Bond yields are certainly going higher, but not in the immediate future, say BMO Nesbitt Burns economists.

In its January bond strategy report, Nesbitt assert that bond yields will head higher this year. “However, with little risk of rising inflation and the Bank of Canada having set the stage for at least one more rate cut, yields are unlikely to move sharply higher in the next few months,” it says, counseling, “Stay no more than neutral on duration, favouring the short-end and avoiding 5-year bonds.”

Nesbitt notes that the U.S. economy is expected to grow by between 4.5% and 5% in 2004, lowering the unemployment rate to the mid-5% range by the end of the year. “The economic recovery is abundantly evident in the factory sector, which is now expanding at a torrid pace. As the economy continues to regain its footing, bond yields will head higher and the Federal Reserve will begin to raise interest rates. However, the temperate inflation environment will limit the increase in yields and keep the Fed patient early in the New Year,” it predicts.

The Canadian economy will benefit from the U.S. recovery, and will likely expand by 3% this year, Nesbitt suggests. “The surge in the loonie will dampen the rebound and is the main cloud on the Canadian economic landscape. Moderate inflation readings give the Bank of Canada the flexibility to trim rates further should it feel the need to offset the soaring Canadian dollar,” it says.

Nesbitt says that the Bank of Canada has the market virtually convinced it will cut rates during the first quarter, and it sees a move on January 20 as a possibility.

The U.S. Federal Reserve is expected to remain on hold after the two-day meeting on January 27-28, but could reinforce the neutral stance adopted in December, the firm says.