Market Extra: Bank of Canada has to weigh oil prices and Nafta risk for summer rate hike timing

Oil price gains, which support the oil-producing and exporting Canadian economy, have offset the Nafta renegotiation risk for the minute, but it is unclear how these factors will play for the Bank of Canada, which is due to make its latest interest rate decision at the end of the month.

Oil prices have climbed higher of late, pushed up by renewed sanctions on oil-producing Iran and thereby supporting commodity currencies, such as Canada’s dollar USDCAD, +0.0860% that is also known as the loonie. On Wednesday, West Texas Intermediate crude CLM8, +0.13%   as well as Brent crude LCON8, +0.19%  closed at their highest levels since November 2014.

“As WTI is getting closer to $72 a barrel, we’re getting ready for the Canadian dollar and oil to move in tandem again,” said Lennon Sweeting, director of institutional trading at Coinsqure Capital Markets. At times the connection between oil prices and commodity currencies is considered tenuous.

The U.S. dollar bought C$1.2801, up 0.1% from Wednesday, but down 0.4% in the month so far, according to FactSet. In the quarter-to-date, the loonie gained 0.8% against its U.S. rival.

Read: Why it may be downhill from here for the U.S. dollar

But this positive factor has been overshadowed by risks pertaining to the renegotiation of the North American Free Trade Agreement, which have kept investors on their toes since last year when the trade talks began.

“Negotiations to save the North American Free Trade Agreement have reached an impasse with no meetings scheduled among the top leaders ahead of month-end,” wrote Ashraf Laidi, market strategist at Intermarket Strategy, in a blog post.

While market participants expect a deal in principle to be reached this month, deadlines surrounding it are appearing to lose relevance, Laidi said. Mexico initially pressed for an agreement by May 1 due to its impending July 1 presidential election, while U.S. House Speaker Paul Ryan had set a deadline for Thursday, which evidently hasn’t been met. The U.S. is facing congressional mid-term elections in November. Canada is the only Nafta member with no major election in the near-term.

Read: Here’s what traders forget as headlines suggest imminent Nafta deal

But there has been more at play in Canada that the BOC will have to take into account. The central bank is due to meet on May 30.

Canada’s household debt is one of the highest in the world, said an OECD report from last year, with a household debt-to-GDP ratio of 101%. The country also has a housing bubble on its hands thanks to sky rocketing home valuations. UBS put Toronto at the top of its global real estate bubble index in February. Vancouver came in fourth.

In other economic indicators, last week’s soft jobs report hurt the loonie, as the data underperformed expectations but included some encouraging details, including an flat unemployment rate at 5.8%.

“The reason the Canadian dollar was one of the best G10 performers last year was the Bank of Canada’s initial steps toward monetary policy normalization,” wrote Neil Mellor, senior currency strategist at BNY Mellon. The BOC hiked rates for the first time in seven years last July, and followed it up with another rise in September, pushing the loonie to a two-year high against it’s Southern rival. The central bank last raised rates in January.

But from there on out, the BOC’s language grew more conservative, so as to say “not so fast,” and the Canadian currency reversed course.

“But with the Canadian dollar now at a lower, stabler level, with Canadian inflation rising to a to a three-year high of 2.3%, and with wages ‘actually positive in real terms’, speculation abounds that the BOC will raise rates once more before too long after hiking rates a third time at the start of the year,” Mellor said.

Market expectations stand at 37.3% for a May rate hike to a 1.5% key interest rate, while the probability for June rates move is 52%, Sweeting said.

“How that will net out against a Fed rate hike in the summer in terms of currency appreciation is another question,” Sweeting added.

The Federal Reserve is leading developed economy central banks in normalizing rates, which is helping the U.S. dollar and could undermine the loonie’s tailwind this summer.

Also check out: Turkish lira hits historic low as Erdogan eyes control of country’s central bank

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