Fundamental Forecast for Canadian Dollar: Neutral

The Canadian dollar recouped the losses from earlier this month as the economic docket reinforced an improved outlook for the region, and the commodity currency may continue to strengthen over the following week as market participants speculate the Bank of Canada to normalize monetary policy further this year. However, as the marked appreciation in the local currency bears down on the recovery, the BoC is likely to retain its wait-and-see approach throughout the first-quarter as the economic outlook remains clouded with “significant” uncertainty.

After holding the benchmark interest rate at 1.00%, the BoC raised its economic assessment and sees the economy growing 2.4% this year amid an initial forecast for a 2.3% expansion in the growth rate. However, the central bank struck a neutral tone for future policy as Governor Mark Carney maintained his pledge to “carefully” consider tightening monetary policy further, and the central bank head may continue to talk down speculation for higher borrowing costs as the underlying strength in the Canadian dollar drags on foreign trade. According to Credit Suisse overnight index swaps, investors now anticipate the BoC to raise the key rate by 50bp over the next 12-months after pricing 75bp worth of rate hikes during the previous week, and interest rate expectations may continue to deteriorate over the coming months as the central bank expects the real economy to operate below full-capacity until the end of 2012. In turn, the short-term rebound in the USD/CAD may gather pace going forward, and the exchange rate may continue to pare the sharp decline from the end of 2010 as the BoC remains comfortable with its current policy.

Nevertheless, consumer prices in Canada are forecasted to increase at an annual pace of 2.5% in December following the 2.0% expansion in the previous month, while the core rate of inflation is projected to grow 1.6% after rising 1.4% in November. The rebound in price growth is likely to spark a bullish reaction in the Canadian dollar, and the data could stimulate interest rate expectations as the economic recovery gathers pace. At the same time, the FOMC is widely anticipated to maintain a cautious outlook for the U.S., and dovish comments from Fed Chairman Ben Bernanke could spur a selloff in the USD/CAD as private sector activity in Canada outpaces the recovery in the world’s largest economy.

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