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What's behind the narrowing yield spread?

The narrowing gap

The yield spread between Canadian and U.S. government bonds has narrowed in recent weeks, but still remains large.

An example from last week: With a two-year Canadian note at 1.85 per cent Wednesday and the comparative U.S. instrument yielding just under 0.8 per cent, the difference was more than a full percentage point. The yield spread has been at least 100 basis points for all but two trading days since mid-October.

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Yet last week's numbers represented a smaller difference than earlier this year: In mid-January, the spread topped 120 basis points.

Why is the yield spread declining? One reason is the Bank of Canada's unexpected caution in its 2011 growth forecast last month. Had the central bank come out as bullish as the market expected on GDP gains, rates would have been higher based on the belief the bank would be reining in the economy. The central bank's muted view tempered Canadian yields.

Second, U.S. investors have been piling into stocks over the last two months. As investors embrace the risk trade and lessen their demand for the safety of Treasuries, prices have fallen and yields have risen.

"To be clear, Canadian yields have risen, but they've risen less than the U.S.," says Kam Bath of RBC Dominion Securities Inc.'s global rates strategy department. Mr. Bath says he expects the spread to widen again as the Bank of Canada "gets back on track around mid-year."

China's real interest rates

Interest rates in China keep rising - but the real cost of borrowing remains near historic lows, says Stéfane Marion of National Bank Financial, who reminds us of the concept of real interest rates - the nominal interest rate after it's been adjusted for inflation.

The central bank of China raised the one-year lending rate last week by 0.25 percentage point to 6.06 per cent, the highest level since October, 2008. It was the third time in less than four months the bank raised the rate.

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Yet if you adjust the rate for non-food inflation, Mr. Marion notes, the one-year lending rate remains well below the level of October, 2008. At just under 4 per cent, real interest rates in China remain more than 100 basis points below their decade average of 5.12 per cent, he notes.

"This means that there is scope for a further increase in lending rates in the coming months, accompanied with an appreciating currency," Mr. Marion said. He says current pricing on forward contracts suggest an appreciation of the Chinese currency of 2.5 per cent over the next 12 months.

"We find this to be rather complacent," Mr. Marion said. "The last time China raised interest rates by more than 70 basis points, the [yuan]strengthened by around 8 per cent versus the U.S. dollar in the following year."

A muted recovery

Think that the bad news is past for the U.S. economy? The bearish money managers at Pennsylvania-based Comstock Partners have a different view.

Comstock notes that we are 36 months from the previous economic peak. To compare this recovery to past ones, the firm took the most recent readings for eight significant economic indicators. They then compared them to readings 36 months after the last two pre-recession economic peaks in 1990 and 2001.

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"The results are very clear that the current recovery is far weaker than the prior two expansionary periods, which themselves were below the average of other postwar expansions," the Comstock Partners wrote.

The most striking difference is in new home sales, which were up an average of 23 per cent in the two prior recoveries, and are down 47 per cent now.

Other measures also tell the tale of an exceptionally slow rebound, from retail sales to non-farm payrolls, to gross domestic product, up just 0.2 per cent now, compared with an average of 6.4 per cent at this point in the previous two cycles.

"The current recovery is far weaker than the prior two across a broad array of major economic numbers, and the Fed apparently agrees," Comstock Partners say. "The current market action seems based on the same type of [delusional] views that prevailed at the tops in early 2000 and late 2007, and therefore rests on a rickety foundation."

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