Bank of Canada Adopts Dovish Tone

By Win Thin

The Bank of Canada hiked rates by 25 basis points to 0.75%, as expected. However, the accompanying statement was a bit more dovish than the market was expecting, because it said further hikes would have to be "weighed carefully" in light of ongoing uncertainty regarding the economic outlook.

The Bank of Canada also noted that the global recovery is not yet self-sustaining, although it said that risks of an "adverse outcome" in Europe had diminished. The BOC sees core and headline inflation staying near its 2% target through 2012, but it cut its 2010 growth forecast (to 3.5% from 3.7%) and its 2011 forecast (to 2.9% from 3.1%), and raised its 2012 growth forecast (to 2.2% from 1.9%).

The Canadian dollar (CAD) is slightly softer after the decision, and recent U.S. growth concerns have made the loonie the worst-performing G10 currency over the past week, down more than 2.5% vs. the dollar (USD).

With the U.S. economic outlook still in question, we expect CAD to continue underperforming over the near term.

Charts point to a retest of the early July highs for USD/CAD around 106.70-80. After that, the next big target is the May high around 1.085. Bankers Acceptances futures have rallied today (implying a lower BOC policy rate), with the December contract down 2 basis points to 1.23%.

Back in April, the December contract was pricing in a policy rate in excess of 2%, but expectations have shifted sharply since then, and this has hurt the Canadian dollar.

Indeed, CAD peaked back the same day as the December contract (April 21) at .9931 vs. USD and has weakened steadily since then as the U.S. growth outlook has weakened.

The correlation between CAD and December Bankers Acceptance contract has risen to more than .80, underscoring how important the interest rate story has been for the Canadian currency.

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