Canadian bonds sold off after a hotter-than-expected inflation reading for May prompted traders to dial back wagers on the Bank of Canada cutting interest rates in July.

The short-end of the curve led the retreat, with yields on policy-sensitive two-year notes climbing as much as 10 basis points back to 4.0 per cent for the first time in two weeks. Swaps contracts priced in about nine basis points of cuts for the July BOC meeting, down from 15 basis points, or about 60 per cent probability of a quarter-point reduction, before the inflation report. The loonie briefly rallied on the news.

The consumer price index increased 2.9 per cent in May from a year ago, up from 2.7 per cent seen in the prior month, Statistics Canada reported. On a monthly basis, the index climbed 0.6 per cent, versus expectations for a 0.3 per cent gain.

“Today’s inflation data is by all means not constructive for a July BOC rate cut. Service inflation saw a large uptick, food inflation also increased sharply,” said Howard Du, a FX strategist at Bank of America Corp. “The BOC will get another CPI data before the July monetary policy meeting. The next CPI data should allow the BOC assess whether the inflation surge today was a one-off that can be overlooked or not.”

The unexpectedly higher inflation reading also sparked a brief rally in Canadian dollar before headwinds from a strong greenback reversed gains. Hawkish comments from Fed Governor Michelle Bowman, who warned of upside risks to U.S. inflation, appeared to contribute to the U.S. dollar’s advance.

“Canada is in the same boat as everyone else these days,” said Brad Bechtel, global FX head at Jefferies. “For most countries inflation has stopped falling and is sort of basing here. But with growth slowing still and employment pressures increasing the central banks are sort of stuck.” 

Short Positions

Speculative traders, meanwhile, now hold their biggest bet on record that the loonie will decline further in the weeks and months to come.

Non-commercial traders — a group that includes asset managers, hedge funds and other speculative market players — are holding some US$10.9 billion in short positions on the Canadian dollar, according to the latest data from the Commodity Futures Trading Commission through June 18. Totaling some 150,000 derivative contracts, that’s the most bearish in CFTC data going back to 1995.

The post-data selloff was led by the front-end, with the spread between two- and 10-year yields tightening by around 2 basis points. In the swaps market linked to the Bank of Canada rate decisions, a full 25 basis points of easing was priced out to the October meeting from being fully priced into the September meeting prior.

For Simon Harvey, chief FX analyst at Monex, the latest inflation report has done little to alter his view of a quarter-point cut in July. “While on the surface May’s inflation data has cast uncertainty over” the possibility of a consecutive cut from the BOC, the details of the report “are far less damning,” he said. 

“Most of the increase in inflation stemmed from seasonal and transitory factors, meaning the latest bout of inflation doesn’t signal a departure from the previous disinflationary trend,” he added.