Economists at BMO Nesbitt Burns forecast higher bond yields over the next year.

In the firm’s Bond Strategy report for March, the Nesbitt team says that economic prospects look bright with solid U.S. growth, a buoyant housing market, accelerating business investment and a factory sector that is turning the corner.

“Longer-term yields have recently trended lower as the output gap remains large and inflation has dropped below the Bank of Canada’s 2% target. However, with firming global growth, Canada seems to be on the verge of a period of stronger activity,” it says. “The Canadian dollar will remain a key challenge, but surging commodity prices and solid U.S. demand provide important offsets. Despite the recent trend toward lower rates, we continue to expect yields to be higher a year from now.”

Nesbitt notes that bond yields fell at all maturities in both Canada and the U.S. in February. “A number of factors provided support for Canadian bonds in February, including a tepid employment report for January and a sharp drop in the headline rate of inflation. As well, there were signs that Canadian consumer spending ended 2003 in a downbeat fashion and that the private sector is expecting to boost capital spending by just 1.7% in 2004. With the Bank of Canada placing heavy emphasis on domestic demand to support growth, the market continues to contemplate further rate cuts by the Bank of Canada,” it says.

Total provincial issuance in February was about $3.5 billion, with amortizing product dominating. “Going into the budget season we expect issuance to slow down, but to ramp up as provinces start new fiscal years with new borrowing authorities,” Nesbitt says.

On the corporate side, February’s new issuance was $3.3 billion. This is higher than January’s $2.5 billion, but well below a year ago’s $6.8 billion, Nesbitt says. “Corporate bond spreads continued to tighten last month. The short end outperformed slightly as most names in the 5-year part of the curve tightened 4-to-5 basis points,” it says.

As for strip bonds, Nesbitt says, “Long strip product is, in many cases, at all-time wide spread levels. We continue to believe that spreads will be tighter in a few months time but there may be some near-term widening before that occurs. Further Bank of Canada easing will make it even more expensive to hedge inventories of strip – buying strips and selling bonds, with the net cash raised banked at overnight to pay out the coupon on the bonds you are short. The outlook is bleak for spreads, but that is usually the time to buy.”