Bank of Canada CPI Core (YoY) (MAY) (11:00 GMT; 7:00 EST)
Expected: 2.3%
Previous: 2.5%

Headline CPI (YoY) (MAY) (11:00 GMT; 7:00 EST)
Expected: 2.2%
Previous: 2.2%

How Will The Markets React?

The prospects of a rate hike to 4.50 percent by the Bank of Canada in July has drawn quite a bit of attention by the markets after the central bank’s core CPI measure surged to a four year high of 2.5 percent in April. This represents a complete 180 degree turn from their policy stance just a few months ago, when the Bank of Canada said that risks to the economy were balanced. In fact, after the most recent policy meeting, the Bank issued a very hawkish policy statement saying that “there is an increased risk that future inflation will persist above the 2 percent inflation target and that some increase in the target for the overnight rate may be required in the near term.” However, the release of May CPI figures could curtail some of the market’s rate hike expectations as the Bank of Canada’s core measure is anticipated to ease back to 2.3 percent while the headline reading is forecasted to hold steady at 2.2 percent. Nevertheless, should the core reading hold above the Bank’s 2.0 percent target, traders will continue to look forward to policy tightening in July. On the other hand, if the markets see a surprisingly sharp contraction in prices, bond and FX markets could be sent reeling as the Bank of Canada would be less likely to take action next month.

Bonds – 10-Year Canadian Government Bond Futures

While 10-year Canadian government bonds eased back slightly today, leading yields higher, the pick up from the June 13th lows of 109.10 could continue if Tuesday’s CPI report shows that inflation pressures are easing. Prices could take aim on the 111.00 level, especially if the data raises the potential that the Bank of Canada will leave rates on hold in July. On the other hand, if the central bank’s core measure is released stronger-than-expected, CGB’s could plummet, especially as CPI above the BOC’s 2.0 percent target will up the ante for policy tightening in the near-term.

FX – USD/CAD

Of all the Canadian financial markets, the Canadian dollar has garnered the most attention over the past two months as the currency’s steep rally stirred fears of a move towards parity with the US dollar. However, since hitting formidable support at 1.0550, USDCAD has quietly worked its way up above 1.0700 from greatly oversold levels and Tuesday’s Canadian CPI report may only exacerbate this move. The Bank of Canada’s core inflation measure for May is anticipated to ease back to 2.3 percent from four highs of 2.5 percent, signaling that prices pressures may be abating and that April’s surge was just a one-off event. Such a result would lessen speculation for a hasty rate hike by the central bank in July, especially if the figure is released at a lower-than-expected rate, and could push USDCAD up to test 1.0750. However, even if we do see softer inflation figures, the move higher may be very brief as long as the core measure remains above the Bank of Canada’s 2.0 percent target, since they will still be very likely to pursue policy tightening next month.

Equities – S&P/TSX Composite Index

Canadian stocks rose for a fourth straight day, leading the S&P/TSX Composite Index up 0.3 percent to close at a record of to 14,176.42 in Toronto. Reports that BHP Billiton Ltd. is considering bids for Alcan Inc. or Alcoa Inc. reignited speculation that there will be a bidding war involving the aluminum producers, leading shares of Alcan to gain 81 cents to C$89.50. Meanwhile, crude oil for July delivery gained 1.6 percent to $69.09/bbl in New York after Nigerian labor unions threatened to strike this week. The news helped push EnCana, Canada's biggest natural-gas producer 31 cents higher to C$70.52 for its second straight record.

The S&P/TSX could be in for additional gains on Tuesday for a break of the May high of 14,216.21, as inflation pressures are forecasted to drop off. The Bank of Canada’s core CPI measure is predicted to ease down to 2.3 percent from its four year high of 2.5 percent, which could lead traders to believe that the central bank will hold off on raising interest rates in July to 4.50 percent. However, as long as core inflation holds above the Bank’s 2.0 percent target, a rate hike could still be in the cards and any gains in the S&P/TSX could be limited. On the other hand, if inflation reports are actually released at stronger-than-expected figures, there will be little doubt that policy tightening looms on the horizon and Canadian equities could be driven lower, leading the S&P/TSX towards 14,000.

Terri Belkas is a Currency Analyst for FXCM.