Canada Bonds End Lower; Short End Underperforms Longer Issues

TORONTO (Dow Jones)--Canadian bonds ended lower Wednesday, with the short end of the yield curve selling off sharply along with U.S. Treasurys as comments from U.S. Federal Reserve Chairman Ben Bernanke incited speculation that the Fed could embark on monetary tightening earlier than previously expected.

1.50s 2012   100.33     dn     0.13  1.34% vs 1.28% 
   2.00s 2014    97.67     dn     0.33  2.52% vs 2.45% 
   3.75s 2019   102.50     dn     0.46  3.43% vs 3.38% 
   5.00s 2037   115.74     dn     0.68  4.04% vs 4.01% 
   10-Yr Spread to U.S. 10-Yr:    -27 vs -26 

"I would say all the action is Fed related today," said James Price, senior vice-president and director of fixed-income at MacQuarie Private Wealth.
In prepared testimony before the House Financial Services Committee, Bernanke suggested the rate paid to banks on excess reserves held at the central bank may for a time replace the Fed funds rate as the main operating target for policy.
As part of the Fed's plans to end its liquidity programs, Bernanke also said the central bank could "before long" increase the spread, or difference, between the discount rate it charges banks for emergency loans and the Fed funds rate.
"We initially had Bernanke speaking, saying there's a chance we might see the discount rate start to move higher, as opposed to the fed funds rate," said MacQuarie's Price.
"He almost immediately backtracked by saying this doesn't mean we're going to be in all-out-tightening mode. Nonetheless, he said it, and that had the short end underperforming right off the bat and the curve flattening," Price said.
A tepidly received auction of $25 billion of 10-year U.S. Treasury notes also weighed on North American bond markets Wednesday.
The Bank of Canada reported an average yield of 1.875% at an auction of C$3.2 billion (US$3.0 billion) of 1.75% non-callable government bonds due March 1, 2013.
With the issue of the new bonds, the outstanding total of 1.75% bonds due March 1, 2013, will be C$6.4 billion.
"To be honest, I think most people were watching the Treasury side of the equation more than the homegrown," said MacQuarie's Price. "Our supply is still relatively constricted compared to theirs, so the bearish talk we hear on the Street because of excessive Treasury supply doesn't necessarily apply to us."
The weakness in the front end of the yield curve resulted in significant flattening of the Canadian yield curve Wednesday, with the spread between two-year and 30-year bonds moving to 270 basis points from 274 Tuesday.
Price said he expects further flattening of the yield curve in response to the prospect of central bank tightening. The Bank of Canada, and, to a lesser extent, the U.S. Federal Reserve both have some room to tighten interest rates in the coming months, he said.
"I think they've got room to start lifting the short-term rates, or at least hinting that they're going to lift, and still be very accommodative," he said.
In domestic data on Wednesday, Canada's trade deficit widened to C$246 million (US$230 million) in December from an upwardly revised C$201 million the previous month. The market had expected a C$100 million deficit.
On Thursday, the new housing price index for December will be released.