Bond investors should move from underweight to overweight in the middle part of the yield curve, BMO Nesbitt Burns Inc. says in its latest bond strategy report.

Nesbitt says it sees the bond market sell-off as overdone.

“Last month, we recommended a radical underweight in the middle section of the yield curve based on our view that the short end of the curve was poised to outperform,” Nesbitt says. “The short end rallied in Canada as the Bank of Canada cut rates and tilted toward further easing steps.

However, as the perceived possibility of nontraditional easing measures by the Fed fell, and as the U.S. economic outlook brightened, intermediate yields in Canada and the U.S. soared. We now recommend shifting to overweight the mid section of the curve, while keeping overall duration close to benchmark.”

Nesbitt says that it expects the Fed to remain on hold at its Aug. 12 meeting and to clearly reaffirm its intention to wait until the decline of inflation stabilizes. “The Fed has virtually promised to keep its policy rate on hold for the balance of this year, at a minimum,” it notes. “However, a run of considerably brighter economic data has the bond market in retreat. Spurred by mortgage-related dynamics in the market, we now believe the powerful sell-off has, if anything, overshot the fundamentals.”

Yet it still sees a further rate cut coming from the Bank of Canada. “The lingering impact of the SARS, and the ongoing impediment represented by mad cow disease, along with the hit to imports due to the strong loonie justify this change. And a sudden reversal of fortunes on inflation removed the only roadblock to easing.”

Nesbitt notes that the provincial new issue market was very quiet in July, and it expects things to continue to be quiet in August, “with borrowers potentially revisiting their financing programs in September”.
Also, July heralded the onset of the summer slowdown for new issuance activity with only $1.8 billion of deals brought to the market during the month, compared to $3.2 billion in June.