There's money to be made in Canada's bond market as bets on rate hikes soar

There's money to be made in Canada's short-term bond market with traders getting ahead of themselves in pricing in steadily rising interest rates this year, according to some fund managers.

Potential potholes from a breakup of NAFTA, to a stronger loonie and growing household debt means the Bank of Canada won't raise rates too aggressively after a likely hike at its next announcement on Wednesday, according to managers at CIBC Asset Management Inc., Leith Wheeler Investment Counsel Ltd. and Manulife Asset Management Ltd.

While this week's announcement is a “coin toss,” what's more certain is that the front end of the Canadian yield curve has become “a bit too bearish, providing an opportunity” to pick up beaten down bond prices which have fattened yields, said Patrick O'Toole, who helps manage $65 billion in fixed income at CIBC Asset Management.

Canadian bond yields shot up earlier this year, with two-year rates reaching a six-year high of 1.79 per cent after gangbuster jobs growth sent the unemployment rate to a 40-year low of 5.7 per cent in December. A Bank of Canada report also showed building capacity constraints among businesses. The Canadian dollar strengthened to 80.93 US cents after the jobs data release on Jan. 5, the strongest level since September.

Twenty-three of 26 economists surveyed by Bloomberg expect the Bank of Canada to increase its key rate by 25 basis points to 1.25 per cent Wednesday with the market for overnight interest-rate swaps pricing in an 88 per cent certainty on Tuesday. In total, the swaps market is wagering rates will rise three times this year to 1.75 per cent.

That's all a bit too optimistic for the money managers.

“Any number of risks could easily materialize to prevent the Bank of Canada from hiking more aggressively, including — ironically — that the bank tightens too quickly in the first half of 2018 and ends up straining a highly indebted household sector,” said Ben Homsy, a Vancouver-based fixed income portfolio manager at Leith Wheeler, who helps oversee $20 billion. “The market is being too aggressive in terms of what is priced for the whole of 2018.”

James Dutkiewicz, chief investment officer at Sentry Investments Inc. pointed to the market's reaction to reports of NAFTA ructions as an example of how quickly sentiment can turn. Yields tumbled along with the loonie on Jan. 10 after Canadian government officials were said to see an increasing likelihood the U.S. would give six months' notice to withdraw from the North American Free Trade Agreement which governs $1 trillion in flows between the U.S., Canada and Mexico annually.

NAFTA Nerves

“The NAFTA headlines strongly suggest any hike will be followed by long delay,” said Dutkiewicz, who heads a team managing US$14 billion.

The central bank is facing a tug of war between an economy that's currently overheating versus a cloudy outlook, said Frances Donald, senior economist at Manulife Asset Management. “The long end in Canada will likely continue to be supported by global hawkish central bank activity, but a more dovish than expected Bank of Canada, could lower the front end somewhat.”

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