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Alvin T. Tan, Research Analyst at Societe Generale, explains the hawkish commentary from Bank of Canada officials this month has taken the FX market by storm and the implied probability of a 25bp BoC rate hike in its 12 July meeting has exploded from under 5% just three weeks ago to over 70% currently, and a full hike is priced in for 3Q17, according to Bloomberg.

Key Quotes

“BoC Governor Poloz's latest comments earlier this week were pointedly hawkish, stating that the 2015 rate cuts (of 50bp) “have done their job”, and that the BoC should be reconsidering the policy rate level, as “excess capacity is being used up steadily.” Deputy Governor Patterson also mentioned this week that “the economic drag from lower [oil] prices is largely behind us.”

“We previously mentioned the positive growth momentum in Canada this year, but noted that inflation remained the crucial missing piece. Wage growth has been unexpectedly weak despite the low unemployment rate, and core inflation readings have trended lower for several months. Nonetheless, the signal from the BoC is very clear, and a rate hike is imminent, if not in the July meeting, then in September. A full economic update will be released with the BoC’s monetary policy report after the 12 July meeting.”

“The BoC is gaining confidence in the growth and employment outlook, and is essentially betting on the Philips Curve reappearing soon. Another reason for the hawkish turn is the BoC giving greater prominence to its financial stability concerns stemming from high Canadian household indebtedness and regional housing booms centred in Toronto and Vancouver.”

“Canada's Parliamentary Budget Office (PBO) recently forecasted that debt servicing costs of Canadian households would rise to 16.3% of disposable income by 2021, which would be a record level. The pre-crisis 2007 record high was 14.9%. Household debt as a share of disposable income is over 173% currently and expected to climb to 180% by 2020. The PBO concluded that the financial vulnerability of Canadian households “would rise to levels beyond historical experience”, and the BoC raised similar concerns in its June Financial System Review.”

“We had maintained that the Canadian dollar is undervalued, and we had previously expected USD/CAD to trade to 1.30 by early 2018. That target level has now been reached, and the medium-term outlook for the CAD has turned more much bullish given the BoC's hawkish shift. The loonie’s undervaluation should support further appreciation. Our technical strategist has pointed to USD/CAD 1.25 as the target once support at 1.30 is broken, as is likely in coming weeks.”

“Perhaps more interesting from a relative viewpoint is to go short NZD/CAD following its failure to break through 0.98 earlier this month. A decline to NZD/CAD 0.92 by year-end seems to be in the cards now. A rally in crude oil prices towards year-end would be an added benefit to the loonie.”

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