“Grim” is the only word for it. Toward the end of summer, sentiment in the bond market moved from worries about the word “inflation” embedded in the concern that Canada would suffer from stagflation to an arguably deeper concern that inflation would be just a mild problem in an economy racked by recession.

The outlook has changed from potential increases in interest rates to the prospect of cuts in rates and reduction in income from bonds.

“The bond market is undergoing a major change in expectations,” says Paul Ferley, assistant chief economist with Royal Bank of Canada in Toronto. “In the face of dismal economic news — the worsening housing crisis in the U.S., rising unemployment in Canada, as well as falling commodity prices and declining energy prices — the outlook for Canada’s equity markets has turned negative. With that, the bond market has forgotten about stagflation and is now focusing on recession.”

The evidence for the shift in expectations shows up in the returns of bond portfolios. For the month of August, conventional bond prices, which move inversely to interest rates, rose by 0.7%.

The Bank of Canada left its overnight rate unchanged at 3% in its Sept. 3 announcement. Balancing inflation and recession concerns, the BofC’s actions were in accord with the consensus, which held that rates would not change.

Looking ahead, bond analysts anticipate that the BofC could cut rates further, by 25 or 50 basis points, by the end of 2008, says Edward Jong, senior vice president for fixed-income with MAK Allen & Day Capital Partners Inc. in Toronto and portfolio manager of frontierAlt Opportunistic Bond Fund.

“The Bank of Canada should be giving guidance at its next meeting on Oct. 21,” Jong notes. “The yield curve is now normal, and it is pricing in falling rates by the end of the year. It is very flat, and that suggests that the bond market is pessimistic about economic recovery.”

Baseball legend Yogi Berra usually gets credit for the comment: “Making predictions is always hard, especially about the future.” Whether that was one of his fa-mous malapropisms or a philosophical insight doesn’t matter; it is, in fact, the essence of the problem of predicting where the yield curve is headed and how advisors and their clients should react.

From 90-day treasury bills priced to yield 2.45% to maturity to long bonds paying about 3.98%, the curve has 153 bps of positive slope. In a year of troubles, it has gone from inversion to a normal, if rather gentle, upward slope. The return to showing long rates higher than short reflects a drop in near-term inflation expectations. And most of that has happened in late summer.

Bank of Nova Scotia senior economist Adrienne Warren says the consumer price index headline inflation rate should show a rise of 2.8% for all of 2008, down from an expected 3.8% before commodity and energy prices eased. But more easing in the U.S. is foreseeable, she says: “Mounting job losses are coming and inflationary concerns are declining. Lower materials prices imply lower headline inflation rates.”

In Canada, inflationary pressures have eased enough that the BofC can do its business as usual without buying up bad assets from banks, as the Federal Reserve Board has done with some U.S. investment dealers, says Patricia Croft, chief economist for Phillips Hager & North Investment Management Ltd. in Toronto: “If the Canadian bond market acts on core inflation of 1.2%-2% rather than on higher headline rates, there won’t be pressure to price in higher inflation.”

The consensus for Canada is a cooling economy, falling inflation rates, less pressure on prices and some need to stimulate the industrial economy. That implies a drop in rates. In this environment, conventional bonds should do well, while real-return bonds continue to lose appeal.

“The Canadian bond market has reached levels at which there is little downside in yields,” says Michael McHugh, vice president and portfolio manager with Dynamic Funds Management Ltd. in Toronto. “The Canadian debt markets have priced in 50 bps of rate cuts by the Bank of Canada by the end of 2008 or early 2009. While yields are bottoming out, over the next few months we don’t see government bond yields rising much because investors continue to worry about the health of the financial system. Instead, the money to be made is in corporate bonds.”

@page_break@For now, the best place to be is in short-term, investment-grade corporate debt with strong fundamentals, McHugh says. He likes the Bank of Nova Scotia 5.04% issue due April 8, 2013, recently priced at $102 to yield 4.55% to maturity. There’s also a TD Bank Financial Group 4.85% due Feb. 13, 2013, recently priced at $101.30 to yield 4.52% to maturity. In comparison, a five-year Canada pays 3.07%. The 1.4% yield pickup on these high-quality bonds amounts to a boost of almost a third more than government bonds.

That’s the reality of the present market — and a relative gain that would be unattainable in an economy with fewer fears, McHugh adds. That’s the bad news, but the good news is that those spreads were at 200 bps in March. Things may be tough, but they are getting better.

For its part, the BofC said in its July 17 Monetary Policy Report that “although credit conditions in Canada remain challenging, they are better in many respects than those in other major markets.”

The BofC further noted that, while spreads on corporate over government debt have expanded in the 12 months since the global credit crisis began in the summer of 2007, the target overnight rate it charges has come down by much more.

The bottom line is whether the fears brought on by tumbling equity prices, the residential mortgage crisis in the U.S. and the spreading global contagion of the U.S. credit crisis justify the high prices of Canadian government bonds and the relatively low prices of Canadian investment-grade bonds.

Bond investors who have sold off high-grade corporate debt, especially financial services companies’ bonds, are clearly not as confident of the solidity of the financial system as the BofC is. For now, investors can take advantage of high spreads on bank debentures or sit on the fence, staying short in T-bills. As McHugh says, investors are already counting on a 50-bps drop in rates within four to five months. Safety is expensive these days, but a five-year ride on bank debt may be a reasonable bet. It locks in a relatively strong return in a market that is likely to offer even less income. IE