FX - USD/CAD: Trading the Bank of Canada Interest Rate Decision

Trading the News: Bank of Canada Interest Rate Decision

Why Is This Event Important:

As market participants expect the Bank of Canada to maintain its wait-and-see approach in January, dovish comments from the central bank could lead the Canadian dollar to retrace the advance carried over from December as interest rate expectations falter. The BoC is likely to maintain a cautious tone for the region as it curbs its outlook for future growth, and the rate decision could spark a sharp reversal in the USD/CAD as the pair carves a near-term-term bottom around 0.9850.

What’s Expected:

Time of release:01/18/2011 14:00 GMT, 9:00 EST

Primary Pair Impact :USDCAD

Expected: 1.00%

Previous: 1.00%

DailyFX Forecast:1.00%

Will This Be Market Moving (Scenarios):

A Bloomberg News survey shows all of the 32 economists polled forecast the BoC to hold the benchmark interest rate at 1.00% in January, while investors are pricing a 4% chance for a 25bp rate hike, according to Credit Suisse overnight index swaps. At the same time, the DailyFX team anticipates the central bank to keep borrowing costs on hold this month, but comments following the rate decision is likely to spark increased volatility in the exchange rate as investors weigh the prospects for future policy. We expect the BoC to maintain a dovish outlook for inflation as the ongoing slack within the real economy bears down on price growth, and the central bank may look to revise its economic assessment as the recovery appears to be weaker than initially expected.

The Upside

Household spending in Canada increased for the fifth consecutive month in October, with the labor market adding another 22.0K jobs in December, and the expansion in private sector activity may lead the central bank to hold an improved outlook for the region as it aims to encourage a sustainable recovery. In turn, the BoC may see scope to normalize monetary policy further over the coming months, and the USD/CAD may work its way back towards the 2008 low (0.9709) as interest rate expectations gather pace.

The Downside

However, as the marked appreciation in the exchange rate dampens global trade, with businesses scaling back on spending, the BoC may retain its pledge to “carefully” consider tightening monetary further as the economic outlook remains clouded with high uncertainty. Accordingly, dovish comments from central bank Governor Mark Carney could spark a sharp reversal in the exchange rate, which should lead the USD/CAD to work its way back towards parity.

How To Trade This Event Risk

Trading the given event risk is certainly not as clear cut as some of our previous trades, but the recent economic developments could encourage the BoC to hold an improved outlook for the region as private sector activity accelerates. Therefore, if the central bank raises its growth forecast and adopts a hawkish outlook for inflation, we will need a red, five-minute candle following the policy statement to establish a sell entry on two-lots of USD/CAD. Once these conditions are met, we will set the initial stop at the nearby swing high or a reasonable distance after taking market volatility into account, and this risk will generate our first target. The second objective will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its mark in an effort to protect our profits.

In contrast, the ongoing slack within the real economy paired with the uncertainties clouding the fundamental outlook may lead the BoC to maintain a dovish outlook for future policy, and the central bank may talk down speculation for a rate hike in the first-quarter of 2011 as it aims to balance the risks for the region. As a result, if the BoC maintains a weakened outlook for growth and inflation, we will implement the same strategy for a long dollar-loonie trade as the short position laid out above, just in reverse.

Potential Price Targets For The Rate Decision

Impact the Bank of Canada Rate Decision has had on CAD during the last meeting

December 2010 Bank of Canada Interest Rate Decision

The Bank of Canada held the benchmark interest rate at 1.00% in December given the “significant excess supply” within the real economy, and the central bank is likely to retain its wait-and-see approach throughout the first-quarter of 2011 as it aims to balance the risks for the region. The BoC said that economic recovery “appears slight weaker” than initially expected as the appreciation in the local currency “continued to exert a significant drag” on foreign demands, and the central bank went onto say that “any further reduction in monetary policy stimulus would need to be carefully considered” as the fundamental outlook for the world economy remains clouded with uncertainties. As the U.S., Canada’s largest trading partner, faces a tepid recovery, the BoC may see scope to retain its current policy over the medium-term, and the central bank may try to curb the rise in the Canadian dollar as it hampers the outlook for future growth.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario: If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the USD against the Canadian Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on USDCAD ahead of the data release.

Bearish Scenario: If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the USD against the Canadian Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on USDCAD ahead of the data release.

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View the Expo Presentation on ‘Trading the News’ For Additional Resources

To discuss this report contact David Song, Currency Analyst: dsong@fxcm.com