Will Canadian CPI Allow the BOC to Bail Out the Markets With a Rate Cut?

[B]AUG 21[/B]
[B]BOC Core CPI (MoM) (JUL) (07:00 EST; 11:00 GMT)[/B]
[B]BOC Core CPI (YoY) (JUL) (07:00 EST; 11:00 GMT)[/B]
[B]Expected: 0.1%[/B]
[B]Expected: 2.3%[/B]
[B]Previous: 0.0%[/B]
[B]Previous: 2.5%[/B]

[B]How Will The Markets React?[/B]
Inflation growth in Canada is expected to slow during the month of July, with the Bank of Canada?s core CPI measure estimated to have fallen back to an annualized rate of 2.3 percent from 2.5 percent. Such an easing in price pressures will help to alleviate the Bank of Canada?s inflation concerns, after the bank said on July 10th that another “modest” increase in rates might be needed to return inflation to its 2 percent target. However, the financial instability created by the toppling of the US subprime sector could create a few road bumps for the Canadian economy. Until recently, the Bank of Canada had been expected to raise interest rates in September, but now that the central bank has had to pump C$4.3 billion into the system through bond purchase-resale deals, speculation of a hike has been cut back significantly. Indeed, futures contracts now show that investors are betting on a rate cut before the end of the year. Canadian markets are particularly vulnerable to movements in the US, as the economies are extremely intertwined. In fact, ten financial institutions recently had to agree to bailout Canada’s C$116 billion asset-backed commercial paper (ABCP) market amidst the widespread liquidity crunch. As a result, Canadian markets will likely remain purely responsive to changes in risk aversion trends. However, if Canadian CPI shows very surprising result, fixed income, forex, and equity markets will at least see a knee-jerk reaction.
[B]Bonds - 10-Year Canadian Government Bond Futures[/B]
Canadian government bond futures pushed up against resistance at the 200-day moving averages (simple and exponential) at 112.31/58, as continued risk aversion worked in favor of government bonds. However, the contracts have slowed in their upward momentum as daily oscillators reflect overbought levels that have marked price peaks in the past. While risk aversion trends derived from global liquidity concerns will likely continue to play a greater role in CGB price action, event risk out of Canada creates hazards for CGBs, as a major shift in inflation data could either add to or curb speculation of a rate cut by the Bank of Canada this year. As a result, signs that CPI remains strong could lead the contract back down towards the 111.50 level, as the news would stir some speculation that the Bank of Canada will at least keep rates steady. On the other hand, a weaker-than-expected reading has the potential to send CGBs rocketing up towards Fibonacci resistance at 112.95.

The Federal Reserve?s 50 basis point cut to the discount rate to 5.75 percent sent the US dollar plummeting on Friday (for more on this story, click here), and the move was particularly severe against the Canadian dollar as the currency will benefit if volatility declines and investors return their focus to the Canadian economic outlook. USD/CAD price action early in the week will depend greatly upon how the US dollar fares, as the currency has turned into a safe-haven asset as the liquidity crunch takes its toll on the equity markets and carry trades. However, on Tuesday, the release of Canadian CPI provides substantial event risk for the Loonie. The Bank of Canada?s core measure is anticipated to ease back towards their 2 percent target to 2.3 percent, down from 2.5 percent, which will allow the central bank to forego their previously expected September rate hike. In fact, futures contracts now show that investors are betting on a rate cut before the end of the year, as the yield on the December bankers’ acceptance contract fell to 4.23 percent today, well below the bank’s benchmark rate of 4.50 percent. A sharper-than-expected decline in CPI will only exacerbate this sentiment and could catapult USD/CAD towards resistance at 1.0930. On the other hand, signs that price pressures persist could weigh USD/CAD down to keep the pair near 30-year lows. Regardless, traders should be aware that USD/CAD reaction may only be a knee-jerk one, as broader themes are likely to continue to dominate the forex markets.

[B]Equities - S&P/TSX Composite Index[/B]
The S&P/TSX Composite Index recovered on Friday, gaining for the first day in seven by 1.56 percent to close at 13,049.58, as the Federal Reserve 50 basis point cut to the discount rate triggered rallies in US and European equity markets as well. Looking at daily charts of the S&P/TSX, the index hit a supporting trendline going back to May 2005 on Thursday before makings its way higher. Price action in Canadian equity markets will likely remain contingent upon risk aversion trends in global markets, but on Tuesday, the S&P/TSX faces additional event risk from the release of CPI figures. Price pressures are anticipated to soften in July, which will add to market speculation that the Bank of Canada will refrain from hiking rates this year and could add to strength in the Canadian equity index. On the other hand, if inflation pressures remain strong, the S&P/TSX could be more vulnerable to decline further since the central bank would be less likely to consider cutting rates in 2007 as interest rate futures are currently pricing in.