Bond yields should begin to move higher, but market action is muted in the face of war worries says BMO Nesbitt Burns in its February Bond Strategy report.

“We believe yields will soon head moderately higher, propelled by the easing of geopolitical risks and modest but definite inflation pressure in Canada. Commodity prices are already up meaningfully, and massive policy stimulus in the pipeline suggests that yields are unlikely to fall further. There is also an emerging global reluctance to invest in North American markets amid the fall in the U.S. dollar,” says Nesbitt in the report.

“Yields in both the U.S. and Canada have been volatile but range bound so far this year. With the equity market rally having stalled, the war rhetoric heating up, and no convincing evidence of an upside economic breakout in the U.S., bonds have been able to maintain very lofty levels, particularly in light of the U.S. dollar’s decline,” it says.

Nesbitt says that North American government notes have been range bound, since bouncing off highs in early October. “Treasuries received an irregular but material bid from flight-to-safety with the looming threat of war between the U.S. and Iraq. Confidence in the progress of the U.S. economic recovery continued to wax and wane as the Bush Administration proposed a stimulus package and the Fed maintained its view that the economy was on the mend, with evidence supporting that due to accumulate this spring,” Nesbitt says. “There is no question about Canada. The economy and inflation pressures justify further Bank tightening.” It predicts that as the growth and inflation rates of the U.S. and Canadian economies converge, the spread should narrow further.

“The yield curve has flattened significantly since the Bank started their hawkish talk,” Nesbitt says. “The biggest beneficiary has been long-dated Canada coupons and residuals. The curve may take a breather but the long-term trend is clearly towards a flatter curve.”

On the corporate side, the new issue market has been surprisingly quiet. “Despite much anticipation, new issue activity in the Canadian corporate bond market was relatively muted in January at roughly $2.5 billion, versus nearly $4 billion of issuance for the same month in 2001.”

“Corporate bond spreads started the month on a positive tone as the market witnessed strong buying interest for higher yielding product in sectors like telecom, cable, oil & gas, and autos. Initial interest in corporate bond products even spread to beleaguered names like TELUS, Bombardier and Dominion Canada Finance. However, the recent string of weak economic indicators and growing geopolitical uncertainties, coupled with the concomitant downward pressures on stocks, precipitated a reversal of corporate bond spread movement,” Nesbitt says. “The spread widening was exacerbated by a number of negative rating agency actions in the latter half of the month on names like TransAlta, Bombardier and Shaw Communications. As a result, corporate spreads ended the month a little weaker than where they started, with few exceptions.”