A Tale Of Two Bond Markets: Canada And The United States

Two countries as closely intertwined in trade and capital flows rarely get out of sync. However, since the Bank of Canada announced its recent rate hike, Canadian long term bond markets have behaved quite independently.  

As Figure 1 clearly demonstrates, the two bond markets have moved  virtually in  unison  this past year, a pattern that is reflective of historical behavior. However, as news of the relatively strong Canadian growth performance emerged this past quarter and the subsequent hike in the bank rate, the first in seven years, Canada’s 10 yr yields took off . The Canada 10 yr rate moved up from 1.4% to 2.1% in less than one month.  Meanwhile the U.S. 10 yr rate actually moved south, creating a wide disparity between the two bond markets.

 

Figure 1Canadian and U.S. 10-yr Bond Yields

The Canadian bond market was fueled by expectations of further rate hikes by the Bank of Canada, perhaps as early as October. More to the point, some investors started to anticipate a series of rate increases through 2018. As expected, the Canadian currency appreciated from  74 cents (US/CDN) to just over 80 cents since June 1.  Analysts were touting that Canada is “firing on all cylinders” and the proof was the strong Loonie. The combination of an appreciating currency and rising long term yields, is a perfect recipe to encourage capital inflows. In an earlier article, I argued that this exuberance in the Canadian outlook needs to be tempered by some hard facts, such as:

• Canada’s inflation rate remains well-below the 2% target and is trending downward; industrial prices actually fell 1.0% in June over May, continuing a trend established since March; this should give the Bank of Canada some pause for concern about future rate hikes;

• The Bank of Canada’s own forecasts call for growth to moderate considerably from the recent fast pace of 3.5%; its model anticipates that growth in 2018 will moderate to 1.9% and continue at that moderate pace into 2019;

• The Loonie’s surge is a form of monetary tightening that will negatively influence directly the export sector which accounts for about 30% of national income 

• The U.S. growth performance continues to be positive, but weak; the Fed will have to consider the consequences of future rate hikes and the unwinding of its balance sheet on monetary conditions.

As of the time of writing, the Canadian 10yr yield is starting to reverse course, in large measure for all the reasons given above. With the Canada-U.S. yield spread still wide, Canadian bonds offer an opportunity to pick up capital gains.