. April July Oct. Jan. April July Oct Graph The fourth quarter of started on a positive note for Canada Sources: Statistics Canada and Desjardins, Economic Studies Graph 7 Canada s businesses continue to expect sales to improve over the next months In % Balance of opinion In % on the change in sales growth over the next months Sources: Bank of Canada and Desjardins, Economic Studies Forecasts: A first increase to the overnight rate could be ordered in the second half of, when surplus production capacity will be nearly absorbed. Our scenario rules out any key rate cuts until then. Graph 8 Canadian inflation will remain fairly low in the coming quarters Ann. var. in % Ann. var. in % Consumer price index (CPI).. Desjardins forecasts Total CPI CPIX* * Bank of Canada s core index. Sources: Statistics Canada and Desjardins, Economic Studies

5 The Yield Curve January Overseas central bank A long period of low inflation in the euro zone European Central Bank (ECB) The ECB did not modify its monetary policy in January, although it changed the tone of its statement. Faced with the likelihood of an extended period of low inflation, the ECB put more emphasis on its commitment to keeping key rates at or below their current levels for an extended period. Mario Draghi stressed the importance of this change in tone at the press conference, then indicated that unwanted firming of the money market or lower medium-term inflation forecasts could force the ECB to act. Because Euroland s economy and banking system are fragile, it would take only a slight negative shock to lower inflation forecasts or affect the money market. The chances that the ECB will intervene further therefore seem quite high. The ECB says it is ready to use all of the tools at its disposal, but is giving little indication of the tool it would favour first. In our opinion, as key rates are already very low, asset purchases or loans to the banking sector could be more effective. Bank of England (BoE) The BoE is dealing with a very different situation than the ECB. The economy is doing much better in the United Kingdom and the unemployment rate is falling rapidly. The latest figures put the unemployment rate at 7.%, close to the 7.% threshold set by the BoE. According to the policy announced in August, the BoE could soon contemplate raising its key rate or reducing its asset holdings. On the other hand, it could also wait several more quarters before taking action. Weak inflation, which is at its lowest point since November 9, should become a more decisive factor in conducting its monetary policy. Among other things, the BoE expects excess production capacity and weak salary growth to limit the rise by inflation. Graph 9 Inflation rate in the euro zone Ann. var. in % Ann. var. in % Consumer price index (CPI) CPI CPI excluding food and energy Graph Inflation rate in the United Kingdom Ann. var. in % Ann. var. in % Consumer price index (CPI) CPI CPI excluding food and energy Bank of Japan (BoJ) In order to get the inflation rate up to.% and keep it there, the BoJ will buy around 7,B in assets in. Inflation is currently at.%, but drops to.% when we exclude fresh food and energy. The rise by prices is therefore not yet widespread. It will probably take several more quarters for the BoJ to reach its target, especially if Japan s economic growth slows during the year. It is expected to show some vitality in the short term, before the sales tax hike is implemented in April. After that, economic growth and inflation could disappoint, a situation that would force the BoJ to take additional action. Among other things, it could decide to extend its asset purchases into. Graph Inflation rate in Japan Ann. var. in % Ann. var. in % Consumer price index (CPI) CPI CPI excluding fresh food CPI excluding fresh food and energy

