The fixed income market is being too sanguine about the Bank of Canada’s rate tightening plans, according to a report from TD Economics.

In the report, Marc Lévesque, chief strategist, North America, FX and fixed-income research, TD Securities, argues that the Canadian and U.S. yield curves “have become two different animals, thanks in large part to a sharp divergence in the perceived direction of monetary policy”.

“Over the last three months, the U.S. yield curve has flattened by about 70 bps, as the markets have been pricing in an increasingly aggressive Fed. Three months ago, expectations were focused on a Fed pause at some point in the first half of 2005. Now, the markets are pricing in a rate hike at each of the next three FOMC meetings,” the report says.

As a result, yields on the 10-year bond have dropped, “somewhat astoundingly” the report says, all the way to 3.99%. “And, with the U.S. economy set to continue to grow at an above-trend pace over the next few quarters, inflation no longer below the Fed’s comfort zone, and a host of Fed speakers talking the hawkish talk – albeit at varying degrees – the risk is that further pressure on shorter-term yields could be in store. Meanwhile, a 10-year yield below 4.00% is completely at odds with the fundamentals,” it concludes. “We do not see any real value anywhere on the U.S. curve.”

However, while the U.S. curve has flattened, The report notes that the Canadian 2-10 curve has steepened by about 10bps. “There too, the markets’ perception of monetary policy is at play. While the Bank of Canada was squarely in tightening mode last fall (having raised rates both in September and October), it has since stopped moving rates higher, thanks to the expected impact of the appreciation in the Canadian dollar,” it says. It believes, “the 10-year looks attractive, relative to the rest of the curve, and also relative to U.S. Treasurys. Put it all together, and the Canadian curve looks too steep.”

The report says there are four reasons why it believes that the short end of the Canadian curve is starting to look expensive: the Canadian economy has slowed, but it is not tanking; the economy is operating very close to full capacity, and inflation close to target; the Bank of Canada is not all that dovish; and, the Canadian dollar has lost ground.

“All told, the Canadian 2-10 curve appears too steep. The market is putting too much stock in the Bank of Canada remaining on the sidelines through to the summer. We may view that as the most likely outcome, but at these levels, the short end of the curve is vulnerable to any strong data. And, given where the rest of the curve is sitting, the 10-year appears attractive by comparison,” the report counsels.