INTEREST RATES: Starting the rate hiking cyle - slowly but surely

The Bank of Canada is widely expected to begin its rate hiking cycle on Tuesday, but in an environment in which some countries are contending with deflationary pressures and others are forced to implement austerity budgets, bond traders should not be looking for anything normal, strategists say.

A 25-basis point hike in the target overnight rate to 0.5 per cent seems likely, followed by another increase in July as the central bank moves away from the emergency low levels instituted during the credit crisis, economist say.

They are looking for a series of rate increases this year. (A basis point is 1/100th of a percentage point).

While there is little dispute that the rate-hiking policy is justified by the strength of the domestic economy, the global picture remains murky.

What are the expectations?

"We are not fully convinced that the bank will continue cranking rates higher at each and every meeting through the rest of 2010, especially with the U.S. Federal Reserve Board likely on hold until 2011," said Douglas Porter, deputy chief economist with BMO Nesbitt Burns Inc.

BMO expects the central bank will take at least one pause this year, and overall it expects cumulative rate hikes could total one percentage point by year end.

Predicting a course of action is also difficult because Bank of Canada Governor Mark Carney "has tripped up the market before," said Mr. Porter.

"In July, 2008, the Bank of Canada stayed on hold when everyone was looking for a rate cut."

CIBC World Markets Inc. is looking for five consecutive rate hikes of one-quarter of a percentage point – each meeting until October – followed by a pause until the second quarter of 2011 when growth is expected to fall short of the bank’s forecast.

How will the market react?

The difference in yield between the 10-year and the two-year Canadian government bond is now about 152 basis points. The yield on the two-year Canadian government bond rose 12 points yesterday to 1.84 per cent and it is up almost four-tenths of a percentage point on a year-to-date basis in anticipation of rising interest rates. The 10-year yield is 3.36 per cent.

"The curve [difference between the yield on 10-year and two-year bonds] will flatten, but it will remain relatively high given the pressures on global growth," said Eric Lascelles, the chief economics and rate strategist with TD Securities Inc.

Short-term interest rates will climb as bond prices fall, but the increase in yields will be less than normal, he said. Mr. Lascelles estimates that eventually the two-year yields could reach 3.5 per cent to 4 per cent.

But investors looking for higher yields on long-term bonds could be in for a disappointment. "While Canada’s short rates will top those of other countries in the near term, long bond yields could be lower than elsewhere, given the country’s unquestioned triple-A rating," said CIBC World Markets.

(prepared by Allan Robinson/Globe & Mail)