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Dutch Disease Seen in Manufacturing Bond Decline: Canada

The Canadian bond market suggests manufacturers are being penalized for central bank policies that have allowed a commodity boom to drive up the country’s dollar in what’s being termed as “Dutch Disease” by critics.

Bonds of machinery companies in the Bank of America’s Canadian Industrial Index have returned 1.7 percent this year, compared with gains of 6.5 percent for miners and 3.2 percent for energy explorers. Yields on debt of Finning International Inc. (FTT), the world’s largest dealer of Caterpillar Inc. equipment, are 26 basis points wider in 2012 relative to government benchmarks while average yields in the industrial index have narrowed 21 basis points, or 0.21 percentage point.

Bank of Canada Governor Mark Carney rejected the notion in a speech Sept. 7, saying price gains in oil and other commodities are being driven by demand from emerging markets rather than central bank policies. The country’s main opposition New Democratic Party has said steps should be taken to counter Dutch Disease, a term used in the 1970s to refer to the Netherlands’ uneven economy after natural gas deposits were discovered in the North Sea. The resulting rise in the country’s currency was blamed for the demise of Dutch manufacturing.

“We all know Ontario is struggling with the problems with the auto sector,” said Patrick O’Toole, a Toronto-based money manager who helps oversee C$70 billion ($72 billion) at Canadian Imperial Bank of Commerce’s CIBC Global Asset Management unit and holds Suncor Energy Inc. (SU) and Inmet Mining Corp. (IMN) bonds. “If we didn’t have the west doing well then we’d be in much worse straits. It’s nice we have some engines firing as opposed to none.”

Dollar Strength

While Canadian employment rose faster than economists forecast in August, jobs in the manufacturing sector declined for the third straight month, Statistics Canada said Sept. 7.

Canada’s currency, nicknamed the loonie for the image of the waterfowl on the C$1 coin, appreciated 0.8 percent to 97.86 cents per U.S. dollar last week. It touched 97.55 cents today, the strongest level since Sept. 2, 2011. One Canadian dollar buys $1.0241.

The Canadian currency has strengthened 3 percent this year, the most among nine developed-nation peers monitored by Bloomberg Correlation-Weighted Indexes. The U.S. dollar has lost 2 percent, while the euro has weakened 3.4 percent.

Elsewhere in credit markets, the extra yield investors demand to own the debt of Canadian investment-grade corporations rather than the federal government narrowed one basis point to 150 basis points in the week ending Sept. 7, according to Bank of America Merrill Lynch index data. Yields rose to 3.13 percent from 3.09 percent on Aug. 31, the data show.

Yield Spreads

Government bonds opened little changed, with the yield on Canada’s benchmark 10-year debt one basis point lower at 1.85 percent at 11:41 a.m. in Toronto. The price of the 2.75 percent security due June 2022 rose 10 cents to C$108.04.

In the provincial bond market, the spread over federal debt narrowed two basis points to 76 basis points between Aug. 31 and Sept. 7. Yields increased to 2.57 percent from 2.54 percent, according to another Bank of America index.

Canadian corporate bonds have returned 4.4 percent this year, compared with gains of 1.4 percent by the nation’s government bonds and 1.8 percent by provincials, according to Bank of America Merrill Lynch data.

‘Western Bias’

Carney called the “Dutch Disease” allegations a “caricature” that would limit the beneficial development of the Alberta oil sands, during the speech near Calgary, home to energy companies such as Suncor Energy Inc. and Encana Corp. (ECA)

“We have a western bias in our portfolio,” said John O’Connell, who oversees C$560 million of assets as chief executive officer of the Toronto-based investment firm Davis Rea Ltd. O’Connell holds bonds of Imperial Oil Ltd. (IMO), Cenovus Energy Inc. (CVE) and Canadian Natural Resources Ltd. (CNQ) Captive finance units of makers of autos and heavy equipment “have always been a bad investment decision.”

Alberta’s economy, along with neighboring Saskatchewan and British Columbia, is outpacing national growth, helped by an expanding oil and gas sector where companies such as Suncor and Imperial Oil are building oil sands extraction projects. Canada is the world’s sixth-largest crude producer and the third- largest natural gas producer.

Carney’s rejection that natural resource extraction and oil exports are hurting manufacturing is “positive,” for the oil and gas sector, said Bruce March, chief executive officer of Imperial Oil, in an interview following the speech.

Economic Success

“The energy export diversification issue is still quite big,” March said. “That was one of the highlights near the end of the governor’s remarks.”

Carney sought to silence his critics by pointing to Canada’s success in distancing itself from the financial turmoil that has gripped economies worldwide since 2008.

“The logic of Dutch Disease requires that we undo our successes in order to depreciate our currency,” Carney said. “Taken to its natural conclusion, this logic dictates that we shut down the oil sands, abandon our resource wealth, have high and variable inflation, run large fiscal deficits and diminish our financial sector.”

To contact the reporters on this story: Cecile Gutscher in London at cgutscher@bloomberg.net; Jeremy van Loon in Calgary at jvanloon@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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