6 The Yield Curve January Bond market The rise in yields loses steam U.S. FEDERAL BONDS Bonds are defying projections as begins. After the Federal Reserve s (Fed) decision to reduce the pace of its monthly asset purchases, yields rose at a clip similar to that seen in summer, allowing year yields to reach.%. Investors were then reluctant to take yields to levels that could make the Fed react. However, the Fed never even had to worry about the level of market interest rates, as a report showing December s hires at 7, (compared with the, net hires expected by the consensus) quickly made yields correct downwards (graph ). Although the long end of the curve was barely affected by upside pressure in December, it has benefited the most from the bond market s new momentum. year yields went from.97% at the end of December to.7% on January, with considerable flattening of the / and / curves (graph ). The Fed does not seem overly concerned about the weakness of job creation, however. Many officials indicated that, from a cumulative standpoint, the job market improvement seen since the beginning of its securities purchases remained satisfactory. For some on the committee, the evolution towards more conventional policymaking seems to constitute a welcome change. If upside risks to inflation were to materialize, the Fed would probably not want to be too far into stimulus territory. Therefore, we do not expect occasional negative surprises in employment to slow the pace of tapering, especially since the downward adjustment in bond yields acts as an automatic stabilizer. Bond yields should resume their gradual climb, in line with our scenario for U.S. economic growth. With an inflation rate that will gradually progress towards the % target throughout the year, inflation expectations, which edged down in January (graph ), should begin to move up again. Graph Yields fell sharply after disappointing employment results in December In % In % United States Federal bond yield Payroll report of December. Dec. Jan. -year yield (left) -year yield (right) Graph Pronounced flattening of the curve has been observed since the beginning of December United States Bond rates spread Dec. Jan. -year minus -year (left) -year minus -year (right) Forecasts: The recent drop in yields is more likely a pause within the underlying upward trend. Our year-end target for year yields stands at.%, with a rise that will gradually intensify over the year. Among others, the / and / curves should continue to steepen as they did in until the end of the year, with the trend reversing in. The first policy rate hike, which will then be approaching, will put upside pressure on yields of Treasury bills and short-term bonds Graph Slight decline in inflation expectations since the beginning of the year In % In % United States Implied inflation expectations Jan. April July Oct. Jan. Breakeven -year Breakeven -year in five years

7 The Yield Curve January CANADIAN FEDERAL BONDS Admittedly, the performance of Canadian bonds at the end of largely exceeded expectations. In a way, the narrowing of spreads with U.S. bond yields (graph ) is reminiscent of a situation in which the Bank of Canada (BoC) would have ordered a rate cut. Although that did not happen, the BoC s tone has been deliberately dovish since last fall, especially with regard to inflation, prompting strong reactions from both the currency and from yield spreads (graph ). For example, the spread between Canadian and U.S. year yields went below 7 basis points at the start of the year, following an abrupt basis point drop over the fourth quarter of. Even more remarkably, the spread for year yields shrank basis points over the same period. Canada s year yields thus recently fell below U.S. yields for the first time since the end of the Great Recession (graph 7). Similarly, the year spread neared - basis points recently. The BoC s change in tone and the presence of a new governor, still fairly unknown, had a powerful impact on market perception. The curve for overnight indexed swap futures recently showed that investors were seeing a nearly % probability of a key rate cut by the middle of the year. However, while the BoC continues to stress its concern about weak inflation growth, the Monetary Policy Report mentioned that lively competition in the retail sector was responsible for a. percentage point downside impact on the annual change in inflation, an effect that should dissipate in. Furthermore, the BoC has taken a much more optimistic tone with regard to its outlook for U.S. economic growth and raised its forecast for Canada s economy in. The markets reaction therefore seemed a bit excessive, given that the most likely scenario still calls for rates to stay where they are for a long time. We continue to expect Canada s bond yields to climb, but that spreads could take longer than previously expected to widen. The BoC needs convincing signs that inflation is firming up before it abandons its dovish stance, a situation that might not materialize until the middle of the year. Forecasts: Canadian yields will rise a bit more gradually against U.S. yields than previously predicted, and we now expect the spread for year yields to end the year at - basis points. From a fundamental perspective, spreads do not have much room to narrow further, in our view. Some signs already show that the manufacturing sector is benefiting from the U.S. recovery, and the weak currency could intensify this dynamic, encouraging a rise by inflation. Rate cut expectations should wane as these signs mount up Graph The narrowing of spreads at short maturities was consistent with the depreciation of the currency 8 Jan. April July Oct. Jan. -year spread (left) Canadian dollar (right) Short-end spreads and Canadian dollar US$/C$ Graph 7 -year Canadian rate recently passed under U.S. rates Graph Yields fell at all maturities, but especially in the short end of the curve * Bank of Canada. 8 - Change in federal bond yields since the BoC s* October meeting -year -year -year -year -year yield spread Canada minus United States

