Although bond yields slumped again in December, BMO Nesbitt Burns says that it expects to see them head higher in 2003.

“Despite the December pullback, we still look for yields to head higher over the next year. The Fed has been intensely focused on preventing deflation, commodity prices are already up meaningfully, and massive stimulus in the pipeline suggests that yields are unlikely to fall further,” says Nesbitt in it’s January Bond Strategy report.

BMO notes that both the U.S. Federal Reserve and the Bank of Canada have rate setting meetings in January. Canada’s central bank will reveal its rate decision on January 21, and the Fed will following up on January 28 and 29. “Neither central bank is seen changing rates, and their stances are likely to stay neutral with a cautious tone, given the uncertainty caused by the threat of war,” Nesbitt predicts.

Any decision on whether to go to war with Iraq will likely be made public soon after January 27, says Nesbitt noting that this is the day when U.N. weapons inspectors are expected to submit their final report on Iraq’s compliance with Security Council resolutions. And, this will be followed by President Bush’s State of the Union address.

Treasuries received a boost from flight-to-safety with the looming threat of war between the U.S. and Iraq, and further concern over recent actions by North Korea. As well, even though economic data continue to gradually improve, the U.S. recovery has been uneven, Nesbitt observes.

“The 10-year yield spread between Canada and the U.S. has narrowed from its peak in early October, but at almost 100 basis points, it remains quite wide on a historical basis. This has helped attract foreign investors and provided some support for the Canadian dollar. As the growth rates of the U.S. and Canadian economies and inflation rates converge, the spread should narrow further,” it says.

New issue activity in the Canadian corporate bond market was relatively modest in December, as only $1.3 billion was raised. Issuers included Investors Group with a $175 million 30-year issue, Union Gas with a $200 million 5-year deal, and yet another floating rate issue by GE Capital Canada Funding Company. Great-West Life Capital Trust also came to market with the first issue of Capital Trust Securities.

Issuance activity in most other products was light, too. “The strip market has been extremely quiet through December,” Nesbitt says. “Very low overnight interest rates make it quite expensive for dealers to hold large inventories and market liquidity has suffered as a result. Many accounts are waiting for a backup in yields before they start buying. Our fear is that there will not be a significant increase in yields for some time and that the curve will stay steep for longer than currently expected.”