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Why the U.S. influence on Canadian yields might really hurt this time

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Foreign investors ditched Canadian bonds in record numbers in June – the $19-billion fire sale was double the previous record. The abrupt surge in negative sentiment can be attributed to both an overvalued currency and the tendency of Canadian interest rates to closely follow U.S. yields whether it makes economic sense or not. The latter trend could really hurt the Canadian economy this time.

To a great extent, the more than $15-trillion (U.S.) Treasury market is the dog and every other global bond market is the tail. Every bond price in the world is discussed relative to the equivalent Treasury. Ask a Canadian institutional bond trader what the yield is on a domestic bond issue, for instance, and they won't give you a per cent. They'll say something like "15 inside" – that is, 15 basis points lower than the Treasury bond of the same duration.

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The end result is that every major bond market follows the direction of Treasuries. In Canada's case, they have historically followed U.S yields extremely closely. Despite decidedly different economic growth paths over the past decade, the average difference between Canadian and U.S. 10-year bond yields has been a scant five basis points.

In the current environment, this is not good news. Since May, the Canadian 10-year bond yield has followed the Treasury's 109-basis-point climb with a 94-point jump of its own. South of the border, the rise in rates is somewhat justified by a strengthening economy. But in Canada, rates are rising despite economic data that has broadly been reported below economist expectations.

In a rising rate environment the major banks have to pay more for funding (except for deposit rates – they stay low for a long time). Banks are more than happy to pass this cost along in the form of higher loan and mortgage rates to preserve profit margins.

You see where this is going. U.S. rates rise, dragging Canadian bond yields, loan and mortgage rates along for the ride. The rising Canadian mortgage rates are particularly dangerous at a time when the country's extended housing price boom is increasingly in question.

This is the double-edged sword nature of Canada's close proximity to the economic behemoth to the south. The domestic economy benefited when the Fed helped drive U.S rates lower; the resulting lower mortgage rates helped fuel the housing boom.

Now, if things don't change, it might be time to pay the fiddler.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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