Government of Canada bonds are getting more respect in international markets, fuelling upward price pressures and potential trading profits. The reason is that the International Monetary Fund (IMF) announced on Nov. 19 that it is considering classifying the Canadian and Australian dollars (C$ and A$, respectively) as “reserve currencies.” That would be a boost for the visibility of the loonie in central banking and, as a result, for the potential price and liquidity of your clients’ Canadian government bond holdings.

The IMF move, which would actually take effect in early 2013, means that Canadian federal and provincial bonds, which make up only 5.3% of central bank holdings around the world, will be sought after a little more earnestly for central bank reserves. Other things being equal, that’s one reason the bonds will rise in price and drop in yield.

The IMF classification reflects the relatively good condition of Canada’s economy in a world in which many national economies in the developed world are down on their luck. Canada’s AAA credit rating and the fundamental need for central banks to hold their reserves in sound, liquid currencies have boosted the status of the loonie from being one of “other currencies” on the IMF’s books to the higher status of inclusion in the IMF’s official foreign-exchange reserves when it reports on changes in early 2013.

For now, the world’s official reserve currencies are the U.S. dollar (US$), the euro, the yen, the British pound sterling and the Swiss franc. These five currencies are an odd lot:

– The U.S.’s deficit threatens the US$’s value.

– The euro is a basket case, down by a third against the other reserve currencies in the past decade, with its AAA ratings limited to Germany, the Netherlands and the Scandinavian countries.

– Japan’s ratio of total debt to gross domestic product (GDP) of 200% is among the highest in the world, and its aging and shrinking population suggests that government spending on retirement programs will only grow. In turn, this will impair Japan’s public finances and the yen, even though the yen has surged by 35% in the past 12 months.

– The pound sterling remains a very strong currency.

– The Swiss franc is up dramatically against the US$ in the past 10 years, but Switzerland’s bond market doesn’t have the liquidity needed for global reserve use.

If you wanted to bank on any of these currencies as a single, solid denominator of value, not one would fit the bill. Thus, it’s no wonder the welcome mat is out for both the C$ and the A$.

The IMF’s move to include Canada and Australia in the global currency reserve category recognizes that both countries’ federal fiscal policies are working well. As the IMF notes, Australia’s budget is expected to run a small surplus in 2013, and Canada’s deficit is expected to shrink to 0.6% of GDP from 1.2% in 2012.

The US$ continues to make up 62% of global foreign currency reserves, says Camilla Sutton, chief currency strategist with Bank of Nova Scotia in Toronto. The loonie, by comparison, comprises just 5.3% of global reserves, but Canada’s economy is both mature and relatively robust. “Having a developed bond market [also] is a factor,” Sutton says. “It is a matter of liquidity and stability.”

It is also a matter of profit, even though central banks are in the market not so much to make money as to provide ammunition for currency stabilization. Nevertheless, using the US$ as the measure, total returns from Government of Canada bonds for the past 10 years would have been an annualized 11.6% a year, vs 14.3% for Australian bonds and, by comparison, a relatively modest 6.1% for U.S. Treasury bonds.

The IMF move should increase the buying of Canadas, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax: “What the IMF move does is to make the C$ and A$ more visible in central bank reserves. Central banks don’t hold cash; they use the national bonds of countries in their reserves. Some central banks that do not hold federal bonds of the two countries will buy them [now]. That is positive for our dollar and the Canadian bond market.”

Rising purchases of Canada’s federal bonds would tend to drop the yield curve. But the effect should be more specific, Roger says, on short-term issues and bonds in the belly of the curve.

The downward pressure on federal bond yields is likely to be slight, for the IMF move is less about fundamentals than about visibility of the C$ and the A$. Says Mark Chandler, head of fixed-income and currency research with RBC Dominion Securities Inc. in Toronto: “Each central bank has its own parameters for investing. We find that when a central bank is new to a currency, it will invest in bills or short-dated bonds and then go longer.”

The implication is more pressure being applied on the short end and the belly of the curve, Chandler says. That implies steepening in the yield curve and a relatively better return for long bonds. The gains are likely to be modest; however, for security and peace of mind, your clients can be assured that they have been joined by central banks around the world that now are able to watch their C$ stakes a little more clearly.

Prestige aside, the enhanced visibility of Canada’s government bonds in world central bank reserves won’t change the fundamentals of the market.

“The supply/demand relationship for bonds is about liquidity,” explains Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. “It does not dictate yields. Growth and inflation and other economic fundamentals are the stronger drivers for bond returns. But at the margin, the amount that [bond] yields rise and fall is influenced by liquidity.”

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