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Canada bonds rebound from early losses, end mixed

TORONTO: Canadian government bonds ended mixed on Friday, with the long end moderately higher and shorter maturities dipping lower after a day of intense, volatile trading fuelled in part by fears of larger-than-expected interest rate increases in the U.S.

"There's a lot of different themes going on," said Marcel Kasumovich, associate economist with Goldman Sachs Canada.

North American bond markets tumbled in early trading after two key economic reports pointed to unabated economic strength in the U.S., market watchers said.

The U.S. employment cost index rose 1.1 percent in the fourth quarter, surpassing the expected 0.9 percent increase. Gross domestic product rose at 5.8 percent in the same quarter on an annualized basis. Economists had expected a 5.3 percent GDP growth rate.

"There's no doubt that the initial reaction to the U.S. numbers was significantly negative - the front end traded off, the long end traded off," Kasumovich said. "Since then, we've rebounded considerably."

The Canadian benchmark long bond, due 2027, gained 59 Canadian cents to C$122.56 to yield 6.264 percent.

The U.S. 30-year T-bond gained 39/32 to yield 6.426 percent. The negative spread between the two totalled 16.2 basis points after 22.0 basis points at the previous close.

The strong U.S. numbers had market players questioning the widely held view that the U.S. Federal Reserve will raise interest rates by only 25 basis points next week, and fuelled speculation that instead it might tighten rates by 50 basis points.

"There's some speculation he might go 50, which got the front end of the market going back hard," said one Toronto bond trader. "(With) the back end not moving, there's further inversion."

"Now we sit and wait for next week and see if he goes 50 or not," the trader added.

The collapse of North American equity markets helped bond markets recapture some of their lost ground later in the session.

"It seems like one of the reasons why we've had this rebound has been the degree of the sell-off in the equity market," said Goldman's Kasumovich.

Ailing stock markets may be seen as helping dissipate some of the strength in the U.S. economy, he added. "If we see clear signs of that wealth effect dissipating, then it definitely makes life for the Fed a lot easier, life for the bond market a lot easier, and I think that's the theme that we've seen today."

Trading activity in Canadian bonds was heavy on Friday morning, with CanPx reporting a total of C$1.7 billion in eight benchmark bonds.

The Canadian yield curve flattened as the long end continued to outpace shorter maturities. The Canadian market lagged the U.S. Treasury market in most maturities, with negative spreads at the long end of the curve narrowing.

Canada's two-year dipped 4 Canadian cents to C$98.38, for a yield of 6.197 percent.

The three-month when-issued was at a yield of 5.21 percent, up from Thursday's 5.20 percent.

-Reuters