960404

Canada bonds tempting back international investors

LONDON: Foreign investors are being lured back to Canadian bonds, finding negligible inflation and a dwindling deficit too hard to resist, despite enduring political risk, analysts said on Thursday.

With the U.S. economy beginning to stir, investors are being offered the enticing and unusual possibility that Canadian interest rates can hold below those in the U.S., they said.

"Moves below 136 basis points on the 10-year spread are really confounding the eternal pessimists on Canada," said Sonja Grueter, senior economist at IBJ International in London.

"A lot of this has to do with sentiment of foreign investors. That I really believe is the key," Grueter said.

David Bloom, international economist at James Capel in London, said Canada has managed to cut interest rates below the U.S. without big effects on its currency. "It might be able to unshackle itself from the U.S. if the U.S. has to raise rates."

The Canadian dollar is back under C$1.36 per U.S., a level it has struggled to hold in the past half year. This comes even as Canada dropped its target range centre for overnight lending to 5.0 percent from 5.25 percent on March 21, bringing it below 5.25 percent U.S. federal funds for the first time since 1994.

Meanwhile, the yield on Canadian three-month Treasury bills have been trading around equivalent U.S. bills in recent weeks. Canadian bills were quoted at 5.06 percent in London trade on Thursday, compared with 5.15 percent Treasury bills.

The spread between 10-year bond yields has been slimming as well. It is currently at 131 basis points compared with 140 basis points after the 1996/97 budget was released in March.

Analysts say the recent outperformance has been a reflection of the market's dawning realisation since the budget that Canada is finally getting its fiscal house in order.

Most encouraging is the inflation outlook, Grueter said.

Inflation in Canada is currently at around 1.3 percent year-on-year compared with around three percent in the U.S.

"A lot of investors are seeing Canada as an alternative to Treasuries," she added.

"The fundamentals are much better. You've got a good inflation differential, you have an improving fiscal situation...and you have a fairly decent funding position in Canada," she said."The supply is known and they are on track."

Finance Minister Paul Martin's continued struggle against the deficit was also beginning to show results, analysts said.

Martin was in London this week and said again he expects to undershoot his 1995/96 deficit target of $C32.7 billion and his 1996/97 forecast of $C24.3 billion.

But foreign investors will have to move quickly.

Grueter said the spread on 10-year bonds could narrow to around 125 basis points in the short term but with the Canadian economy expected to trundle along in the second quarter, interest rates might eventually have to rise.

Growth of 0.4 percent in gross domestic product in January exceeded most economists expectations. The Bank of Canada sees growth of 2.5 percent to 3.0 percent for 1996.

And as always, the perennial question of Quebec sovereignity will haunt the Canadian bond market, though with a "No" vote in last autumn's referendum that issue has shifted to the back burner for now, analysts said.

Capel's Bloom saw the spread dipping in as far as 100 basis points in the short term.

Bond traders in London have noted an uptick in interest in Canadian paper.

Japanese investors have begun to make enquiries about Canada again with the start of their new fiscal year on April 1, said Simon Last, trader at Bank of Nova Scotia in London."Have we sold paper into Japan? Yes we have since the year end. Am I detecting a sea change? It's too early to say," he said.-Reuter