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Loonie strengthens despite dovish Bank of Canada

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The Canadian dollar ended stronger against its U.S. counterpart on Wednesday, in defiance of a gloomy outlook from the Bank of Canada, as investor optimism about a European debt summit buoyed risk sentiment.

Pointing at deep global risks, the Bank of Canada painted a darker picture of the domestic economy as it looked to the likelihood of a recession in Europe and continuing weakness in the United States.

In its quarterly Monetary Policy Report, the central bank slashed its fourth-quarter growth forecast to an annualized 0.8 percent from 2.9 percent, down from a likely 2 percent in the third quarter.

While the dovish message -- meaning official interest rates will likely stay low for longer -- would typically weaken the Canadian dollar, traders said a partial recovery by the euro and global stock markets was helping offset the gloom.

"A lot of the reason why dollar-Canada has come back below $1.01 [to the U.S. dollar] is that equities have begun to reverse and the euro has picked up a bit ... (but) I'm a little bit surprised that we've come back to where we are," said David Bradley, director of foreign exchange at Scotia Capital.

The Canadian dollar ended the North American session at $1.0048 to the U.S. dollar, more than a cent above Tuesday's session close at $1.0163 to the U.S. dollar, and well above lows plumbed early in the day.

Bradley said the strength was likely due to investor optimism and market positioning as European Union officials made progress in debt talks.

But he and other currency strategists doubted the Canadian dollar strength could last, given the risks enumerated by the central bank.

"I tend to think the market is pricing in far too much good news," said John Curran, senior vice-president at CanadianForex, a commercial foreign exchange firm.

"If the Bank of Canada is telling us things are going to slow down due to global scenarios, I don't see why the market is not listening to the officials that are involved with the issues. So in my view there is still some pain to come and the exuberance should die off."

U.S. stocks rallied on news that euro zone leaders plan to boost the power of the region's bailout fund, though the euro remained down against the U.S. dollar as investors still awaited details of the rescue plan.

EU governments will signal readiness to back banks with guarantees to avert a credit freeze but give no overall figure for recapitalizing lenders, according to a draft statement from leaders meeting in Brussels on Wednesday.

The Bank of Canada was far from reassuring about risks to the Canadian economy, noting the possibility of a U.S. recession and the risks of a European debt contagion.

"Growth is expected to slip back in the fourth quarter ... in an environment of lower confidence and heightened uncertainty," the bank said in its quarterly Monetary Policy Report.

With rates likely lower for longer, investors tend to be less attracted to Canadian assets, given the lower return, and that should weaken the Canadian dollar.

"Our inclination is dollar-Canada should really be trading higher. It looks as though rates are definitely going to be on hold until early next year, and there is a possibility they could even go lower, which I really don't think is going to happen, but that possibility is definitely alive in the market," Bradley said.

The MPR came on the heels of Tuesday's policy decision by the central bank to keep rates unchanged at an ultra-low 1 percent. Tuesday's dovish statement sank the Canadian dollar, sending it more than 2 cents lower in a matter of hours.
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