Bank of Canada Rate Decision (13:00 GMT; 09:00 EST)
Expected: 4.50%
Previous: 4.25%

How Will The Markets React?

The Bank of Canada sprung no surprises on May 29th when they left rates at 4.25 percent, but the hawkish policy statement released after the announcement caught the market completely off guard. The bank said “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.” This was all traders needed to hear to adjust their expectations in favor of a July 10th hike to 4.50 percent. Just a few months ago, the Bank of Canada said that risks to the economy were balanced, but the central bank has grown increasingly hawkish since then, especially after core CPI for April hit 2.5 percent – well above the 2 percent target. Over the past month, there are signs that inflation has cooled somewhat, with May core CPI down to 2.2 percent annualized. Nevertheless, with home, energy and metals prices adding upside risks, markets are betting on monetary policy tightening this month. The key to trading the event, however, may be more reliant upon the Bank of Canada’s statement regarding monetary policy, as traders will be looking to gauge whether or not more rate hikes loom on the horizon. FX and bond markets will be most attuned to this possible shift in sentiment, however, Canadian equity markets are more likely to hone in on the actual rate decision itself.

Bonds – 10-Year Canadian Government Bond Futures

Daily charts show that 10-year CGB futures have recovered slightly following last week’s steep declines, but with major event risk on the horizon, where will CGB’s go next? The Bank of Canada is widely expected to hike rates for the first time since May 2006, which will stoke some wild volatility in Canadian fixed income markets. While a rate increase has the potential to spark a further sell-off down to the 109.00 level, a more neutral policy statement signaling that the markets may not see another round of policy tightening for quite some time could limit the move.

FX – USD/CAD

The Canadian dollar has shown unabashed strength over the past few months, as USDCAD has most recently plummeted to 30-year lows just below 1.0450. With a rate hike by the Bank of Canada anticipated to be enacted on Tuesday morning, the one thing that forex markets can count on is a large dose of volatility. What we could also see, however, is a solid turn in USDCAD. First consider that heavy support lies below at 1.0450 and 1.0393, limiting substantial downside moves for the pair. Furthermore, policy tightening by the Bank of Canada is more than priced into USDCAD, which brings to mind the price action in GBPUSD amidst last week’s rate hike by the Bank of England. In the days prior to the UK central bank’s widely expected policy decision, we saw GBPUSD trade up to new multi-decade highs above 2.0200. Then, when the actual rate increase to 5.75 percent was announced, we saw the pair spike higher before falling nearly 150 points over the course of the next 24 hours – and this was with a hawkish policy statement!

The lesson learned here is that the run up to the event builds significant pressure in the nation currency, which is only exhausted after the release of the scheduled fundamental risk. As a result, there is a good chance that USDCAD will spike down towards 1.0400 once again, but if the Bank of Canada fails to signal an ultra-hawkish bias in their policy statement, the Loonie may finally start to see sustained weakness, and a break above resistance at 1.0500 could lead to an ascent to 1.0600.

Equities – S&P/TSX Composite Index

Canada's benchmark equity index closed up 0.4 percent at a record of 14,177.52 on Monday amidst takeover speculation, spurred by a report that Alcoa Inc.'s hostile bid for Alcan Inc., which expires tomorrow, may be topped by Rio Tinto Group. Alcan shares added 15 cents to C$91.05. Meanwhile, commodity producers gained on optimism they will profit from higher prices for gold, copper, and crude oil. Barrick Gold, the world's biggest bullion miner, rose 64 cents to C$32.80 while smaller rival Goldcorp Inc. added 36 cents to C$27.33. Kinross Gold Corp., Canada's third-largest producer, increased 35 cents to C$13.85.

Monday’s price action represents the third test of resistance at 14,200, and could mark a triple top for the S&P/TSX Index. Tuesday’s event risk bolsters this case, as the Bank of Canada is widely expected to raise interest rates 25 basis points to 4.50 percent. Such a decision has the potential to send Canadian equities reeling, especially as the markets fears that policy tightening will result in a move by the Canadian dollar to parity with the US dollar. This could have a severe impact on Canadian exporters, who have already felt the effects of Canadian dollar appreciation. As a result, the S&P/TSX could take a dive towards 14,000 on Tuesday morning.

Terri Belkas is a Currency Analyst for FXCM.