[Calxy]

The Bank of Canada rate announcement (Tuesday 9AM EDT) will be watched mainly for the commentary on the exchange rate. Given its commitment to keeping the policy rate at 25bp till the middle of next year, there is little uncertainty with respect to the interest rate decision. In fact, the biggest question is what it will say about the exchange rate and how it will manage comments on the improving state of the economy while not provoking further CAD buying.

CAD rallied after the BoC's previous policy meeting on September 10. The combination of upping the H2 09 growth forecast and downgrading CAD strength to a risk, as opposed to a component of its baseline view, led to CAD buying after the last statement was released: "Persistent strength in the Canadian dollar remains a risk to growth and to the return of inflation to target. In its conduct of monetary policy at low interest rates, the Bank retains considerable flexibility."

If anything, the economic data have been even better, with payroll employment extremely strong (and strengthening on trend) and the most recent business surveys very positive. So the needle it has to thread is to sound adequately confident on the recovery to reflect these improvements while not inviting global investors to bid the CAD up as they have the AUD and other commodity currencies. Unlike the RBA, it has never stopped trying to limit CAD appreciation, so it is unlikely that it will change in the comments. While the CAD has appreciated about 21% since early March on a trade-weighted basis, compared with the AUD's 30%, having the US in the neighborhood is less comfort in terms of future export demand than having China.

The most likely outcome is that it upgrades the currency risk via an additional adjective or phrase, perhaps something like "unwarranted currency appreciation poses a major risk to the recovery." It is also likely to stress that it would act aggressively if it saw currency appreciation endangering the recovery or inflation target. Analysts expect it to make the language as strong as possible while being profoundly non-committal with respect to what level of the CAD would provoke a response and what the response would be. We might see some precautionary CAD selling immediately after such a statement, but would not expect it to persist.

The bigger CAD negative reaction would be if it were concrete with respect to how it would deal with what it considered to be unwarranted CAD strength. While, ultimately, CAD appreciation would be hard to fight, right now the market expects various degrees of anti-CAD rhetoric but nothing that looks like actual action. One possibility for a hint of concrete action is that it indicates that there is room to extend the ultra-low rate policy for longer than mid-year if it sees the exchange rate as increasing the risk of being below target on inflation. This would be tempting, as it would have the sizzle of monetary policy backing the anti-CAD rhetoric but without committing to any actual move behind it. However, despite the temptation, it will not want to give such a signal because its own analysis probably suggests that the post-June policy rate risk is that it has to tighten more than expected, rather than less.

The CAD plus would be if it emphasized the economic upside risks, especially if it gave any hint that it might have to hike aggressively after mid-year to maintain medium-term inflation targets. This may be the real debate within the Bank of Canada, but at this stage it would be loathe to suggest that iy was concerned that the low rates commitment may have been too broad.