July 11, 2017 / 9:28 PM / 11 days ago

ANALYSIS-Rapid climb in yields to temper Bank of Canada's hawkish tone

4 Min Read

TORONTO, July 11 (Reuters) - Canada is leading the charge higher in global bond yields as major central banks turn more hawkish, but the rapid climb in domestic yields may have gone far enough for the Bank of Canada which is also concerned about risks to financial stability.

Investors expect the Bank of Canada to raise interest rates on for the first time in nearly seven years on Wednesday, and once more over the coming months, as the central bank removes a pair of 2015 rate cuts, termed "insurance" at the time, that it says did their job in cushioning the economy from collapsing oil prices.

The median consensus in a Reuters poll showed the bank will hike rates by 25 basis points to 0.75 percent on Wednesday.

But the jump in Canadian yields since the Bank of Canada turned hawkish last month, which is already pushing up borrowing costs for highly indebted Canadians, could soften the message that the central bank sends about its willingness to take back more than the 50 basis points in "insurance" cuts.

"I think the risk is they hike and they're dovish," said Ed Devlin, head of Canadian portfolio management at Pacific Investment Management Co.

"They got a lot more out of the market than they wanted to and so they try to walk the market back a bit."

The 10-year yield has soared 44 basis points since the Bank of Canada turned hawkish. That is much more than the 17 basis point rise for the U.S. equivalent over the same period, even as the Federal Reserve raised interest rates and said it would begin cutting its holdings of bonds and other securities this year.

"They flat-footed the market in a big way," said Scott Colbourne, co-chief investment officer and senior portfolio manager at Sprott Asset Management.

"It was very evident that the markets were very short CAD (the Canadian dollar) and long Canadian rates."

Bearish bets on Canada's currency ramped up in May to a record high as Canada's largest alternative lender Home Capital Group Inc nearly collapsed in April.

Colbourne expects Canada's central bank to be no different than other central banks which are proceeding cautiously on the removal of ultra low interest rates amid concerns about financial stability.

The Bank of Canada said in June that rising consumer debt levels and an unbalanced housing market have raised household vulnerabilities.

An early start to rate hikes could allow the central bank to proceed at a more gradual pace and be less disruptive for the economy.

"I would look to inflation, I would look to the commodity markets to say what's the urgency of trying to get two (hikes) rapidly in," Colbourne said.

The Bank of Canada's preferred measures of inflation are all well below the 2.0 percent target.

Still, the Bank of England and the European Central Bank also sent hawkish signals in June.

"It does have the appearance of a somewhat coordinated set of actions," said James Athey, senior investment manager at Aberdeen Asset Management.

He says that risks to financial stability from running monetary policy "at incredibly easy levels" and reduced fear of deflation have been the two major factors that have altered the mood of global central bankers.

"The thing they were most scared of, outright deflation, that risk has receded ... faster levels of growth and lower employment will tend to raise prices in the future." (Reporting by Fergal Smith; editing by Dan Burns and Clive McKeef)

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