After nearly a year of watching Canadian interest rates stay near historical lows, economists and traders are now betting on steady tightening by the Bank of Canada, but some analysts say the market - and perhaps even the bank - might be getting ahead of itself.
After spending most of 2005 issuing cautiously worded statements and noting an economy performing below capacity, the Bank of Canada has taken a more hawkish tone of late, raising its overnight rate from 2.50 percent to 3 percent over the last two months, and all but promising more of the same.
In response, bonds have sold off, while the Canadian dollar has climbed to 14-year highs, and primary dealers have amended their forecasts. Expectations for the overnight rate at the end of 2006 now range from 3.50 percent to 4.50 percent, which would suggest an aggressive tightening schedule.
But some analysts say that Canada's economy - now operating at capacity, according to the central bank - may still have some landmines to step over, and that too much aggression on the part of the bank may force it to follow the increases with some hasty cuts.
"What is happening is that markets are beginning to focus on the fact that economic growth in North America remains very strong and in fact is accelerating," said Carlos Leitao, chief economist at Laurentian Bank Securities. "But I think beyond that, once we get (past the first quarter) of 2006, we'll see quite a pronounced slowdown."
Leitao expects two more quarter-point increases by the central bank, and says any additional tightening may force the bank to quickly backtrack.
Such a pattern would not be new for the bank, which raised rates five times between April 2002 and April 2003 before a series of economic shocks - such as the outbreak of Severe Acute Respiratory Syndrome in Toronto and the discovery of a case of Mad Cow disease in Alberta - forced it to cut rates five straight times.
TD Securities expects the bank will do another about-face next year, as a slowing US economy weakens demand for Canadian exports.
TD sees the overnight rate at 4 percent by the midpoint of 2006, but expects it back down at 3.50 percent by the end of the year.
"I think there's a very big mishmash between where people see the rates at the end of 2006," said TD Securities economist Carl Gomez. "It really depends on how the situation unfolds."
With energy prices near all-time highs, US current account and budget deficits bloated, and the strong Canadian dollar putting Canadian manufacturers at a competitive disadvantage, there are a lot of "what ifs" to get through.
Even as the central bank raised rates last week, it noted in the accompanying statement that risks to global growth are tilted to the downside starting in 2007. And in House of Commons testimony earlier this week, bank governor David Dodge said the bank would have to be "cautious" in the spring and summer of 2006, suggesting it may only hike through the early part of the year.
But in addition to the external factors - such as the energy prices, US debt levels, and worries that US consumers may stop spending and try to rebuild their savings - some are concerned about home-grown factors as well.
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