Canadian CPI (DEC) (12:00 GMT; 07:00 EST)
Expected: 2.4%
Previous: 2.5%

Canadian Core CPI (DEC) (12:00 GMT; 07:00 EST)
Expected: 1.7%
Previous: 1.6%

What Are The Markets Facing?

The release of Canadian CPI data is likely to remind the markets of the Bank of Canada’s dovish bias following their 25bp rate cut earlier in the week, as the headline CPI reading is expected to ease back to 2.4 percent, while the Bank of Canada’s core CPI measure is anticipated to remain below their inflation target of 2.0 percent at 1.7 percent. The easing in price pressures will be the result of declines in energy prices, as the rally in crude oil paused during the month. Meanwhile, the rapid appreciation of the Canadian dollar throughout 2007 has led import prices to plummet, which explains why CPI figures actually contracted in October. In fact, the Bank of Canada’s monetary policy statement released following the January rate cut did not include the phrase “there continue to be upside risks to the Bank's inflation projection” and instead noted that the “inflation projection has…been revised down since October, especially for 2008…On the whole, the Bank judges that the risks to this inflation projection are roughly balanced. In line with this outlook, the Bank has decided to lower the target for the overnight rate and further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term.” As a result, if Friday’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

The Canadian Government Bonds which topped out at 118.00 should find support at 116.58 the lows from Monday, as the longer term trend remains bullish. It should get support from the BoC which is expected to follow the Fed’s lead and cut rates, their dovish stance should increase as headline CPI is expected to print lower. However, if recession fears go away, you may see a reversal in the long term trend as the market has priced in several rate cuts which may not be forthcoming.

FX – USD/CAD

The Canadian dollar has lost its luster against the greenback since USD/CAD bottomed out at 0.9059 in early November, though the pair recently failed to break above resistance from the 200 SMA. However, one of the pivotal questions for USD/CAD is whether or not it can hold above the psychologically and economically important parity level. Indeed, an emergency rate cut by the Federal Reserve helped weigh the pair down and offset potential weakness in the Loonie deriving from the Bank of Canada’s expected rate cut, as the pair has gone on to test support at the 38.2 percent retracement level of 0.9755 - 1.0378 at 1.0440. 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 the near-term. Indeed, despite a slump in export growth, the Canadian economy has remained fairly resilient given strong domestic demand, which could leave the Bank of Canada hesitant to make monetary policy more accommodative if inflation appears to be accelerating faster than expected. As a result, if CPI fails to fall back in line with forecasts, 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 embark on a Fed-style rate cut cycle this year and lead USD/CAD to bounce higher.

Equities – S&P/TSX Composite Index

Canadian equities have seen extreme volatility after taking a cue from the U.S. equity markets. A global selloff in equities followed by an emergency rate cut by the Fed on Tuesday sent the index on a dizzying ride. An emergency plan for U.S. bond insurers and the anticipation of a rate cut by the BoC fueled an equities rally erasing a 3% loss and finishing up 16.50 yesterday. Look for stocks to build off of yesterday’s gains as an expected easing in the headline CPI will support the BoC’s dovish bias and nearly guarantee that they follow the Fed in cutting rates.

Terri Belkas is a Currency Strategist at FXCM.