Canada's Housing Bubble

March 19,, 2010 Greg Quinn Bloomberg

Investors are bringing forward their expectations for when the Bank of Canada will raise its key interest rate after reports today showed a measure of inflation above the bank’s forecast and strong retail sales.

Annual inflation excluding eight volatile items -- the so- called core rate -- quickened 2.1 percent in February, more than the 1.7 percent median estimate in a Bloomberg survey of 19 estimates. Canadian retail sales rose 0.7 percent as consumers stockpiled home improvement supplies before a federal tax credit expired. The yield on Canada’s benchmark 2-year bond has climbed 34 basis points this month as the outlook for growth improved.

Governor Mark Carney has pledged to keep borrowing costs at a record low 0.25 percent through June unless the inflation outlook shifts. He said in a March 2 rate decision that core inflation has been “slightly firmer than projected.” Yields on overnight index swaps and bankers’ acceptances contracts rose.

“This morning’s high side surprise in the inflation numbers is ramping up rate hike expectations,” said David Love, a Montreal-based trader of interest-rate derivatives at brokerage Le Groupe Jitney Inc.

Love cited today’s surge in yield on the December 2010 bankers’ acceptances contract, which jumped as much as 10 basis points to 1.58 percent, the highest since Jan. 8. Money managers and hedge funds use the contracts to bet on changes in interest rates and manage their exposure. The contracts have settled at an average of 17 basis points above the central bank’s overnight rate since Bloomberg started tracking the gap in 1992.

Higher Swap Rates

Canada’s 6-month overnight index swap rate, which marks what investors expect the central bank’s policy rate will average over that period, rose 3 basis points to 0.395 percent, the highest level since March 25, 2009. The one-year swap rate climbed more than 4 basis points to 0.778 percent, the highest since December, 2008.

Swap markets are pricing a 27 percent chance in June and a 100 percent probability in July of a 25 basis point Bank of Canada rate increase, according to Scotia Capital estimates.

The central bank, which uses the core measure as a guide for future inflation trends, predicted in January core inflation would average 1.6 percent in the first quarter and not reach 2 percent until the third quarter of next year.

“A high-side surprise yet again on core CPI would seriously ramp up the odds of the Bank hiking rates earlier and more often than the market currently expects,” Doug Porter, an economist at BMO Capital Markets, said before today’s report.

Corporate Debt

Elsewhere in credit markets, the extra yield investors demand to own the debt of Canadian companies instead of governments narrowed yesterday to 116 basis points, the tightest since November 2007 and down from 134 basis points at the end of 2009, according to Bank of America Merrill Lynch index data. A basis point equals 0.01 percentage point.

Corporate bonds in Canada yield 3.85 percent on average, down from the high this month of 3.95 percent on March 12. The securities have returned 2.61 percent this year, including a 0.01 percent loss this month.

The gap between the rate on three-month Canadian treasury bills and the three-month Canadian dollar London interbank offered rate, known as the TED spread, narrowed to 0.17 percentage point yesterday, the lowest since August 2007.

Canada Housing Trust, the financing arm of the nation’s housing agency, yesterday sold C$6 billion in mortgage bonds at the lowest relative yields since before the credit markets seized up in 2007. Canada Housing sold five-year, 2.5 percent bonds maturing in March 2015. The debt priced to yield 18 basis points above Canada’s 2.5 percent bonds maturing in June 2015.

Higher Yields

The yield on the Canadian government 1.5 percent bond maturing in March 2012 was 1.62 percent at 10:03 a.m. in Toronto, up from 1.28 percent on Feb. 26.

The central bank’s chief goal is keeping the overall rate of inflation at 2 percent. Inflation slowed to 1.6 percent in February, from 1.9 percent in January, the fastest in more than a year.

The economy grew at a 5 percent pace in the fourth quarter, the fastest since 2000, according to Statistics Canada. The economy shrank for three straight quarters through the middle of last year, the first recession since 1992.

The central bank focuses on the core measure because it can look past short-term swings in inflation.

“Core inflation has been slightly firmer than projected, the result of both transitory factors and the higher level of economic activity,” the central bank said in its March 2 rate decision.