The bond market is in for a challenging year as the economy begins to recover and central banks contemplate raising interest rates, economists said on Tuesday.

At the Toronto CFA Society’s Annual Interest Rate Forecast, Avery Shenfeld, managing director and chief economist at CIBC World Markets Inc., said he expects economic growth to sharply rebound in the first half of 2010, which will prompt the Bank of Canada to start raising interest rates. He expects the central bank to increase its target for the overnight rate by three-quarters of a percentage point in the third quarter.

But he warned that this doesn’t bode well for bonds.

“The strong growth combination plus the prospect of these Bank of Canada rate hikes in the middle of the year isn’t going to make the next six months particularly rewarding for the bond market,” he said.

Shenfeld’s outlook for the U.S. bond market isn’t much rosier. He does not expect the U.S. Federal Reserve to raise interest rates until 2011, but he said the hefty U.S. deficit will put pressure on U.S. bonds this year. In fact, he said U.S. Treasuries may underperform the Canadian bond market due to the substantially larger deficit south of the border.

“Canadian deficits are not as alarming,” he said, “but they’re obviously no where near the surpluses that were benefiting the bond market in earlier years.”

Peter Hall, vice president and chief economist at Export Development Canada, said rising interest rates will also have significant impacts on the economy.

“The middle of this year is going to be a very significant time for the global interest rate cycle. That’s when the beginning of the unwinding of the monetary stimulus that we have seen up until this point will occur,” said Hall.

He added that the gradual removal of fiscal stimulus will also have an impact, taking a bite out of economic growth. Hall expects to see Canadian GDP growth of 1.9% in 2010.

As economic growth returns, Hall warned that there will be widespread fear around inflation, especially as CPI figures move into positive territory and display hefty gains over the negative figures of recent months. But he said inflation does not present a real threat in the near term.

“This is not a return to inflation — it’s simply a base effect,” he said. “Core inflation is still quite tame.”

Hall added that economic growth would need to be much stronger to drive real inflation. “We have way too much spare capacity at this point in time,” he said, pointing in particular to labour markets and inventory levels.

He warned that it’s important for policymakers to avoid prematurely unwinding stimulus in response to the return to growth in CPI.

In terms of currency, the economists agreed that the Canadian dollar is overvalued by about 10¢, which will hamper the performance of exports this year.

IE