Bank of Canada Rate Decision (14:00 GMT; 09:00 EST)
Expected: 4.50%
Previous: 4.50%

How Will The Markets React?

On Tuesday, the Bank of Canada will announce whether they find it necessary to cut interest rates by 25bp to 4.25 percent, as downside risks to growth continue to mount and credit markets remain tight. Indeed, there is much evidence that points to a potential cut, helping to explain why 12 of 27 economists polled by Bloomberg News believe they will do so. Economic expansion in Canada slowed during the third quarter to 2.9 percent from 3.8 percent during the quarter prior. The trade component created a drag on the headline figure, as the appreciation of the Canadian dollar led exports to slow to 2.3 percent from 3.1 percent. On the other hand, the national currency's gains helped business investment to jump and pick up some of the slack of the trade figures, as businesses were quick to take advantage of cheaper machinery and equipment prices in the US. Meanwhile, though Canadian labor markets remain extremely resilient, retail sales softened throughout the third quarter compared to solid gains throughout the second quarter. The combination of slowing expansion led by lackluster demand for Canadian exports and faltering domestic demand would be enough on its own to spark expectations for a rate cut by the Bank of Canada. However, October inflation readings showed a sudden drop in CPI, as the Loonie’s gains led the costs of imported goods to plummet. In fact, the Bank of Canada’s core CPI measure dropped 0.2 percent during the month, bringing the annual rate below their inflation target to 1.8 percent. These economic factors along with unstable financial markets have led futures to price in a roughly 50 percent chance that the Bank of Canada will follow the US Federal Reserve’s lead and make monetary policy more accommodative. Regardless of the actual decision, the news is very likely to spark major volatility in the nation’s bond, FX, and equity markets, so traders should pay heed to the news.

Bonds – 10-Year Canadian Government Bond Futures

Canadian government bonds have held to a short-term ascending trendline, though resistance looms closely above at 115.35 and 115.83. While we still have Monday’s price action to get through, Tuesday’s Bank of Canada rate decision may provide a lift for the contract. Even if the central bank does not cut rates, a pronounced dovish bias in their subsequent policy statement would lead the markets to ramp up speculation that they will move to make monetary policy more accommodative in the first quarter of 2008.

FX – USD/CAD

The Canadian dollar has lost steam in recent weeks since the USD/CAD pair bottomed out at 0.9059 on November 7. While the greenback has generally gained against most of the majors during that period of time, signs that the strength of the Canadian economy is waning has only helped accelerate the rebound in USD/CAD. Recently, the pair managed to push above the critical 1.00 level, but whether the Loonie will hold below parity remains to be seen. On Tuesday, the Bank of Canada will announce their interest rate decision, and the markets are split on whether they will cut lending rates by 25bp to 4.25 percent. Given signs that economic and financial market conditions are deteriorating, there is little doubt that the Bank of Canada will at least issue a somewhat dovish policy statement. The issue is determining what will make the Canadian dollar plummet.

First, an actual rate cut by the central bank will lead USD/CAD to surge towards resistance at 1.0173. Another scenario in which USD/CAD could gain is if the policy statement makes it clear that a rate cut may be implemented during their next meeting in January 2008. This would not be completely out of the norm, as the May 2007 policy statement gave a clear nod to the potential need for a rate hike when they said, “some increase in the target for the overnight rate may be required in the near term.” However, in this case, USD/CAD gains may be short-lived and more of a knee-jerk reaction. On the other hand, if the Bank of Canada maintains that “the current level of the target for the overnight rate is consistent with achieving the inflation target over the medium term” without citing downside risks to inflation or growth, USD/CAD could actually fall lower.

Equities – S&P/TSX Composite Index

Similar to the Dow Jones Industrial Average, the S&P/TSX Composite Index has bounced from the recent lows after plunging throughout much of the month of November. With volatility dying down somewhat, global equities have had an opportunity to gain and they may continue to stabilize throughout the week. Most recently, the S&P/TSX has run into resistance at the confluence of the 200 SMA and Fibonacci resistance at 13,733/35. Bullish targets loom above at the confluence of the 100 SMA and Fibonacci resistance at 13,879/903. While one of the biggest event risks for worldwide stock markets remains the December 11 FOMC meeting, traders should beware the results of Tuesday’s Bank of Canada rate decision. The markets are betting on a 50-50 chance that they will cut rates by 25bp, but there is little doubt that the policy statement will be somewhat dovish even if they don’t reduce rates. As a result, the S&P/TSX could stand to gain.

Terri Belkas is a Currency Strategist at FXCM.