Bond Traders Are Trimming Bets on Bank of Canada Hikes

(Bloomberg) -- The spread between Canadian and U.S. two-year government-debt yields is the widest since 2007 before Wednesday's Bank of Canada meeting, a sign traders are paring expectations for interest-rate hikes this year from America's northern neighbor.

Canada's two-year obligation yielded 1.74 percent Wednesday in London, compared with 2.54 percent for its U.S. counterpart, for a gap of 80 basis points. Since Thursday, the difference has widened six basis points, after data showed Canada's economy practically came to a halt last quarter.

The spread “is telling us that the market is less convinced of a BOC hike,” said Bipan Rai, head of North American foreign-exchange strategy at CIBC. “The market is looking for some form of acknowledgment of weaker-than-expected growth in the statement.”

Rai expects the loonie to weaken to C$1.36 per U.S. dollar over the coming month, recouping its year-end levels, from the current C$1.34. The depreciation would be contingent on weaker data, with all eyes on employment figures due Friday. The report is expected to show Canada's labor market barely added jobs in February, following an unexpected surge of 66,800 in January. The Canadian dollar has been the worst-performing Group-of-10 currency in the past week.

The recovery in oil since the turn of the year and optimism surrounding U.S.-China trade talks had some market strategists betting the BOC wasn't done tightening after five hikes since mid-2017. But deteriorating economic data have traders shifting gears, sending the probability of a rate hike by July below 15 percent, from about 26 percent a month ago.

BOC Governor Stephen Poloz and fellow policy makers are expected to keep rates on hold Wednesday, and for traders the focus will shift to the forward guidance. At its last meeting, the bank said the “policy interest rate will need to rise over time,” with a pace dependent on developments in oil and housing markets and global trade policy, according to a Jan. 9 statement.

“The market is already expecting a more dovish decision today,” said Lee Hardman, a currency analyst at MUFG. “For the Canadian dollar to weaken materially on the back of today's policy meeting, it is likely that the BOC would have to drop their tightening bias by removing the reference to raising rates over time towards neutral which could then encourage rate cut expectations.”

While April seems more likely a point for Poloz to abandon forward guidance altogether, there is still “a material risk” that the BOC would give up on future rate hikes at this month's meeting, according to Andrew Kelvin, a senior Canada rates strategist at Toronto Dominion Bank.

Either way, he expects the two-year yield spread to widen further in the next few months. Investors should go long Canadian fixed-income assets in the front end or the belly, either outright or versus Canadian 30-year bonds or Treasuries, he said.

--With assistance from Anooja Debnath.

To contact the reporter on this story: Misyrlena Egkolfopoulou in New York at megkolfopoul@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Mark Tannenbaum, Elizabeth Stanton

©2019 Bloomberg L.P.