December 14, 2015 / 11:17 PM / 2 years ago

Canada yield curve may steepen after Federal Reserve hikes U.S. rates

TORONTO, Dec 14 (Reuters) - Canada may see higher bond yields and a steeper yield curve as the U.S. Federal Reserve begins to hike rates, according to market players, weighing on the economy while raising borrowing costs for consumers and businesses.

The U.S. central bank is widely expected to raise benchmark interest rates on Wednesday for the first time since June 2006, lifting the federal funds rate from zero to 0.25 percent.

The Bank of Canada on Dec. 2 kept its key policy rate steady at 0.50 percent, but the market is leaning toward another rate cut after crude prices fell further.

Higher borrowing costs will add another headwind to an economy hit by the oil price shock and offsetting the boost from planned fiscal stimulus by the new Liberal government.

The most sensitive part of the curve in Canada is going to be the 10-year maturity, according to Andrew Kelvin, senior fixed-income strategist at TD Securities, as the Bank of Canada’s dovish stance caps yields for shorter-dated maturities.

The steepening in Canada’s yield curve may gather momentum if forecasts for more Fed hikes are borne out. Besides Wednesday’s anticipated hike, the median projection of Fed policymakers in September on the projected path of interest rates was 1.375 percent by end-2016 and 2.625 percent by end-2017.

That would entail 125 basis points in tightening next year, roughly two rate hikes more than implied by the market, assuming the Fed moves in 25-basis-point increments.

Likely flattening in the U.S. curve is not expected to play out in Canada, said Mark Chandler, head of Canadian fixed income and currency strategy at Royal Bank of Canada, pointing to the differing economic performance in the two countries.

In a rising rate environment, a flatter curve sees yields increase more for shorter-dated maturities than for longer-dated maturities.

“I think the front end gets more anchored by monetary policy and by oil and its more the belly and the longer end that gets affected by the U.S. curve,” said Ed Devlin, managing director and head of Canadian portfolio management at Pacific Investment Management Co.

The spread between Canada’s 2- and 10-year yields widened to 125 basis points in July, with the long-end underperforming as an aggressive correction in German Bunds spilled over to other core sovereign debt markets.

It has since narrowed to 95 basis points, toward the bottom of its range since April, as risk appetite deteriorated on a worsening global growth outlook and anticipation of Fed tightening.

Fed lift-off “tightens financial conditions in Canada,” according to Devlin: “We have got very over-indebted consumers, so I think that would play out in lower consumption.”

Canadian household debt compared to income rose to a record 163.7 percent in the third quarter. Last week, the new government took steps to cool parts of a booming housing market.

On the upside, analysts expect the contrasting policy paths to weigh on the Canadian dollar, helping the export sector.

“That will take some of the sting out of the higher longer-term yields,” said Chandler. (Reporting by Fergal Smith, editing by G Crosse)

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