By Fergal Smith
TORONTO, April 7 (Reuters) - The underperformance by
Canadian bonds versus U.S. Treasuries year-to-date is expected
to fade as the Federal Reserve cautiously hikes interest rates
this year even as Canada's central bank holds steady,
strategists said.
Canadian government bond yields generally remain well below
Treasuries. But the differences in yields, or spreads, is
narrower than levels seen before the Bank of Canada surprised
many traders in January by not cutting rates.
The yield on Canada's 10-year bond CA10YT=RR had moved to
a record 90 basis points below its U.S. counterpart US10YT=RR
near the end of last year. The spread moved to 52 basis points
on Thursday, the smallest gap since May.
But strategists said this underperformance is nearly
finished and some already prefer to own Canadian bonds.
Stronger growth and increasing inflation in the United
States will cause the Fed "to hike rates more than is currently
priced in," said Greg Nott, chief investment officer at Russell
Investments Canada, a factor he expects to weigh on Treasuries.
At CIBC Capital Markets, head of rates strategy Richard
Gilhooly expects Treasuries to underperform as the Fed drives
investors into risk assets, such as corporate and high-yield
bonds, and actively encourages a rise in inflation expectations.
"(Federal Reserve Chair Janet) Yellen is deliberately
falling behind the curve to try to not just foster, but to
solidify the gains in inflation that we have seen recently,"
Gilhooly said.
He favors the two-year spread in case oil LCOc1 CLc1
lurches lower, putting the possibility of a Canadian rate cut
back in play. He also likes the 30-year spread as he expects
Canada's long end will mostly avoid increased issuance.
Stronger-than-expected Canadian growth, a partial recovery
in oil prices and fiscal stimulus have sharply reduced
expectations for Bank of Canada rate cuts.
A Reuters poll on Thursday showed forecasters now see rates
on hold until the Bank of Canada starts tightening in 2017.
CA/POLL BOCWATCH
Meanwhile, Yellen surprised markets last week with her
cautious stance.
To be sure, a 45 percent spike in 2016-17 bond issuance as
the budget deficit climbs to C$29.4 billion ($22.39 billion) is
seen as a headwind for Canadian bonds.
"Supply is going to be very abundant, but I think that is
now close to fully priced in," said Jimmy Jean, fixed-income
strategist at Desjardins, who also expects Canadian economic
data to soften after a solid first quarter.
($1 = 1.3133 Canadian dollars)
(Editing by James Dalgleish)