The Bank of Canada said yesterday that gross domestic product will grow 2.4 percent this year and 2.8 percent in 2012, compared with an October forecast for gains of 2.3 percent and 2.6 percent, respectively. The central bank said U.S. growth is being boosted by the extension of tax cuts and the Federal Reserve's plan to buy $600 billion of Treasury securities through June.

"Net exports are projected to contribute more to growth going forward, supported by stronger U.S. activity and global demand for commodities," the bank said in its statement. "However, the cumulative effects of the persistent strength in the Canadian dollar and Canada's poor relative productivity performance are restraining this recovery in net exports."

The Canadian currency weakened 0.4 percent yesterday to 99.13 cents per U.S. dollar after earlier gaining to 98.38 cents, the strongest level since May 2008. It was the best performer over the past three months in a measure of 10 developed-nation currencies, appreciating 3.27 percent.

Canada's trade surplus with the U.S., its largest trade partner, was the lowest in September since December 1993 at
C$1.55 billion. Canada sends about three-quarters of its exports to the U.S., including factory products such as automobiles and machinery. "That's a big issue for the Bank of Canada, they won't want the dollar to run away," said Krishen Rangasamy, an economist at CIBC World Markets in Toronto, who predicts a May rate increase.

Eoin Treacy's view The Canadian yield curve spread (10yr - 2yr) topped out at the upper side of its long-term range from mid 2009 and has contracted somewhat since. As with the USA, when this spread becomes inverted, it is often a harbinger of recession. However, at today's level, monetary conditions are still relatively accommodative and the chances of a recession unfolding the in the short term appear slim.

Nevertheless, the Bank of Canada is treading a delicate path. Commodity price inflation is an increasing worry, the Canadian stimulus package encouraged consumers to take on even more debt, the disparity between the commodity exporting sectors and the domestic manufacturing sectors is becoming increasingly wide and the Canadian Dollar has strengthened considerably over the last couple of years.

The Finance Minister announced on Monday that new rules would be introduced to contain speculation in the housing market. These range from putting a cap on the term of mortgages to tightening home equity credit lines. (This article from the Globe and Mail carries some additional information). This is an indication that the monetary and fiscal authorities are attempting to finesse their tightening measures without raising rates. Interest rate hikes are a blunt policy tool and could put additional upward pressure on the Canadian Dollar.

The Canadian Dollar hasn't been this strong against the US Dollar since the 1970s. A secular bull market in commodities dominated much of the 1970s and it is no coincidence that the currency has again reached parity during another major commodity bull trend. The US Dollar has sustained a progression of lower rally highs since at least May and these would need to be broken, with a sustained move above C$1.05, to begin to question potential for continued lower to lateral ranging.

Interest rate hikes have been delayed for the time being but are a medium-term inevitability, particularly if commodity prices remain on an upward trajectory. The Canadian 10yr retested it 2009 and 1998 peak in September and has fallen to test the 120 level. It has been ranging for the last month but a sustained move above 122.50 would be required to question potential for some additional downside.

The S&P/TSX Composite Index rebounded impressively from its 2009 low and ranged mostly below 12,000 for much of 2010. It hit a new recovery high in October and has since extended the medium-term uptrend. While somewhat overextended relative to the 200-day MA, a sustained move below 12,500 would be required to begin to question medium-term upside potential.

The TSX Financials Index ranged mostly below 1600 from August 2009, It failed to hold the upward break in March 2010 and pulled back to test the lower side of the range. It rallied impressively in September and has been trending steadily higher since. A sustained move back below 1600 would be required to delay medium-term upside potential.

Royal Bank of Canada (15.3% of the sector index) has been consolidating above the 2007 peak for more than a year and is currently rallying from the lower side. Toronto Dominion Bank (13.4% weighting) has been ranging bear the 2007 peak for a year and is pressuring it highs. Bank of Nova Scotia (11.75% remains in a medium-term uptrend defined by an unbroken progression of rising reaction lows.