Shorter-dated Canadian Bonds Make an Unexpected Gain

As the reality of economic issues continue to grow, the idea that the Bank of Canada would raise its benchmark rate as a concern over its largest trading partner, the United States, was believed by only a few market players. The following article is an in-depth look at how European bank stress tests underrated major banks to sovereign debt, and how the Canadian economy remains healthier than its U.S. counterpart, while "grinding ahead" of their longer-dated peers

Article Source (Dow Jones): Shorter-dated Canadian bonds made a surprising gain on Monday, and their longer-dated peers declined, one day ahead of a policy announcement from the Bank of Canada.

Canada's two-year bond yield was at 1.519%, down from 1.562% late Friday. The 10-year bond yielded 2.363%, from 2.399%. Bond yields fall as prices rise.

"It's surprising to see a rally in the front end of the curve. It's really caught me offsides," said Mohammed Ahmed, rates strategist in CIBC World Market's Macro Strategy group.

A Toronto bond trader attributed some of the rally to exceptionally thin trading, which often results in exaggerated market moves. He also cited a broad move to cover bets against the short-dated government securities, ahead of Tuesday's rate announcement.

"Everyone has the same positions. Everyone is in the same side of the boat, so to speak," he said.

The Bank of Canada is scheduled to make a rate announcement at 9 a.m. Tuesday.

The 12 economists at primary government security dealers polled last week by Dow Jones unanimously predicted that Canada's central bank will raise its overnight target rate by 25 basis points to 0.75%. The rate increase would be the second in seven weeks.

"I would have expected a bit of a selloff going into the meeting tomorrow, given the extent of the rally that has taken place to date. That, and the fact that it will be difficult for [Bank of Canada Governor Mark Carney] to be more dovish than he was on June 1," Ahmed said.

He said the rally came as investors pared their expectations for a rate increase.

Monday morning, the Overnight Indexed Swap, considered the most accurate measure of market sentiment, heralded a 90% probability that Canada's central bank would raise its overnight target rate by 25 basis points. By late afternoon, those expectations had been trimmed to about 85%, Ahmed said.

On June 1, Canada's central bank raised the overnight target rate from its emergency setting, becoming the first central bank in the Group of Seven to raise interest rates since the onset of the global economic crisis.

The bank has cautioned that future rate increases were not assured, and would be weighed against domestic and international economic conditions.

In data Monday, a report showed that foreign investors bought a record monthly net C$23.16 billion of Canadian securities in May, fueled by the second-largest investment in bonds on record.

Foreigners acquired C$15.22 billion of Canadian bonds, the largest since the all-time high of C$19.5 billion a year ago. Led by U.S. investors, purchases were driven by a C$11.5 billion investment in federal government bonds with a wide range of maturities and focused on Canadian dollar-denominated debt, as the Canadian dollar weakened against the U.S. dollar for the first time in four months. Yields on federal government bonds fell to their lowest levels since April 2009.

Foreign investors also added C$2.66 billion in Canadian money market instruments to their portfolios, including C$3.7 billion worth of federal government paper.

"It's generally a trend that we believe will continue as the Bank of Canada raises interest rates going forward, while most other advanced economies are on the sidelines," said Sal Guatieri, senior economist at BMO Capital Markets in Toronto.

He said foreign demand for Canadian debt instruments will likely remain "very strong" for the rest of 2010, lending support to the Canadian dollar and keeping Canada's longer-term interest rates low in the face of monetary tightening.