Bank of Canada Core CPI (YoY) (12:00 GMT; 07:00 EST)
Expected: 1.7%
Previous: 1.8%

Headline CPI (YoY) (12:00 GMT; 07:00 EST)
Expected: 2.4%
Previous: 2.4%

How Will The Markets React?

The release of Canadian CPI data is likely to remind the markets of the Bank of Canada’s dovish bias following their unexpected rate cut earlier in the month. The headline CPI reading is expected to hold steady at 2.4 percent, while the Bank of Canada’s core CPI measure is anticipated to fall further below their inflation target of 2.0 percent to 1.7 percent. The divergence will be the result of huge increases seen in energy and food prices, as oil and wheat futures surged to record highs during the month. On the other hand, the rapid appreciation of the Canadian dollar throughout the year has led import prices to plummet, which explains why CPI figures actually contracted last month. In fact, the Bank of Canada’s monetary policy statement released following the December rate cut noted that “the Bank now expects inflation over the next several months to be lower than was projected in the MPR.” However, the Bank also judged that “the Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank's inflation projection.” If Tuesday’s inflation data proves to be unexpected, the Canadian dollar is likely to respond immediately, though its reaction may be more severe in the case of an upside surprise. Canadian government bonds, on the other hand, may show a sharper response to soft CPI figures.

Bonds – 10-Year Canadian Government Bond Futures

Canadian government bonds have bounced from the 38.2 percent retracement level of the rally from June – early December at 113.36, though the contract has struggled near 114.00. While upside remains to resistance at 114.26, the bigger picture for CGB’s appears to be bearish. Tuesday’s CPI report could impact price action, but how long the effect lasts will depend greatly on how far the data deviates from expectations. Especially strong figures could send CGBs plunging, as the Bank of Canada is already somewhat concerned about inflation risks and the news would prevent them from cutting again in January. On the other hand, if CPI contracts for the second month in a row, CGBs will likely rally towards 114.26, with sharper gains targeting 114.47.

FX – USD/CAD

The Canadian dollar has lost its luster against the greenback, especially after the Bank of Canada’s unexpected rate cut helped ensure that USD/CAD would hold above the psychologically and economically important parity level. Since then, the pair has simply meandered higher, but has also managed to push above trendline resistance. As a result, it appears that USD/CAD will likely continue to rise towards Fibonacci resistance at 1.0440 and the 200 SMA at 1.0528. However, surprising Canadian CPI figures could derail the pair, especially if the data signals a resurgence in price pressures that will prevent the bank from cutting rates again in January. Indeed, despite a slump in export growth, the Canadian economy has remained fairly resilient given strong domestic demand, which leaves the Bank of Canada hesitant to make monetary policy more accommodative. As a result, if a drop in import prices fails to hold CPI down, USD/CAD may take aim on parity once again. On the other hand, with instability in the financial markets and the widespread credit crunch looming as serious potential downfalls for the economy, a weaker-than-expected CPI report would raise speculation that the central bank will follow the Fed’s lead and take rates down another 25bp.

Equities – S&P/TSX Composite Index

Canadian equities have pulled back below the confluence of resistance at the 38.2 percent retracement level of the rally from 12,463 – 14,625 and the 200 SMA at 13,800. Furthermore, news that there was a C$24.3 billion outflow of Canadian securities investments in October suggest that international traders are not entirely confident that the Canadian markets are the best place to park their money. With the financial markets remaining a precarious place, the S&P/TSX may be susceptible to additional declines, especially if the index breaks below support at 13,550 to target 13,200. Canadian CPI figures on Tuesday may trigger additional declines for equities, as soft import prices may not be enough to pull the headline and core indexes lower. However, if CPI actually contracts for the second month in a row, the S&P/TSX could actually rally as the news would raise speculation of another rate cut by the Bank of Canada in January.

Terri Belkas is a Currency Strategist at FXCM.