Best-in-class Canada growth erases yield gap to US Treasuries

TORONTO: For two years, bond investors have been betting the US would raise interest rates more aggressively than Canada. That bet now appears to be fading.

The yield on two-year Canadian government bonds briefly pushed above those of the US last Friday after data showed slower-than-expected US jobs growth in August, before both ended trade at an even 1.34%.

The last time the yield gap was negative on a closing basis was in May 2015.

The market shift followed surprisingly strong Canadian second-quarter growth data on Aug 31, which bolstered the view the central bank will increase rates for the second time this year – possibly as early as its announcement today.

At the same time, the slowdown in US job creation and a continued tepid inflation outlook have prompted traders to pare back wagers the Federal Reserve with raise rates a third time by year-end.

The Canadian “economy has surpassed everyone’s expectations by leaps and bounds,” Derek Holt, Toronto-based head of capital markets economics at Bank of Nova Scotia, said in a note.

“The central bank remains on the path toward raising its policy rate by about one full percentage point by the end of next year in a more front-loaded set of moves,” Holt said.

As of last Friday, investors saw a 58% probability of a Canadian interest-rate increase tomorrow, according to overnight index swaps data compiled by Bloomberg.

That was up from just 27% before the figures, with Canadian Imperial Bank of Commerce and Bank of Nova Scotia among banks pulling forward forecasts for a hike to September.

The odds that policy rates will be higher before the end of the year now stand at 85% compared with 34% for the US.

To be sure, the US Federal Reserve is well ahead of the Bank of Canada on the tightening curve.

It boosted rates in December after laying dormant for seven-years after the financial crisis.

Three more increases later the federal funds target rate stands at 1% to 1.25%. Canada first moved in July, surprising the markets at that. Its overnight lending rate is at 0.75%.

But Canada’s economy strengthened dramatically over the first half. Gross domestic product expanded at an annualised rate of 4.5% in the second quarter, the strongest pace in almost six years and top among its Group of Seven peers.

“Most impressively,” output has been well balanced, with consumers, capital spending and exports all making big contributions, economists at Bank of Montreal note.

Until last week, “September was kind of dead and now all of a sudden people are saying, ‘old on a second,’” Benjamin Reitzes, a Toronto-based rates and macro strategist at Bank of Montreal, said last Friday.

Still, Bank of Montreal expects the central bank to wait until October to tighten. “It’s really hard to believe the Bank of Canada will be that much more aggressive than the Fed.” — Bloomberg