FX Strategy

We expect the Bank of Canada to key policy rates on hold and 0.5% at its meeting on Wednesday. In the absence of a monetary policy report (MPR) or press conference, the tone of the statement will be a key determinant of the market reaction.. With the data since the October MPR largely in line or a bit better than expected, the Bank of Canada will likely maintain its assessment that risks around the inflation outlook are ""roughly balanced". Additionally, the overall tone is still likely to be one of cautious optimism even as governor Poloz noted that uncertainty remains extremely high in recent comments. Overall the statement will suggest - as Poloz did in comments this week - that absent a material shock to their inflation outlook the bar for a cut remains relatively high.

Data: good, not great. Recent data leaves little to push the BoC off its comfortable, on hold perch. Q3 GDP outpaced the Bank of Canada's October forecast of 3.2%, driven accordingly by a rebound in exports from Q2 and still strong household consumption. The balance in exports fits the BOC narrative that exports will help support a rebound in H2 growth, but it still wasn't enough to offset the Q2 decline. Additionally, the continued weakness in business investment is likely to leave them cautious about a strong pickup in manufacturing in coming quarters. Employment data has also remained strong with the 6m trend accelerating to an above trend 20K. On the flipside, the trade balance reached its widest level on record (about 3% of GDP) as export growth remains uneven.

Tighter financial conditions from US spillovers. The 50 basis point rise in US yield since the election has brought Canadian yields higher as well, posing some concern about a premature tightening of financial conditions. Despite the rising US yields the Canadian dollar trails only the British pound in its relative out performance versus the US dollar since the election. It is likely too early to expect.

FX: Focus on Fed, US yields with high hurdle for near-term BoC cut. The BoC's on hold stance is likely to hhave short-term little impact on USDCAD, particularly with market pricing consistent with little BoC action through mid-2017. However with the OIS curve relatively flat, we continue to believe the market is underpricing the risks around the Canadian economy.. The pricing out of cuts since the October meeting has been one reason the C$ has performed well,, despite broader US dollar strength and additional risk premium from Trump-induced trade policy uncertainty. However, USDCADs inability to sustainably selloff following OPECS surprise decision to cut production by 1.2 Mn BBL/day suggest the market is more focused on global yield story than the oil price movements. Indeed $50/bb; WTI prices are still a lot of full cycle breakeven cost of many Canadian producers.

We continue to expect a sustained move higher in USDCAD toward yyear-end and over the course of 2017 driven by:

  1. a faster pace of Fed hikes in the market is currently expecting
  2. a tepid pace of Canadian growth as capacity and competitiveness issues hamper non-energy exports leading to a BoC cut in H2 2017 and
  3. increase uncertainty risk with respect to Canadian trade as President-elect Trump seeks to renegotiate trade deals

With oil prices likely to move higher post OPEC, implicitly we are assuming the recent decline in correlation between CAD and oil will continue to be displaced by rate differentials. As we have shown empirically, CADs sensitivity to rate differentials has increased in recent years. While higher will will lend some residential demand for CAD, we expect the rate story to dominate over the coming years, underpinning are bearish view

BoA/Merrill targets USDCAD at 1.36 by year-end and 1.38, 1.40, 1.41, 1.43 by the end of Q1, Q2, Q3 and Q4 of 2017 respectively.

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The Bank of Canada decision will be announced at 10 AM ET/1500 GMT on Wednesday. The expectation is for no change in rates at 0.50%.

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