By Fergal Smith
TORONTO, Dec 14 (Reuters) - Canada may see higher bond
yields and a steeper yield curve as the U.S. Federal Reserve
begins to hike rates, according to market players, weighing on
the economy while raising borrowing costs for consumers and
businesses.
The U.S. central bank is widely expected to raise benchmark
interest rates on Wednesday for the first time since June 2006,
lifting the federal funds rate from zero to 0.25 percent.
The Bank of Canada on Dec. 2 kept its key policy rate steady
at 0.50 percent, but the market is leaning toward another rate
cut after crude prices fell further.
Higher borrowing costs will add another headwind to an
economy hit by the oil price shock and offsetting the boost from
planned fiscal stimulus by the new Liberal government.
The most sensitive part of the curve in Canada is going to
be the 10-year maturity, according to Andrew Kelvin, senior
fixed-income strategist at TD Securities, as the Bank of
Canada's dovish stance caps yields for shorter-dated maturities.
BOCWATCH
The steepening in Canada's yield curve may gather momentum
if forecasts for more Fed hikes are borne out. Besides
Wednesday's anticipated hike, the median projection of Fed
policymakers in September on the projected path of interest
rates was 1.375 percent by end-2016 and 2.625 percent by
end-2017. FEDWATCH
That would entail 125 basis points in tightening next year,
roughly two rate hikes more than implied by the market, assuming
the Fed moves in 25-basis-point increments.
Likely flattening in the U.S. curve is not expected to play
out in Canada, said Mark Chandler, head of Canadian fixed income
and currency strategy at Royal Bank of Canada, pointing to the
differing economic performance in the two countries.
In a rising rate environment, a flatter curve sees yields
increase more for shorter-dated maturities than for longer-dated
maturities.
"I think the front end gets more anchored by monetary policy
and by oil and its more the belly and the longer end that gets
affected by the U.S. curve," said Ed Devlin, managing director
and head of Canadian portfolio management at Pacific Investment
Management Co.
The spread between Canada's 2- and 10-year yields widened to
125 basis points in July, with the long-end underperforming as
an aggressive correction in German Bunds spilled over to other
core sovereign debt markets.
It has since narrowed to 95 basis points, toward the bottom
of its range since April, as risk appetite deteriorated on a
worsening global growth outlook and anticipation of Fed
tightening.
Fed lift-off "tightens financial conditions in Canada,"
according to Devlin: "We have got very over-indebted consumers,
so I think that would play out in lower consumption."
Canadian household debt compared to income rose to a record
163.7 percent in the third quarter. Last week, the new
government took steps to cool parts of a booming housing market.
On the upside, analysts expect the contrasting policy paths
to weigh on the Canadian dollar, helping the export sector.
"That will take some of the sting out of the higher
longer-term yields," said Chandler.