December 9, 2016 / 8:26 PM / 10 months ago

Wider Canada-U.S. bond spreads to soften blow of Fed hikes on Canada

TORONTO, Dec 9 (Reuters) - Yields on Canada’s bonds will fall further below those of their U.S. counterparts, say strategists, softening the blow of expected Federal Reserve interest rate increases on already stretched Canadian households.

Investors betting on U.S. economic stimulus and Fed rate increases have pushed up global bond yields, raising borrowing costs for Canadians struggling with record household debt and a lackluster domestic economy.

Strategists see a limit as to how high Canadian yields will reach, however, and expect the 2-year yield to fall as much as 80 basis points below its U.S. equivalent by the end of 2017 as the Bank of Canada shows no desire to follow Fed increases. The spread was -39 basis points on Friday.

“They (the Bank of Canada) are going to be emphatically arguing that we are not raising rates to try to get that spread a lot wider,” said Richard Gilhooly, head of rates strategy at CIBC Capital Markets.

“They are trying to get that wider spread to compensate for stronger oil prices and still keep the Canadian dollar weak.”

Weakening of the Canadian dollar faded after the Organization of the Petroleum Exporting Countries agreed last week to cut output, boosting the price of oil, one of Canada’s major exports. The loonie on Friday touched a seven-week high of C$1.3153.

The Bank of Canada left rates on hold at 0.50 percent this week. It made clear that the recent rise in Canadian bond yields was driven by higher global yields rather than strength of the domestic economy, strategists said.

The rise in yields may be a focus for the central bank because high levels of household debt can amplify the slowdown in the economy resulting from higher borrowing costs, said Andrew Kelvin, senior rates strategist at TD Securities.

Canadian household debt as a share of income reached a record high of 167.6 percent in the second quarter.

Government tightening of mortgage rules has also contributed to higher borrowing costs.

The discounted 5-year mortgage rate rose from 2.09 percent at the start of November to 2.32 percent on Thursday, data from financial comparison platform RateHub shows.

Wider spreads will reduce pressure on mortgage rates, but the Bank of Canada may cut its policy rate if yields rise in a way that’s out of kilter with the strength of the economy, said Jimmy Jean, senior economist at Desjardins. (Reporting by Fergal Smith; Editing by Steve Orlofsky)

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