Canada-US yield spreads turn a corner on trade war bets

By Fergal Smith

TORONTO (Reuters) - The Canadian government bond market is unlikely to return to the record outperformance against U.S. bonds seen in February, as investors are now betting the trade war will slow the U.S. economy as well as hurt Canada's growth.

The Bank of Canada has been among the most aggressive of major central banks in the current easing cycle, cutting its benchmark interest rate by two and a quarter percentage points to 2.75% to support Canada's economy.

That led to the Canadian 10-year yield trading as much as 153 basis points below its U.S. equivalent in early February, the largest gap seen in LSEG data going back to 1994, but the spread has since rebounded to -125 basis points.

A negative yield spread indicates investors earn a lower return on Canadian bonds than on U.S. bonds if the investments are held until maturity.

A move to smaller spreads, including on shorter-dated bonds, could ease pressure on the Canadian dollar, which last month touched a 22-year low at 1.4793 per U.S. dollar, or 67.60 U.S. cents. Investors tend to favor higher yielding currencies.

"I think we've peaked," said Darcy Briggs, a portfolio manager at Franklin Templeton Canada. "The market assumed that whatever economy had the tariffs applied on (it) would be hurt, but now there is a growing realization that U.S. growth is actually set to come down considerably as well."

The Organization for Economic Cooperation and Development has forecast that U.S. economic growth will slow to 2.2% in 2025 and expects the economy to lose more steam next year. For Canada, the OECD sees growth slowing to 0.7% this year and next.

A decline in U.S. Treasury yields would likely be the main driver of smaller spreads as the market prices in a lower end-point for the Federal Reserve's easing campaign, said Robert Both, senior Canada macro strategist at TD Securities.

Canada's 10-year yield is "sitting much closer to fair value," Both said, forecasting the 10-year spread will hit -55 basis points by the end of 2026.

The BoC has said it would "proceed carefully" on further rate cuts given the need to consider upward pressures on inflation from the trade war. Canadian inflation heated up in February to an annual rate of 2.6% and that doesn't yet reflect the impact of tariffs.

New Canadian Prime Minister Mark Carney is expected to call a snap election within days, which could delay possible government economic support to counteract the impact of tariffs. Polls show the ruling Liberal Party in a tight race with the opposition Conservatives.

Regardless of who wins, analysts say that Canada has the fiscal room to respond to a crisis.

The Canadian government's latest projection shows the deficit at 1.6% of gross domestic product in the current fiscal year, much less than in the United States. The U.S. budget gap was 6.4% of GDP for fiscal 2024.

"Fiscal expansion is coming in one form or another," which would likely include spending on the military, infrastructure investment and tariff-related support for the economy, Jason Daw and Simon Deeley, strategists at RBC Dominion Securities Inc, said in a note.

Canadian bonds are unlikely to exceed their recent outperformance, the RBC strategists said.

"It would require a perfect storm of large and sustained tariffs without a fiscal offset and material Canada growth underperformance," they wrote.

(Reporting by Fergal Smith; Editing by Caroline Stauffer and Deepa Babington)