Look for interest rates to go higher in the mid-term, but there will be short-term risks, says BMO Nesbitt Burns Inc.

In its latest bond strategy report, Nesbitt argues that a sustainable business-led economic rebound is taking hold in the U.S.

“Much of the burden for growth has been lifted off the back of the U.S. consumer,” it says. “Despite the good economic news, the Fed remains adamant that there is no rush to raise interest rates. While the Fed is expected to remain sidelined into the second quarter of 2004, the strength of the data released late in the month caused many in the market to reconsider how long the Fed may stay on hold.”

As for the Bank of Canada, Nesbitt notes it remained on the sidelines in December, but continued to stress that further rate cuts are possible should the economy falter or be tripped up by the surging dollar.

“The Bank could cut rates again if the pace of growth does not accelerate after GDP’s lacklustre 1.1% expansion in Q3 that highlighted the slack in the Canadian economy. Together with moderate inflation, Canadian interest rates are unlikely to face substantial upward pressure in the near term. However, with core inflation creeping upward the Bank may face pressure to raise rates by late next year,” it says.

“The improving economic outlook suggests that the mid-term trend is toward higher interest rates,” Nesbitt concludes. “However, short-term factors will provide underlying support for bonds: inflation remains moderate, while terrorism, protectionism, and the mutual fund scandal are concerns. As such, we suggest lifting duration to just below the benchmark.”