The Bank of Canada, as expected, hiked rates by a quarter point to 0.75% in today's meeting. The accompanying release, while saying economic activity in Canada was unfolding largely as expected, did cut its forecasts for growth in 2010 and 2011. Growth in 2010 is now forecast at 3.5% from 3.7%, while the forecast for 2011 was revised to 2.9% from 3.1%. This revision reflects a slightly weaker profile for global economic growth and more modest consumption growth in Canada.

From the Release: Reflecting all of these factors, the Bank has decided to raise the target for the overnight rate to 3/4 per cent. This decision leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

Expectations are that the BOC will hike rates again to 1%, but then consider pausing in order to gauge how the global economy and the US - Canada's main trading partner - performs throughout the rest of this year.

As the BOC pushes its interest rate to 1%, and the assumption is that the Fed will hold pat, that increases the spread between Canadian and US yields and should be supportive of the Canadian Dollar.

On the other hand, further Canadian rate increases could slow Canada's recovery by boosting the country's dollar and curbing exports. In terms of borrowing costs, strong demand for Canadian debt from foreigners should work to keep longer term yields down, so the effect of the bank's hikes will be felt more on the short term end of the yield curve.

We had a report yesterday showing foreign investors bought a record monthly net C$23.16 billion (US$22.29 billion) of Canadian securities in May, fueled by the second-largest investment in bonds on record. Foreigners acquired C$15.22 billion of Canadian bonds, the largest since the all-time high of C$19.5 billion a year ago. It's generally a trend that I believe will continue as the Bank of Canada raises interest rates going forward, while most other advanced economies are on the sidelines.

Again this lends support to the Canadian Dollar, and it should also keep Canada's longer-term interest rates low in the face of monetary tightening.

In a short term view of this pair, we see recent greenback strength as concerns build around the US recovery which has hampered the outlook for global growth and weakened commodity currencies. Following the BOC decision, the USD/CAD tested its resistance for this week near the 1.0585 area, as the downgrade to growth assessment weakened the CAD. If the pair moved above this resistance, we can see an attempt to test the 1.0670 area.

 

In a longer term view of this pair, we see that the USD/CAD has been mainly confided to ranged trading, with the bulk of action coming between the 1.07 and 1.02 area. We have some factors working against each other in this pair. While higher interest rates and demand for Canadian debt from foreigners should help the CAD, weaker Canadian growth and a larger than expected slowdown in the US hampers the CAD's prospects. For now, the pair looks to test the upper regions of its recent trading range, however, in the medium term I think the CAD is better positioned, and as oil price pressures pick up (from the US moratorium and potential pick up in growth following this summer's slowdown due to stress from the Euro-zone debt crisis) the CAD should regain its footing and again test the 1.03 area and even parity.