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TORONTO, Dec 4 (Reuters) - Canadian real return bonds, which saw firm demand at an auction on Thursday, still look attractive relative to conventional bonds, according to some market players who see the potential for higher inflation in coming months.
Real return bonds sold by the Canadian government are designed to offer inflation protection, with their principal and payout linked to the consumer price index (CPI).
Spreads between yields on regular Canadian government and real return bonds, known as inflation breakevens, are trading below 160 basis points for 30-year maturities, having narrowed from 200 basis points in the spring of 2014.
A narrower spread implies the market sees a reduced risk of inflation.
The breakeven narrowed as oil prices tumbled, pushing the Canadian economy into a mild recession and cooling the headline inflation rate. Data last month showed Canada's annual inflation rate held at 1.0 percent in October, the lower end of the central bank's target range.
To be sure, Canada had more bad economic news on Friday, with reports showing more jobs lost than expected in November, while exports tumbled in October. This suggests little economic momentum that could dampen inflation.
But some analysts said inflation could still move higher in coming months as the year-on-year drop in gasoline prices diminishes and a weaker Canadian dollar makes imports more costly.
The narrowing of breakevens in real return bonds is "over-blown," according to Andrew Kelvin, senior rates strategist at TD Securities, who expects headline CPI to rise to about 1.8 percent by the first quarter of 2016.
A relative lack of liquidity in real return bonds may also be a factor keeping inflation breakevens low, according to Kelvin.
At Scotiabank, the feeling is "that the market is under-pricing inflation risk in a number of markets," including Canada, according to Derek Holt, vice president of economics.
Holt said it will take years to see the full pass-through from a depreciating Canadian dollar, adding it "will be the more dominant story in the next few years in terms of being at or potentially above (the Bank of Canada's inflation) target."
The market is questioning the ability of the Bank of Canada and other central bankers to achieve their inflation targets, noted Sal Guatieri, senior economist at BMO Capital Markets. (Editing by Jeffrey Hodgson; Editing by Chris Reese)