Fundamental Forecast for Canadian Dollar: Neutral

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The Canadian dollar is likely to face increased volatility over the following week as the economic docket is expected to reinforce an improved outlook for growth and inflation, and the recent developments may encourage the central bank to normalize policy further in the second-half of the year as the recovery gathers pace. However, a shift in market sentiment may lead investor to neglect the improvement in the Canadian economy as risk trends continue to dictate price action for the major currencies.

Consumer prices in Canada are anticipated to hold flat in May after expanding more-than-expected during the previous month, while the core rate of inflation is forecasted to increase 0.3% for the second month, and mounting price pressures could stoke expectations for a rate hike in July as the central bank aims to balance the risks for the economy. At the same time, a fifth consecutive rise in household spending would certainly provide the Bank of Canada with increased scope to normalize policy further as growth prospects improve, and a rise in interest rate expectations could drive the exchange rate higher as the central bank looks to withdraw support for the real economy going forward. However, investors are pricing the BoC to raise borrowing costs by nearly 125bp over the next 12 months according to Credit Suisse overnight index swaps versus bets for 150+bp during the previous week as Governor Mark Carney maintains a cautious outlook for the region, and the uncertainties surrounding the European debt crisis could lead the central bank to adopt a wait-and-see approach next month as it aims to secure a sustainable recovery.

BoC Governor Carney said that future rate hikes are not “preordained” during a speech earlier this week, and went onto say that the “bank must balance the competing influences on Canadian activity and inflation of momentum in domestic demand and the increasingly uneven global recovery.” In addition, the central bank head noted that the turmoil in Europe “could lead to a more protracted recovery” as the governments around the region struggle to manage their public finances, and pledged to act if the negative effects of the global imbalance increases the downside risks for the economy. Moreover, Mr. Carney stated the Canadian economy “is not as productive as it could be” as businesses keep a lid on production, but sees encouraging signs in the labor market as employment increases throughout the first half of 2010. As a result, the governing board may look to keep rates on hold next month as the outlook for global growth remains clouded with uncertainties, but the recent fundamental developments could fuel speculation for a rate hike next month as the rebound in economic activity gathers momentum.

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