8 The Yield Curve January Provincial and corporate bonds After contracting substantially last fall, the yield spread between provincial and Canadian bonds stabilized somewhat in early. Note that the spreads are currently very narrow (graph 8). Ontario s spread for year bonds hit 9 basis points recently, its lowest point in almost two years. The same holds true for Quebec s year bonds, where the spread against Canadian bonds of that maturity fell to basis points recently. All the same, the interprovincial dynamic maintained the spread between Quebec and Ontario yields; the spread had widened in September, as speculations over possible elections in Quebec ran rampant. Although this scenario never materialized, the spread has continued to fluctuate between and basis points since. In contrast, British Columbia s bonds performed well against Ontario s last fall. Although we can take for granted that the western provinces economies will continue to grow more quickly than the economies of Quebec and Ontario, the weaker Canadian dollar could stimulate the latter s manufacturing sectors, a situation that could translate into stronger economic growth and higher government revenues than expected. In this scenario, the western provinces bonds could have a hard time making additional gains against Quebec s and Ontario s. For corporate bonds, yield spreads remain rather low (graph 9), as the start of the year has been fairly uneventful for issuing. It seems there is limited room for additional narrowing, given current levels. However, heightened foreign interest (graph ) in Canada s corporate sector should prevent any dramatic widening. Graph 8 Provincial spreads stopped shrinking at the beginning of the year Provinces -year yield spread against Canadian federal government bonds 9 8 Jan. April July Oct. Jan. British Columbia Ontario Quebec Sources: Desjardins, Capital Markets and Desjardins, Economic Studies Graph 9 Corporate spreads are at their lowest in almost a decade Spreads* of AA corporate bond yields * Against with federal government bond yields. Graph Foreigners have demonstrated a strong interest in Canadian corporate bonds In $B In $B Net foreign investment in Canadian bonds by type of issuer Federal government Corporations Provincial governments Sources: Statistics Canada and Desjardins, Economic Studies 8

9 The Yield Curve January End of period in % Q Q Q Q Qf Qf Qf Qf Qf Qf Qf Qf United States Federal funds Canada Overnight funds Euro zone Refinancing rate United Kingdom Base rate Japan Overnight funds f: forecasts Table Key interest rates Table Schedule and key rates Date Central Bank Decision Rate Date Table Coming soon Central Bank October Bank of Mexico - b.p.. Reserve Bank of New Zealand s.q.. Federal Reserve s.q., /, Bank of Japan s.q.. November Reserve Bank of Australia s.q.. 7 European Central Bank - b.p.. 7 Bank of England s.q.. Bank of Japan s.q.. 7 Bank of Brazil + b.p.. December Reserve Bank of Australia s.q.. Bank of Canada s.q.. European Central Bank s.q.. Bank of England s.q.. Bank of Norway s.q.. Bank of Mexico s.q.. Reserve Bank of New Zealand s.q.. Swiss National Bank s.q.. 7 Bank of Sweden - b.p..7 8 Federal Reserve s.q., /, Bank of Japan s.q.. January 9 European Central Bank s.q.. 9 Bank of England s.q.. Bank of Brazil + b.p.. Bank of Canada s.q.. Bank of Japan s.q.: status quo; b.p. : basis points Source: Desjardins, Economic Studies January 9 Federal Reserve Reserve Bank of New Zealand Bank of Mexico February Reserve Bank of Australia European Central Bank Bank of England Bank of Sweden 8 Bank of Japan Bank of Brazil March Reserve Bank of Australia Bank of Canada European Central Bank Bank of England Bank of Japan Reserve Bank of New Zealand 9 Federal Reserve Swiss National Bank Bank of Mexico 7 Bank of Norway April Reserve Bank of Australia Bank of Brazil European Central Bank 8 Bank of Sweden 8 Bank of Japan Bank of England Bank of Canada Source: Desjardins, Economic Studies 9

10 The Yield Curve January End of period in % Q Q Q Q Qf Qf Qf Qf Qf Qf Qf Qf Key rate Federal funds Treasury bills -month Federal bonds -year year year year Yield curve -year - -month year - -year year - -month f: forecasts Table United States: fixed income market End of period in % Q Q Q Q Qf Qf Qf Qf Qf Qf Qf Qf Key rate Overnight funds Treasury bills -month Federal bonds -year year year year Yield curve -year - -month year - -year year - -month Spreads (Canada - U.S.) -month year year year year f: forecasts Table Canada: fixed income market