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Analysis-Loonie bulls reel as Bank of Canada trails Fed on terminal rate bets

By Fergal Smith

TORONTO (Reuters) - As higher borrowing costs slow Canada's outsized housing market, investors are betting the Bank of Canada will raise interest rates to a lower end-point than the Federal Reserve, an outcome that could spell more trouble for the Canadian dollar.

The BoC has set the pace for tightening this year among central banks overseeing the 10 most traded currencies, lifting its key interest rate by 300 basis points to a 14-year high of 3.25% to tackle soaring inflation.

But in the face of the Fed's growing hawkishness and signs that higher borrowing costs may already be slowing the Canadian economy, money markets now are betting the Fed will end its tightening cycle with a higher policy rate than the BoC.

The U.S. central bank last week raised its benchmark overnight interest rate by three-quarters of a percentage point to a range of 3.00%-3.25% and signaled more large increases to come.

Investors expect the Fed's policy rate to reach a terminal rate of about 4.60% by the end of the first half of 2023, compared to around 4.10% for the BoC's policy rate. Just a few weeks ago, the end-point for both central banks was seen at roughly 3.75%.

A lower terminal rate for the BoC than the Fed is not uncommon, but it threatens to pour cold water on Canadian dollar bulls' expectations that interest rate differentials would help underpin the currency over the coming year.

Speculators have slashed their net long positions in the Canadian dollar to the lowest level since early June, data from the U.S. Commodity Futures Trading Commission showed on Friday.

"We've reached levels of interest rate pricing where markets look at what the impact will be on the Canadian economy and see that the Bank of Canada will have difficulty matching the Federal Reserve in its tightening cycle," said Andrew Kelvin, chief Canada strategist at TD Securities.

LOONIE SLIDES

Canadian bond yields have tumbled below their U.S. counterparts in recent weeks, another possible sign that investors see high interest rates as less sustainable in Canada.

And the inversion of the yield curve, a potential harbinger of recession, has grown much deeper in the Canadian bond market than in the U.S. market.

The Canadian dollar has weakened 7.5% against the greenback since the start of the year. That's a better performance than the euro, yen and other G10 currencies, though almost all of that decline has come since mid-August.

A pullback in the price of oil, one of Canada's major exports, has been an additional headwind for the loonie, which touched on Monday its weakest intraday level since May 2020 at 1.3808 per U.S. dollar, or 72.42 U.S. cents.

"Investors are monitoring negative (Canadian) employment gains, slowing consumption growth and evidence of a slow-motion train wreck in the housing market," said Karl Schamotta, chief market strategist at Corpay in Toronto.

"With rates climbing in the U.S. and at home, the (economic) burden is growing heavier by the day."

Canada's housing market has slowed rapidly in recent months, while its share of the economy, at 9%, is nearly twice that of the U.S. housing market.

In addition, Canadians are likely to face mortgage renewals sooner than Americans - the most common mortgage term in Canada is five years, compared to 30 years in the United States - and Canadian household indebtedness is the highest within the G7, a grouping that includes the United States, Germany, Japan, Britain, France and Italy.

"Canada's economy is simply more interest rate sensitive than the U.S. economy," said Royce Mendes, managing director and head of macro strategy at Desjardins.

"Every interest rate increase in Canada is going to show up more quickly and in a more pronounced fashion than what an equal dose of monetary tightening will do in the U.S."

(Reporting by Fergal Smith; Editing by Paul Simao)