Canadian Dollar: BoC to Disappoint Warns Commerzbank

Above: All eyes are on Tiff Macklem next week. Image © Bank of Canada, Reproduced Under CC Licensing.

The Canadian Dollar has extended its 2022 advance over the British Pound to 0.70% as investors ramp up expectations for an interest rate rise to be announced by the Bank of Canada on January 26.

However, one analyst we follows says much of the "upside now appears to be priced in" and the Canadian currency could therefore soften in the wake of a decision to hike rates.

"Much of the upside seems to be priced in, which in our view harbours the potential for disappointment," says Elisabeth Andreae, a foreign exchange strategist with Commerzbank.

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Next week sees the Bank of Canada's first interest rate announcement of 2022 as well as the release of its Monetary Policy Report.

Money market pricing shows investors expect Governor Tiff Macklem and his team of policy makers to announce an interest rate hike as they look to combat surging inflation levels.

The Bank of Canada's Business Outlook Survey for the final quarter of 2021 showed 67% of respondents now expect inflation above the Bank's range over the next two years.

This saw markets ramp up expectations for a rate hike on Jan. 26 to a near certainty given the Bank relied heavily on the Survey for economic guidance.

The Canadian Dollar was one of the best performing majors of 2021 and 2022 has seen this outperformance extend, thanks to a combination of rising oil prices and expectations for higher rates at the Bank of Canada.

"In the wake of rising rate hike expectations and higher crude oil prices, the CAD trended firmer in January," says Andreae. "High inflation rates, surprisingly strong labour market data and the latest BoC business survey have fuelled market expectations that the BoC could raise its key rate."

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However, Commerzbank go against the consensus and say they are not entirely convinced a January rate hike is a dead certainty.

"According to its forward guidance, the BoC is signalling lift-off for April 2022 at the earliest. It repeatedly emphasised that interest rates would remain at the lower limit until the economic weakness is overcome," says Andreae.

She also points out in December the BoC continued to signal the expectation that price pressures are temporary, notably that headline inflation will peak at an average of 4.8% in the fourth quarter of 2021 and converge to the 2% target by the end of 2022.

"Given the data situation, the BoC is likely to adjust its projections in January. However, we do not think it is a done deal that the BoC will already raise rates, especially in view of the rampant omicron wave and the firmer CAD," says Andreae.

She adds rate hike expectations for the Bank of Canada appear to have already run "very far".

The prospect for disappointment is therefore elevated.