Canadian interest rate predictions shaken by Nafta worries - but currency market is complacent

Fears among Canadian officials that the US is getting closer to ripping up the North American Free Trade Agreement (Nafta) caused traders to rapidly reassess next week’s Bank of Canada decision on its interest rates.

The market-implied odds of a hike initially slumped to 57 per cent from 77.5 per cent, then they spiked above 80 per cent as White House officials denied that President Donald Trump’s position on the matter had changed.

Then they slid back to 62 per cent. All in little more than an hour.

The chances of an increase in the interest rate currently stand around 75 per cent.

But don’t let those wild swings fool you: there are signs of complacency in the currency market about what’s in store for the Canadian dollar ahead of the January 17 central bank decision.

Risk reversals for the US dollar relative to its Canadian counterpart for contracts that would cover the meeting next week remain at levels barely above their one-year average - even after uncertainty swelled.

“Canadian assets (mostly foreign exchange and volatility) have priced in very little risk premium on the Nafta front,” said Mark McCormick, head of North America FX strategy at Toronto-Dominion Bank.

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“Our fair value model on CAD against financial market variables showed USD/CAD running 2-sigmas cheap last week – the opposite of a negative risk premium,” he added.

The recent increase in the risk reversals indicates that calls for the pair have been outperforming similar delta puts – but not by a large margin.

“The central banker response to event risk is to minimise maximum regret so clearly the Nafta headlines do make the Bank next week more two-sided,” McCormick said.