We expect the BoC to cut its O/N rate 25bp at its meeting on Wednesday. Since the publication of BoC’s last Monetary Policy Report in October, the price of Western Canadian Select (WCS) has fallen by half. This has been only partially offset by the 8% nominal multilateral depreciation of the CAD. We estimate that to offset the effect on GDP of the drop in crude prices fully, the BoC would need to cut policy rates at least 50bp in 2016. There is a risk that the central bank decides to hold for now, but regardless, we believe the BoC will clearly indicate its dovish stance and signal further easing in the months to come.
In that regard, the release of the quarterly Monetary Policy Report next week will be closely watched, as it will update BoC views on the economic outlook and its forecasts about inflation and growth. The market is pricing in 20bp out of a 25bp cut for next week and a cumulative 40bp for all of 2016. Given the current market pricing and with no relief on sight for oil prices, we expect the CAD to weaken.
The ECB January meeting and press conference (Thursday) are the most important events for the EUR this week, and while policy settings are widely expected to remain unchanged, dovish rhetoric should place downward pressure on the currency. In the statement and press conference, the ECB is likely to show concern with the tightening in financial conditions that has occurred since its December meeting (Figure 4), including 5% EUR NEER appreciation. This dovish message is likely to be reiterated by President Draghi and Executive Board Member Cœuré when they speak at the World Economic Forum in Davos, Switzerland on Friday. With EA core inflation and market measures of inflation expectations remaining extremely low (the EA 5-year forward, 5-year breakeven inflation rate is about 1.6%, versus above 1.8% in early December, Figure 5), we continue to think longer or greater policy accommodation is likely, which should weigh heavily on the EUR.
Indeed, we now expect euro area inflation to return to negative territory between February and July 2016, picking up thereafter as a result of base effects, but averaging only 0.1% y/y for the year as a whole (vs. 1% in the ECB’s December projections). This would put pressure on the ECB to announce another round of monetary easing measures. However, new measures, including further QE and/or deposit rate cuts, are unlikely to be deployed before June, unless there is another bout of euro appreciation or a further significant drop in inflation expectations.
We look for EURUSD to trade sideways in the near term, but vol-adjusted EURUSD puts are trading at their cheapest level relative to calls in over six years, offering a compelling opportunity to express EUR downside through options. We continue to forecast EURUSD trend depreciation in the coming quarters.
This article originally appeared at eFXnews.