May 21, 2008 / 8:58 PM / in 10 years

Canadian dollar powered higher by inflation data

TORONTO (Reuters) - The Canadian dollar rose 0.8 percent against the U.S. dollar on Wednesday after a report showed inflation was creeping back into Canada, prompting investors to bet the Bank of Canada’s rate-easing cycle was nearing its end.

Domestic bond prices fell as aggressive interest rate cuts were priced out of the market.

The Canadian dollar closed at US$1.0162, valuing a U.S. dollar at 98.41 Canadian cents, up from US$1.0082, valuing a U.S. dollar at 99.18 Canadian cents, at Tuesday’s close.

The currency hit its high of the day, of US$1.0184, at the beginning of the session after data showed inflation in Canada picked up in April for the first time in five months.

Surging gasoline prices fueled a spike in the annual inflation rate to 1.7 percent, which, while below the Bank of Canada’s 2 percent target, was above the 1.4 percent the market had expected.

Canada has been largely immune to the inflation pressures felt by most other major economies due to the price-dampening strength of the Canadian dollar, which was up around 17.5 percent in 2007. That gave the Bank of Canada room to shave 150 basis point off its key lending rate, to 3.00 percent, to spur domestic growth in the face of the U.S. economic downturn.

But as inflation begins to trickle into the economy, some market players say the end of the interest rate easing cycle is upon us.

“Putting today’s data together with the broader environment of rising commodity prices and global inflation fears amid a steady exchange rate, we have no doubt that the BoC will be wondering whether it’s prudent to keep easing in the near term,” David Wolf, chief Canadian economist at Merrill Lynch, said in a note.

“The June 10 decision, and indeed those further out, should now be subject to substantial uncertainty.”

A Reuters poll taken after the release of the inflation data showed that eight of Canada’s 12 primary security dealers still expect the Bank of Canada to cut its key interest rate to 2.75 percent from 3 percent at its June announcement date. But most dealers expect the easing cycle to end within the next couple quarters. See <ID:nTOR003018>

A spike in the price of U.S. crude oil CLc1 to nearly $134 a barrel on supply worries, helped provide a positive backdrop for the currency, as Canada is a major oil exporter.

But while the Canadian dollar is in a position to make short-term gains, it is unlikely to rise past US$1.03, the upper limit of its range since mid-November, said Shane Enright, currency strategist at CIBC World Markets.

He pointed out that while the Bank of Canada was cutting its interest rates, other countries with commodity-linked currencies, like Australia and Norway, were raising rates.

“So you’re getting much higher yields, if you want to play the commodity story, going through Norway or through Australia and some of these other currencies,” he said.

“A 3 percent yield is a bit of a drag.”

BONDS DROP

Canadian bond prices dropped sharply as the market adjusted to the implications of higher inflation.

“The market is re-pricing some of the aggressive Bank of Canada rate cuts out of the market,” said Sheldon Dong, fixed income strategist at TD Waterhouse Private Investment.

“It’s not the end of the world, but basically, the aggressive 50 basis point cuts that some shops were hoping for, including ours, aren’t going to happen.”

The two-year bond fell 29 Canadian cents to C$101.64 to yield 2.910 percent. The 10-year bond slid 52 Canadian cents to C$103.18 to yield 3.583 percent.

The yield spread between the two- and 10-year bond was 67.3 basis points, down from 75.0 at the previous close.

The 30-year bond dropped 69 Canadian cents to C$115.92 for a yield of 4.061 percent. In the United States, the 30-year treasury yielded 4.550 percent.

The three-month when-issued T-bill yielded 2.66 percent, up from 2.62 percent at the previous close.

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