CAD rates to continue to outperform US

Recent economic data point to continuing divergence of monetary policies in US and Canada. Q1 GDP in Canada at -0.6% came much weaker than projected by the BOC, showing a greater negative impact from the oil shock than previously thought. 

Although employment data surprised on the upside in May, employment growth is expected to decline going forward as firms should optimize profitability when facing weak economic growth. Core CPI has declined to 2.2% on the YoY basis, which confirms the BOC view on the temporary nature of the increase in inflation seen earlier this year.

At the same time, financial conditions in Canada have tightened owing to the recent global selloff led by Bunds, with the 10y CDA rate higher by about 50bp since March, and are likely to tighten even further if the Fed proceeds with hikes in September.

If Canadian growth remains weak the BOC should see a combination of weak growth and tighter financial conditions as a risk to financial stability given still elevated household leverage, which increases the likelihood of a dovish response. Indeed, the Bank motivated the insurance cut in January, in part, by financial stability concerns. 

"Our economists expect the BOC to deliver another cut by the end of the year. As a result, we expect CAD rates to continue to outperform US rates", says BofAML Research.