(Bloomberg) -- For two years, bond investors have been betting the U.S. would raise interest rates more aggressively than Canada. That bet has now faded.
Yields on two-year Canadian government bonds pushed above those of the U.S. after data last weak highlighted strength north of the border and weakening to the south. 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 on Wednesday. At the same time, a slowdown in U.S. 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."
Strengthened Dramatically
The yield on Canada's two-year federal government bonds rose one basis point to 1.35 percent, while the rate on similar-maturity U.S. Treasuries was down three basis points to 1.31 percent on Monday. The Canadian dollar strengthened 0.3 percent to C$1.2375 per greenback at 9:10 a.m. in Toronto.
Investors see a 48 percent probability of a Canadian interest-rate increase on Wednesday, according to overnight index swaps data compiled by Bloomberg. That's up from just 27 percent before the growth data, 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 82 percent compared with 34 percent for the U.S.
To be sure, the U.S. Federal Reserve is well ahead of the Bank of Canada on the tightening curve. It boosted rates in December 2015 after laying dormant for seven-years after the financial crisis. Three more increases later and the federal funds target rate stands at 1 percent to 1.25 percent. Canada first moved in July, surprising the markets at that. Its overnight lending rate is at 0.75 percent.
But Canada's economy strengthened dramatically over the first half. Gross domestic product expanded at an annualized rate of 4.5 percent 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, ‘hold on a second,'” Benjamin Reitzes, a Toronto-based rates and macro strategist at Bank of Montreal, said on 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.”
To contact the reporter on this story: Maciej Onoszko in Toronto at monoszko@bloomberg.net.
To contact the editors responsible for this story: Jacqueline Thorpe at jthorpe23@bloomberg.net, Christopher DeReza at cdereza1@bloomberg.net, Boris Korby
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