TORONTO, Sept 8 (Reuters) - Canadian bond yields are exceeding their U.S. counterparts for the first time in about three years, as investors brace for further Bank of Canada interest rate increases while dialing back expectations for the Federal Reserve.
The catch-up in yields signals that bond investors believe in a better growth outlook for Canada and that the country's central bank will at least match Fed rate increases over the coming years.
"There has been some throwing in of the towel on the notion that the U.S. is going to be much more aggressive than Canada," said Mark Chandler, head of Canadian fixed income and currency strategy at Royal Bank of Canada. "After four quarters of good growth (in Canada), the question is how much is the U.S. ahead, if at all."
Data on Friday showed a much-awaited acceleration in Canada's wage growth as the country's economy added more jobs than expected in August, sending the unemployment rate to its lowest since the financial crisis.
The 5-year yield, which has surged as much as 89 basis points since early June, pushed above its U.S. equivalent on Thursday for the first time since October 2014. The 2-year yield crossed that threshold two days earlier and the spread has since widened to more than 20 basis points.
Canada's central bank struck a more confident approach to economic growth on Wednesday with its second rate increase in three months.
In contrast, Minneapolis Federal Reserve Bank President Neel Kashkari, one the U.S. central bank's most dovish policymakers, questioned this week whether the Fed's increases have done "real harm to the economy."
To be sure, Canada's 10-year yield is 10 basis points below its U.S. counterpart, but the spread has narrowed from -84 basis points near the end of May.
Investors had expected the Bank of Canada to proceed cautiously after it increased rates in July for the first time in nearly seven years. Wednesday's hike took some off guard and has left them scrambling to protect against additional increases. The median forecast in a Reuters poll is for rates to rise to 1.75 percent next year.
"It was a little bit of a wake up call for many people that the bank might be on a different path than what they were thinking," said Paul-Andre Pinsonnault, senior fixed income economist at National Bank Financial. "(The central bank) will need to do more than take back 50 basis points."
The central bank has now removed a pair of 2015 rate cuts, termed "insurance" at the time, that it says did their job in cushioning the economy from collapsing oil prices.
Money markets are pricing in two further increases by the end of 2018, which is one more than discounted from the Fed.
Still, Pinsonnault says that markets are "underpricing" prospects of Bank of Canada tightening. He projects a 2 percent rate by the end of 2018 as an increase in the minimum wage in Ontario's tight labor market boosts inflation and as fiscal spending juices the economy ahead of provincial and federal elections.
The unemployment rate in Ontario, Canada's most populous province, has fallen to its lowest since January 2001, Friday's jobs data showed.
"With the U.S. facing political gridlock and weather related hits to GDP, it is probable that momentum continues with Canadian yields rising above those of U.S. Treasuries at least in the short-term," said Anugs Sippe, multi-asset portfolio manager at Schroders. (Reporting by Fergal Smith; Editing by Steve Orlofsky)