Foreign-exchange traders who had all but priced in a Bank of Canada rate hike are suddenly paying up to hedge against the risk of a letdown at Wednesday's policy meeting.
The country's five biggest lenders all brought forward their rate-hike expectations to January from April this month after the nation's jobless rate dropped to its lowest in more than 40 years. But the cost to protect against loonie losses has skyrocketed after reports the U.S. would withdraw from the North American Free Trade Agreement gave investors pause and thrust the prospect of a stand-pat BOC into the spotlight.
Implied volatility contracts with a tenor of one week spiked to 10.6 intraday Tuesday, the highest since the days surrounding the central bank's September gathering, when officials shocked markets with their second hike in as many meetings. The loonie fell as much as about 0.95 per cent Jan. 10, the most in more than two months, the day the NAFTA speculation swirled. The Canadian currency has gained about 6 percent versus the U.S. dollar in the past 12 months, and the pair currently trades around $1.2430.
The market-implied odds that the BOC raises rates this week still stand at about 92 percent, based on overnight index swap pricing. They fell to as low as 73 per cent last week after Canadian officials said they saw an increasing likelihood that U.S. President Donald Trump would withdraw from NAFTA. Twenty-six of 27 economists surveyed by Bloomberg forecast the central bank will raise its benchmark rate 25 basis points to 1.25 per cent.
"There are more two-way risks around the hike than the bond market is pricing in," said Mark McCormick, a strategist at TD Securities, which pushed forward its rate-increase call to January. Mr. McCormick said he puts the odds of a rate boost this week around 65 per cent.
Even if the BOC did hike, it probably wouldn't do much to help the Canadian dollar since NAFTA talks resume next week and there's more at stake in the next round of negotiations, Mr. McCormick said.
If the Bank of Canada does raise rates Wednesday, it could signal that further increases are unlikely to be aggressive, a so-called "dovish" hike, in an effort to extend the economy's stellar 2017 performance. And if it leaves rates unchanged, the bank could still offer a resolute tone on gradual tightening as policy makers must now be wary of stoking inflation.
"In the event that we do get a hike, it would be a dovish hike," said Eric Theoret, a currency strategist at Scotiabank. "In the event we get a hold, it would be a hawkish hold because in the event of a hold, I don't think it's an environment in which they'd want to ease financial conditions. That's the outcome I would lean toward, a hawkish hold."
Scotiabank's house view is for a rate increase Wednesday, though Mr. Theoret says "the hawkish hold is underappreciated as an outcome."
Following the report on Canadian officials' concerns about NAFTA negotiations, a White House official said there hasn't been any change in the president's position on the agreement. U.S. Treasury Secretary Steven Mnuchin said Jan. 11 he expects the pact "will be renegotiated, or we'll pull out."
The sixth round of NAFTA talks is scheduled to start Jan. 23 in Montreal. Canada, Mexico and the U.S. have already planned a subsequent round of talks in February in Mexico City, two people familiar with plans said.