The combination of strong economic data and the prospects for higher inflation has created a perfect storm for bonds, says TD Bank senior economist Craig Alexander.

“Over the past six weeks, North American bond yields have climbed sharply, as markets increasingly priced in Fed rate hikes this year and an end to Bank of Canada rate cuts, which warranted a higher term risk premium. At the same time, the mix of data pointing to stronger growth and upward pressure on prices prompted investors to demand a higher inflation premium from fixed income markets,” Alexander says in a new report.

The result is that U.S. bond yields have climbed by roughly 100 basis points over the past six weeks, and Canadian bond yields have been pushed higher by the sell off in U.S. bonds. Alexander says that Canadian bonds have outperformed significantly, with the result that Canada-U.S. interest rate spreads have collapsed from 46 basis points to a mere 4 basis points.

“Looking ahead, there is no debating that fixed income markets have gone through a watershed change in expectations,”Alexander explains. “Concerns about disinflationary forces and the U.S. jobless recovery have been replaced by anticipation of rising inflation and central bank rate hikes. However, while yields are likely to grind higher in the coming quarters, the profound sell-off that has already occurred suggests that the future increase is likely to be far more subdued.”

The strong data flow has been fairly constant over the past couple of weeks, capped by market-beating jobs reports on both sides of the border this morning. Inflation concerns are currently centered around energy prices, with oil in the US$40/barrel range.

However, Alexander says that, “while the elevated level of energy prices will pinch consumer wallets and will constrain profit growth in some industries, the overall economic fallout in both Canada and the United States is likely to prove modest.”

But the impact of higher energy prices should start showing up in inflation statistics. “Indeed, headline inflation as measured by the consumer price indexes in United States and Canada will rise, likely reaching 3% and 2%, respectively, before the end of this year — representing more than a full percentage point increase from current levels. However, this should not unduly worry the central banks, unless there are signs that the energy costs are feeding through to higher core inflation,” says Alexander.