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Summary: We expect the Bank of Canada to maintain the policy interest rate at 4.5% this week, but the possibility of an unexpected rate hike cannot be ruled out given stronger-than-expected inflation and GDP, as well as robust labor data. The market expects only a 25% chance of a rate hike on June 7, and a tough stance should be enough to support the Canadian dollar.

Fundamentals

A strong start to 2023 for the Canadian economy could prompt the Bank of Canada to actively consider a rate hike this week. However, we believe it will ultimately maintain the pause in its rate hike path from January, leaving the overnight rate at 4.5% for now.

Canada's economy rebounded sharply in April after barely growing in February and March. Economic growth in the first quarter was also slightly above expectations overall, thanks to still-strong consumer spending and a strong boost from exports. Meanwhile, the year-to-date unemployment rate has not moved from its unusually low level. The resale housing market appears to have bottomed out earlier than previously feared, and inflation rose unexpectedly in April.

Nonetheless, there are still signs that a fault line is forming in the booming economy. The labor market remains strong, in part due to a population boom, which has increased consumer demand and available labor supply. We expect employment in Canada to increase by 20,000 in May, on top of a surge of about 250,000 from January to April. However, the unemployment rate is expected to remain higher as "excess" labor demand continues to ease.

The Bank of Canada will announce its interest rate resolution next Wednesday, a meeting with neither economic forecasts nor a press conference. Since March 2022, the Bank of Canada has raised rates by a cumulative 425 basis points, which will ultimately cause wider damage in the form of higher unemployment and lower GDP, even if it takes longer than previously thought.

With inflation still high, the Bank of Canada will not be able to wait long if the recent positive momentum continues. Two more employment reports, an inflation report, and the ever-closely watched business outlook survey will all be released between the June and July policy decisions. Further indications suggest that higher rates have not slowed down economic growth as expected. Even if the Bank of Canada chooses to pause rate hikes next week, it would signal a tendency towards a rate hike in July.

The Canadian dollar has been the best-performing G10 currency over the past month, thanks largely to its high beta to the U.S. economy and the repricing of Canadian domestic interest rates and economic growth. These factors masked crude oil's sluggish performance in May and some volatility in risk sentiment.

The Bank of Canada's strong tone at its June meeting was clearly an important factor in keeping the Canadian dollar bullish. And while the recent repricing of Fed rate expectations has led to a rally in the U.S. dollar's short-term swap rates relative to most currencies, the USDCAD 2-year swap rate differential has been trending lower. As long as the Bank of Canada does not oppose the pricing of a summer rate hike, we expect the Canadian dollar to continue to be supported.

Technical Analysis

After a small pullback in the last trading session of May, the USDCAD plunged 1.2% in the first trading session of June as prices fell back to near the bottom of the range, increasing the risk of continued bearish trading.

Following the significant price drop, there are hardly any bullish signs in the short term, but the possibility of forming a bottom around 1.3400 cannot be ruled out as the stochastic oscillator is rapidly approaching its oversold level of 20. The RSI has fallen back below the 50 neutral mark, while the MACD has not continued to diverge downwards below the 0-axis. Moreover, the price is some distance above the lower Bollinger Band, indicating further potential for decline. The target is set at the 1.3386 level, which also serves as the starting point of a demand zone.

In terms of trend signals, a bearish crossover between the shorter-period and longer-period SMAs is underway. If successfully completed, it could trigger a price decline toward the 1.3386 level.

Instead, the price will rally above the SMAs after testing that level, while the 1.3500 level could trigger a bullish return, pushing the price higher to the 1.3650 ceiling. Further gains would initially stall around the 1.3740 supply area before aiming for tough resistance of 1.3800-1.3820. A break of this zone would clear the way for a top test at 1.3976 in 2022.

Overall, USDCAD remains under bearish control in the short term, awaiting confirmation of direction after the completion of testing. It is recommended to buy the dips.

Trading Recommendations

Trading Direction: Long

Entry Price: 1.3386

Target Price: 1.3740

Stop Loss: 1.3229

Valid Until: 2022-06-19 23:55:00

Support: 1.3407, 1.3680, 1.3335

Resistance: 1.3484, 1.3550, 1.3655