(Bloomberg) -- As the Bank of Canada meets this week amid trade-war chaos, a big unanswered question will loom over the gathering: Who’s right about the nation’s economic prospects, gloomy traders or optimistic policy makers?
Markets are worried that Canada is deeply exposed to the U.S.-China trade spat. The Canadian yield curve is inverted, with three-month government debt yielding more than 10-year notes, suggesting fear the dispute will weigh on global growth. The rates market is pricing in 17 basis points of central bank easing through the next 12 months, according to trading of forward contracts.
But the Bank of Canada has been resolute. Governor Stephen Poloz said May 17 that there’s much evidence the economy is strong, calling signs to the contrary just a “detour” and saying interest rates will rise once the headwinds dissipate. The central bank will reveal its latest policy decision Wednesday morning.
The pesky trade dispute seems to be the wild card here. And it’s little wonder why: The U.S. and China are Canada’s biggest trading partners.
The BoC is “caught between big global uncertainties that are negative and recent data surprises erring on the positive side,” said Alan Ruskin, strategist at Deutsche Bank AG (DE:DBKGn). “There’s a tendency in the U.S. and Canada for the market to take a more dovish view of expected policy than policy makers. The curve will be another element encouraging caution.”
Around the world, traders have pushed bond yields lower, as appetite for risk assets wanes and central banks around the globe cut forecasts for growth. The trade war has taken a toll on sentiment, weighing on global stocks and sapping demand for most commodities.
The foreign-exchange market isn’t pricing in a dovish central-bank policy stance in Canada just yet. As of Friday, the loonie was still the best performer among currencies from Group-of-10 nations in 2019, supported by crude oil, which had gained 30% this year despite recent losses. The loonie was up 1.5% this year versus the U.S. dollar.
Still, the outlook is cloudy. For Canada, 17% of its economic growth is exposed to the fight between the U.S. and China, according to a May 24 report from Bloomberg Intelligence economists. That means the Canadian dollar is 10% overvalued, they argued.
Recent economic data indicating strong Canadian employment and retail sales strengthen Poloz’s optimistic position even after the central bank last month abandoned its bias toward rate hikes and dropped a reference to future increases. Citigroup Inc (NYSE:C).’s Canada economic surprise index, which measures data surprises relative to market expectations, is at the highest level since April 2017.
“That outperformance alone tilts the balance of risks towards a constructive assessment of prospects” in the next BoC policy statement, Shaun Osborne, strategist at Scotiabank, wrote in a May 24 note to clients. It “provides the basis for a mildly hawkish hold decision from the policy makers.” He sees the Canadian dollar strengthening to end the year at C$1.28 against the greenback. It finished Friday at C$1.34.
Others aren’t so bullish. The loonie will weaken toward C$1.352 after Wednesday’s decision, strategists Andrew Kelvin and Mark McCormick at TD Securities wrote in a note May 24. They expect the yield differences between 5-year and 10-year as well as 10-year and 30-year Canadian government debt to narrow.
“The balance of risk around the BoC also supports continued flattening,” they said. The narrative “remains biased towards lackluster performance” in the currency as better Canadian data “reflects very weak expectations rather than strength in the economy.”