Income Strategy September 28, 2007:                

The bond markets have been very volatile over the past couple of months due to the uncertainty surrounding the asset backed investment markets. The Bank of Canada had to inject another billion dollars in added liquidity to ensure that the short term investment markets would continue to function. The Bank was forced to try and calm the markets after the so called “Montreal Group” announced that they will need an extension in order to workout the non-bank issued Asset Backed Corporate Paper (ABCP) situation.

The Montreal Group was formed when the non-bank Asset Backed Corporate Paper market collapsed when liquidity dried up in July. This group is led by the Caisse de Depot and has arranged a stand still agreement with the institutions involved in order to make arrangements to convert $35 billion of the short term ABCP issues in to longer term bond style investments.  

The group includes a number of international banks including JP Morgan Chase and Deutsche Bank all of who have agreed not to force the redemption of these instruments which could lead to a complete collapse of this sector of the money market. The main sticking point seems to be the length of the term on the new bonds which would be created out of the 22 trusts that are the collateral for the ABCP’s.

This situation is far for being out of the woods and if an extension is not reached then the short term asset backed corporate paper market could be for a major sell off as holders of these instruments are forced to sell at any price to realize on their investment.

The Bank of Canada has been quite vocal on the reasons for the freeze up in the ABCP market stating that more transparency is required so that investors can identify for themselves the level of risk attached to the investments. The Bank has been firm on the idea that investors should have done more complete due diligence before committing such large sums to this sector of the market.

The slow down in the US and the higher Canadian dollar are starting to have an impact on the pace of economic expansion in Canada, Stats Canada just released GDP data for July which showed the economy growing at 0.2% for the month slightly below the 0.3% pace forecast. This new data suggests that the Canadian economy will grow at only 2.0% for the third quarter much slower than the 3.4% seen in the second quarter and this is before the full impact of a Canadian dollar at par has been felt.

On the inflation front it appears there is a benefit from a stronger Canadian dollar as producer prices were down 1.0% in August as raw material prices, most of which are priced in US dollars, were down 2.8%.

A similar situation was reported in the Industrial Products Prices Index (IPPI) which monitors the prices producers receive as goods leave the plant. The IPPI was down 0.7% in August, if the impact of the Canadian dollar is excluded the IPPI would have been up 1.5%. This data points out the dramatic impact that currency changes can have on the profitability of the manufacturing sector over time.

Until there is a clear understanding of the full impact of the changes in the credit markets interest rates are likely to remain stable or trend slightly lower if inflation remains under control.