Interest rates will rise by the end of June in the United States, and bond yields will going higher on both sides of the border, predicts BMO Nesbitt Burns in its Bond Strategy Report for June.

“There is clear evidence that the U.S. economic recovery is well entrenched, with the pace of growth likely to peak in the current quarter,” say Nesbitt economists . “With two months of strong job gains — through April — accelerating factory activity, and persistent signs that inflation pressures are building, the Federal Reserve is expected to raise rates starting on June 30.”

Notwithstanding that rate hike, Nesbitt says that will still leave the fed funds target quite low. As well, Nesbitt notes the Federal Reserve will still have quite a bit of work to do lifting rates back toward neutral territory. “We see the fed funds target rising to 3.5% one year from now. Longer-term yields are also seen rising, although the curve will flatten over that horizon,” it says.

Nesbitt says that the Canadian economy is unfolding broadly in line with the Bank of Canada’s view, although growth is carrying more momentum into Q2 than the Bank anticipated. Inflation risks lie to the upside, it says. “This suggests that the Bank of Canada will remain on the sidelines for a few more months, but that rate hikes are possible before the end of the year,” Nesbitt says. “October 19 is seen as a likely date for the first move.”

“Bond yields are heading higher in both Canada and the U.S. Corporate spreads remain poised to widen as government bond yields rise,” it predicts. Already, Canadian short-term yields have shot up by 34 basis points, but by only four basis points at the long end.

“With more curve flattening on the horizon, we continue to favour coupons and residuals on a spread basis versus the same maturity Canada bond,” it counsels. “The yield curve, and hence strip spreads, still has a long way to go. The backup in yields seems to have attracted buyers to the long end of the provincial strip market, where yields are now well in excess of 6%. We have seen interest both institutionally and through retail — another trend we expect to continue.”

Nesbitt predicts that more provinces will be tapping the bond market, too.” With rates heading higher, and with most provinces still having healthy borrowing requirements, we would expect to see several issuers access the market in June with a bias towards terming out their new borrowing,” it says. “We do not expect to see relief in the trend toward wider provincial spreads until larger issuers move into non-domestic markets.” However, corporate new issue activity slowed significantly in May to just $1.5 billion from $3.85 billion last month.