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Macroeconomic outlook The Canadian economy is now back on the rails after several quarters of stagnation. Robust employment growth over the last quarter, together with signs of a pick-up in the US economy, point to accelerating GDP growth over the second half of this year and into 1997 (Chart 1). While fiscal policy will continue to act as a major drag on domestic spending, there should be sufficient momentum from exports, and stimulus from monetary policy, to support 2.0% growth in real GDP this year and 3.1% in 1997. Structural changes in the economy, which have held back the expansion, bode well for the future performance of Canadian debt markets. There is a huge fiscal drag ­p; the contractionary imact on the economy of government spending cuts ­p; which we estimate will chop roughly 1.5 points this year from growth. But fiscal deficits are shrinking rapidly. Finance minister Martin will continue easily to better his targets for deficit reduction ­p; and, in the process, eliminate net federal financing requirements by fiscal 1998/99. That would mark the first time in almost three decades that the federal government will not undertake net new borrowing. Provincial deficits have been halved over the past four years, with eight of Canada’s 10 provinces expected to post balanced budgets or small surpluses this year. What remains of provincial deficits is now the target of aggressive deficit-cutting agendas in Ontario and Quebec. The fiscal adjustment, coupled with weak domestic demand and a cheaper Canadian dollar, has in turn whittled down Canada’s other chronic deficit ­p; an historically large current account imbalance. Spearheaded by a succession of record merchandise trade surpluses, Canada’s current account deficit has melted from a G7-leading 4% of GDP only three years ago to less than 1% of GDP this year. Although the trade surplus faces some erosion with a healthier domestic consumer next year, fiscal drag has slowed the rise in foreign debt to a crawl. Large interest outflows which have historically undermined Canada’s balance of payments position will soon be stemmed. Lastly, fiscal discipline has made a major contribution to price stability. Canada should continue to outperform the US on the inflation front, both this year and next, with CPI inflation running anywhere from a full point to a point and a half lower than the US. Next year will mark the sixth consecutive year in which Canadian inflation will remain below the US. Market outlook Judged on the merits of its own fundamentals, there is a compelling case to be made in favour of Canadian debt markets, as evidenced by the recent tightening of Canada-US spreads. However, in the near term, the Canadian fixed-income market will remain a casualty of an ongoing correction in the Treasuries market. A further sell-off at the long end of the US Treasuries curve, with prices dropping 5%, should elevate 10-year Canada yields to the 8.5% range. The prognosis for the Canadian fixed-income market should brighten considerably next year once US long Treasury yields stabilize and ultimately decline. Backed by strong domestic fundamentals, long Canada yields should drop nearly 100bp over the course of 1997 with the yield on the 10 year benchmark falling to about 7.5%. At the short end of the yield curve, latent support for the Canadian dollar has permitted the Bank of Canada to ease independently from the Federal Reserve. This has driven Canadian bill yields to levels lower than the equivalent Treasuries. We expect flat to slightly negative bill spreads to persist until the autumn. This posture could become a liability for the Canadian dollar when US money market yields rise in Fed tightening later this year. Faced with much more economic slack and no inflation threat, the Bank of Canada should initially lag behind Fed tightening, leaving the exchange rate with the US dollar vulnerable. We expect a return to the $1.39 range by year-end. However, building domestic demand should gradually sway the Bank of Canada to a tighter stance, with the Canadian dollar rallying through most of next year to $1.34 once the Bank lets go of short-term rates. How government bonds are issued The Government of Canada issues marketable bonds in its own name. These are underwritten by the primary distributors ­p; investment dealers and Canadian chartered banks. There is now only one method of issuance: the auction system. (Prior to late 1991 the government also employed the allotment method for some issues. Here, primary dealers were paid a commission to distribute bonds at a fixed price, set by the Bank of Canada.) The Bank of Canada’s auction mechanism is very similar to the US system. At the beginning of each calendar quarter, it announces the quarterly auction schedule, setting out the dates of the auction, the settlement date and the maturity terms to be auctioned. Currently there is at least one auction each quarter in the following terms: 2-year, 3-year, 5-year, 10-year and 30-year, along with the inflation-linked Real Return Bond. The auction system continues to evolve, reflecting the Bank of Canada’s announced goal of improving the liquidity of the domestic market. This goal is to be achieved by increasing the amount outstanding of the individual benchmark issues. This implies a strategy to issue and re-open benchmark issues. Auctions will be held for a particular benchmark bond repeatedly, with C$1 billion to C$2.5 billion sold at each auction. For example, in March 1996 the government raised its targets for the benchmark bonds. The ranges now set for 2-year and 3-year benchmarks are C$5 billion to C$7 billion, and for the 5-year, 10-year and 30-year benchmarks the targets are C$7billion to C$10 billion. On the Thursday prior to the actual auction date on the following Wednesday, the Bank of Canada announces the maturity and size of the issue. At that point, active open market trading begins on a yield basis in the When Issued market. The details announced to the market include the term, the amount to be auctioned, the maturity date and, if the bond is being re-opened, the coupon level; for a new bond, the coupon level is set the following Wednesday at the auction based on the average yield at the auction. On the auction date, bids are submitted to the Bank of Canada and dealers receive bonds ­p; up to 20% of the total issued ­p; based on the competitiveness of their bids. Yield calculation and the shape of the yield curve Yield calculations on all domestic Canadian dollar government bonds are semi-annual with accrued interest calculated on an actual/365 day basis. Following a completed trade, good delivery for Canada bonds less than three years in maturity must occur on the second clearing day. Government of Canada bonds greater than three years maturity, and all provincial, municipal and corporate bonds, must be delivered within three business days. Over recent years, liquidity in the Canada market has continued to improve, resulting in a narrowing of bid-offer spreads. Currently, bid-offer price spreads are typically 2¢ for 2-year bonds, 5¢ for 5-year bonds, 7¢ for 10-year bonds and 10¢ for 20-year and 30-year trades. Currently, individual institutional transactions in the government market are typically in the C$25 million to C$50 million range. However, C$100 million to C$200 million tickets are reasonably common, with C$250 million to C$500 million trades being done on occasion. Chart 2 shows the slope of the Canadian yield curve (the spread between 2-year and 10-year yields) since 1980. The chart shows that currently the curve is quite steep. This reflects the Bank of Canada’s aggressive lowering of interest rates, to below those in the US, in light of Canada’s slow growth and low inflation. However, the curve has been steeper in recent years, particularly during the bull market of 1993. By Jeffrey Rubin and Daniel Kelly Tel:(416) 594-7357 7371 CFA (416) 594-7371 Fax: (416) 956-6117 For further information,please contact your account officer in: London 44 171 234 7163 Institutional 44 171 234 7119 Non-institutional Toronto 1 416 594 8513 New York 1 212 856 6608 Singapore 65 538 9177 Tokyo 813 5512 8900 Hong Kong 852 284 16111 On Bloomberg Type WG On Reuters Type WGBA |
