DB FX Daily: Bank of Canada and USD/CAD

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FX Daily: Bank of Canada and USD/CAD

Bank of Canada takes centre stage, but is USD/CAD effectively priced for a more hawkish statement?

In the wake of continued strength in the activity data, and more recently and more significantly an upside surprise on core inflation, Canadian interest rate markets have moved to price a rate hike by the end of the year. Today's BoC announcement, however, is almost universally expected to pass without a change in rates from the BoC. Rather, our Canadian economist (and we suspect the market) is looking for the statement accompanying the decision to evolve in a more hawkish direction.

In its last statement accompanying a rates decision the BoC noted that it continued "to judge that the risks to its inflation projection are roughly balanced, although there is now a slight tilt to the upside." With our US DB Macro Pulse Index having been on an upward trend since May and having recently moved above the Euro-zone MPI, the risk of a `more pronounced slowdown' in the US would appear to be receding (this being the key downside risk highlighted by the BoC in its last statement). Further, the most recent inflation data in Canada showing an increase in core inflation to 2.5% suggests that the risks around the BoC's inflation projection (which was for core inflation to moderate back to 2% by end 2007) may no longer be `roughly balanced'.

As far as USD/CAD is concerned, we noted in the FX Weekly that it has tightly followed the sell-off in the BAX strip (Chart 1, below) despite less supportive developments in commodity markets. In particular, USD/CAD has moved well beyond what oil prices alone would imply (Chart 2). We therefore see USD/CAD as being effectively priced for a move in a more hawkish direction from the BoC and perhaps more priced than rates markets are.

Indeed the risk to us given how far USD/CAD has moved recently would appear to be for a modest pullback near term. Should this eventuate, we would view it as an opportunity to re establish short USD/CAD positions as we continue to see the medium term outlook for USD/CAD as bearish. In particular, with the global economy remaining resilient, which should provide some medium term support to commodity prices, and the BoC expected by us to hike in July, we think that USD/CAD could test 1.05 in coming months.