Canadian government bond owners face downside risk

Investors in Canadian government bonds will be sharpening their pencils Friday to size up the impact of the real return on their bonds after adjusting the yield for the effects of inflation.

WHAT ARE THE EXPECTATIONS?

The core annual consumer price index, which excludes the eight most volatile items, is forecast to be 1.9 per cent in June, compared with 1.8 per cent in May, according to a survey of economists by Bloomberg.

That is close to the Bank of Canada's 2-per-cent target, but for investors in two-year Canadian government bonds - the current yield is 1.54 per cent - it implies a negative real rate of return. Investors in three-year bonds are also losing money when the return is adjusted for inflation. Holders of 10-year bonds with a 3.2 per cent yield are faring a little better.

HOW WILL

THE MARKETS REACT?

"That's one of the drawbacks of running an emergency low-interest rate policy," said Sal Guatieri, a senior economist with BMO Nesbitt Burns Inc. The Bank of Canada has been raising the target overnight bank rate, but it remains at an extremely low level historically.

Over all, the consumer price index in June is forecast at 1 per cent on a year-over-year basis, down from 1.4 per cent in May, according to the survey. The drop is expected to reflect, among other things, lower gasoline prices.

However, the overall rate of inflation rate is expected to spike by 0.7 percentage points in July when the HST is added to the national total, said BMO Nesbitt Burns in a report to clients. The effect of the HST will not show up in the future core inflation rate because the Bank of Canada strips out the impact of sales and other indirect taxes on the core rate, Mr. Guatieri said. Longer term, the HST should even lower the rate of price increases if manufacturers pass on their tax savings to their customers, he said.

Based on the overnight index swap rate, investors are currently estimating a 65-per-cent chance of another one-quarter of a percentage point rate hike in the target overnight bank rate by the Bank of Canada at its next meeting in September, said Stewart Hall, a currency and fixed-income strategist with HSBC Securities (Canada) Inc. That is almost twice the probability investors were estimating in their initial reaction after the recent rate increase to three-quarters of 1 per cent.

"People are beginning to look beyond the verbiage and [are] concentrating on the forecast," Mr. Hall said. The central bank expects the economy will be operating at full capacity by the end of 2011.

As a result, HSBC Securities expects the central bank's regulated rate will reach 1.5 per cent by the end of 2010 and it could reach 2.5 per cent by 2011, which would still be mildly accommodative to economic growth. But a lot of uncertainty remains, Mr. Hall said. "Interest rate markets will need to sit on the sidelines and appraise the market on a meeting-to-meeting basis," he said. But it does appear that there is very little upside for the two-year government bond prices and significant downside risk if bond prices drop as interest rates climb higher, he said.