The one impact of the US debt ceiling extension has been that government bond yields have dropped significantly over the past week. For instance, the 10-year Canadian government bond benchmark has lost about 25 basis points which is a huge drop:

10-year bond yields are now lower now than they have been since January 2009 (the depths of the financial crisis). The bond markets are highly pessimistic about any form of economic recovery and are trading as such.

Short term rates are no longer pricing in a sure chance of a rate increase – BAX futures are as follows:

The December BAX Futures are at 98.66 (1.34%) compared to 98.46 (1.54%) when the Bank of Canada made its last pronouncement on short term rates.  It no longer appears that short term rates will be rising at all.  Three month corporate paper is still at 1.17%.  If there is any hint of economic recovery, it is not seen in the bond market.

Examining the short-term interest rate expectations of the futures market:

The Japanese earthquake and general instability in the marketplace has driven the June futures up from 98.545 on March 1st to 98.66 today – which is pricing in a small chance that the Bank of Canada will increase interest rates on their May 31 interest rate announcement. It is far more likely that the short term rate will be 1%.

The futures still anticipate that the year-end short-term rate will be 1.5%, so it will be interesting to see if this comes to fruition. With reports of food inflation rising (primarily due to commodity price increases), the Bank may have to make an undesirable decision to raise interest rates to stem inflation, which would have an adverse effect on the economy and stock markets.

I stated earlier I do not expect the Bank of Canada to raise interest rates until 10-year government bonds go above 3.5%, and they are presently at 3.19%:

Notably, the Canadian 10-year bond is trading at a yield of 10bps less than the US 10-year note.

As predicted, the Bank of Canada leaves rates at 1%, citing:

The recovery in Canada is proceeding slightly faster than expected, and there is more evidence of the anticipated rebalancing of demand. While consumption growth remains strong, there are signs that household spending is moving more in line with the growth in household incomes. Business investment continues to expand rapidly as companies take advantage of stimulative financial conditions and respond to competitive imperatives. There is early evidence of a recovery in net exports, supported by stronger U.S. activity and global demand for commodities. However, the export sector continues to face considerable challenges from the cumulative effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance.

While global inflationary pressures are rising, inflation in Canada has been consistent with the Bank’s expectations. Underlying pressures affecting prices remain subdued, reflecting the considerable slack in the economy.

This language is similar to the previous release, and suggests that at the April 12th release that the Bank of Canada, barring any major events between now and then, will be keeping rates steady at 1% for that meeting.

BAX Futures are a shade higher, although it should be noted that the June future is at 98.545, implying a coin toss for a 0.25% rate hike at the May 31, 2011 announcement.

I am projecting that the Bank of Canada will leave the short term interest rate target at 1%. Their next policy rate announcement is on Tuesday.

BAX Futures for March are at 98.67, which suggest a low probability of a rate hike, but I stated before that I very much doubt the Bank of Canada will move until the 10-year benchmark yield is over 3.5% – with the geopolitical instability in North Africa, rates ended last Friday at 3.29%.

Especially with the Canadian currency at relative highs against the US dollar (which has a dampening effect on the export-driven Canadian economy) a rate hike seems unlikely at the moment, but the wording of the text may suggest that the next meeting may consider a hike if conditions warrant, beyond the already existing language.

The Bank of Canada holds the overnight target interest rate steady which resulted in a very mild decrease in the Canadian dollar as traders positioned themselves when reading the language in the statement.

Specifically:

Underlying pressures affecting prices remain subdued, reflecting the considerable slack in the Canadian economy. Core inflation is projected to edge gradually up to 2 per cent by the end of 2012, as excess supply in the economy is slowly absorbed. Inflation expectations remain well-anchored. Total CPI inflation is being boosted temporarily by the effects of provincial indirect taxes, but is expected to converge to the 2 per cent target by the end of 2012.

This is “fed speak” that is likely “We’re not going to do anything on our next meeting as we see how things unfold.”

BAX Futures have nudged slightly up in reaction to the statement:

I still maintain that long-term rates maintain much more relevancy – 10 year benchmark bond rates are at 3.25%, and it is likely that in order for the Bank of Canada to raise short term rates that the long-bond will need to go higher. It is my guess that the BOC has a silent objective to keep a 2-2.5% yield spread between short term and 10-year rates.

In 2011, the Bank of Canada will have eight announcement dates for the short term interest rate target:

January 18
March 1
April 12
May 31
July 19
September 7
October 25
December 6

Currently, the BAX Futures have the following quotations:

The markets are inferring there is a chance the Bank of Canada will raise rates by 0.25% during the March 1 meeting, and if not by then, then a good chance on April 12.  Three month corporate paper is currently yielding 1.18% (98.82 on BAX).  Clearly, the market is pricing in inflationary fears as opposed to factoring in economic or currency differentials, relative to the USA.  For people that have floating rate mortgages or margin loans, your cost for these loans is likely to increase slightly throughout 2011.

BAX futures suggest that the overnight target rate will be held at 1% for the December 7, 2010 Bank of Canada meeting:

The rates do suggest that by mid-year we might see another 0.5% increase in rates throughout 2011, but this is financially speculative noise peeking through the woodwork. 3-month corporate paper is yielding 1.17% at present, so there is not much of a divergence between existing rates and implied December 2010 rates.

In terms of long-term rates, Canadian 10-year bonds have crept up to 2.98% at the end of November 10th trading. While this is not anything significant in terms of the range over the past 12 months, it is up about a quarter point over the past month. The big scare for real estate gurus out there was likely in the early second quarter (April) when 10-year bond rates went to 3.7%. Still, this is nothing close to the past decade’s average of 4.3%, and the peak rate of roughly 5.96% back in the year 2001.

I am struggling to make what is a rather boring interest rate post interesting, so I will leave it here.