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Blackrock sees Canada bonds beating US again on Poloz action

[TORONTO] Canadian government debt is poised to beat US Treasuries again in 2018 as the Bank of Canada will probably trail the Federal Reserve in raising rates, according to BlackRock Inc.

The world's largest money manager expects no more than two hikes from the BOC next year, compared with as many as four from the Fed. With the US jobless rate at a 17-year low, the Washington-based central bank has already been more aggressive in 2017, tightening three times, compared with two times for its counterpart in Ottawa.

The policy divergence has helped swell the extra yield that Treasuries offer over Canadian debt, and BlackRock expects more of the same in 2018. Against that backdrop, US dollar-based investors have earned 5.4 per cent in Canadian obligations this year, compared with 1.8 per cent for Treasuries, Bloomberg Barclays sovereign bond index data showed as of Dec. 22.

"The Canada-US spread is something we should be looking at as an opportunity," said Aubrey Basdeo, head of Canadian fixed income at BlackRock, which oversees almost US$6 trillion. "The 10-year part of the curve is where you'll get a bigger bang for your buck," in addition to the five-year, he said.

Ten-year Treasuries yielded 2.48 per cent Friday, or 46 basis points above similar-maturity Canadian debt. The spread, which is more than double the average for the past decade, shrank to as tight as seven basis points in September after the BOC's second rate increase this year sparked bets that Governor Stephen Poloz would keep tightening.

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That conviction has faded. The bank kept rates on hold at its last two decisions and the governor emphasized that he'd be "cautious" on future rate increases. The market-implied expectation for a hike in January was at 53 per cent Friday, based on overnight index swaps.

Greg Nott, chief investment officer at Russell Investments Canada, also expects the Fed to be more hawkish than the Bank of Canada next year.

"There's decent growth in the US and the Fed is hiking, so that will drag the Canadian yields up as well," Mr Nott said, adding his firm is overweight in five- to seven-year Canadian obligations. "We expect yields will rise in Canada in 2018, but by less than in the US" Strategists at Toronto-Dominion Bank take the opposite view. They predict the BOC and the Fed will move in lockstep in 2018, helping compress the yield spread between the two countries from what they see as "historically rich" levels.

For TD, the best way to express that view is by shorting Canada's 1.5 per cent notes due June 2026 against same-coupon Treasuries maturing in August 2026, the bank said in an outlook published last month. It targeted a 10-year spread of 15 basis points.

"End-of-cycle rates for the Fed and BOC should be within 25 basis points of each other, so if the two central banks are going to be normalizing policy rates in lockstep it is hard to justify spreads at these levels," Andrew Kelvin, a senior fixed-income strategist at TD, said via email.

Most strategists are on TD's side. The yield on Canada's 10-year note is expected to rise to 2.55 per cent by the end of next year, compared with about 2.88 per cent for the U.S. side, according to forecasts compiled by Bloomberg. That would narrow the spread to 33 basis points.

Unlike the BOC, the Fed provides a forecast for policy moves. It expects to raise rates three times in 2018, it said this month after increasing borrowing costs by a quarter-point to a target range of 1.25 per cent to 1.5 percent. Canada's benchmark is currently at 1 per cent.

Canada's economy unexpectedly stalled in October, the statistics office said Friday. The report caused the loonie and Canadian yields to fall, a reversal after faster-than-anticipated inflation and retail sales growth data Thursday.

The uncertainty over the future of the North American Free Trade Agreement and the economy's sensitivity to higher rates because of Canadian consumers' debt burden will keep the BOC from more aggressive tightening, according to BlackRock's Mr Basdeo. Plus, inflation in Canada will likely be more muted than in the US, he said.

In the US, "all the ingredients are there for upside surprises to growth as opposed to downside surprises," Mr Basdeo said. "The BOC is really trying to walk this fine line in terms of how it goes about normalizing the overnight rate."


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