Statistics Canada reported a huge surge in foreign buying of Canadian bonds and this would seem at first glance to be a vote of confidence for the economy and Canadian dollar. A closer look, however, reveals that the inflow, and its positive effects on the loonie, are likely short-lived.
Last week's report on foreign purchases of Canadian securities showed non-Canadian purchases of government bonds at $23-billion so far in 2015. This is a vast improvement over the almost $10-billion of foreign investment in domestic bonds during the same period of 2014.
Why the interest? A Bloomberg report cited experts who believe global bond experts were merely chasing performance – the Canadian bond market is alone among G7 nations in having positive returns. Fears of interest rate hikes in the United States caused weakness elsewhere.
But the "chasing performance" explanation is unsatisfying once the value of the Canadian dollar is factored in. The domestic bond market, as measured by the BMO Aggregate Bond Index ETF, is up by one half of 1 per cent, year to date. But the loonie is lower by 5.4 per cent over the same period. A U.S. investor in the broad Canadian bond market would have an investment loss of 4.9 per cent after accounting for weakness in the Canadian dollar.
There are also prominent economists, led by Emanuella Enenajor of Merrill Lynch, who are predicting that the Bank of Canada will cut interest rates again in 2015. Ms. Enenajor points to the weakening outlook for domestic economic growth – the consensus 2015 GDP forecast for Canada has dropped from 2.5 per cent at the end of 2014 to the current 1.6 per cent – as a sign that monetary stimulus will be needed in the next few months.
A cut in the bank rate would likely result in a rally in Canadian bonds – yields would move lower and bond prices higher to adjust to the central bank's policy change. But it would also cause severe weakness in the Canadian dollar. When Bank of Canada Governor Stephen Poloz last cut rates in January, the loonie fell 6.2 per cent versus the U.S. dollar. For global bond investors, the risk of a sharply lower loonie far outweighs the potential gains in bond prices.
I asked BMO Nesbitt Burns economist Doug Porter for his explanation for the global popularity of Canadian bonds and, to me, his answer was far more believable. Mr. Porter believes that European investors were diversifying away from negative interest rates early in the year. In addition, Japanese investors, most of whom are already loaded with U.S. dollar investments, were buying Canadian dollar fixed income to avoid near-zero rates on Japanese bonds.
Mr. Porter's thesis implies that the global inflow of assets into Canadian markets is temporary. European yields are much higher than a few months ago. In Germany for instance, the 10-year bond yield went from seven measly basis points in mid-April to the current 88 basis points.
Despite the welcome global interest in Canadian bonds, the domestic economic growth outlook means the path of least resistance for the loonie remains lower relative to the U.S. dollar.
Follow Scott Barlow on Twitter @SBarlow_ROB.