A badly sagging central Canadian economy should drive the Bank of Canada’s overnight interest rate down 100 basis points to 3.25% by the end of next year, according to CIBC World Markets Inc.’s latest economic forecast.

The forecast reports that with even a 100 bps interest rate cut, Canada’s GDP will grow by a disappointing 2.5% in 2007. But that growth will be marked by wide regional disparities with continued sizzling growth in the resource-rich provinces like Alberta and struggling performance in the country’s industrial heartland. A slowing U.S. economy and a US90¢ Canadian dollar has resulted in the Canadian manufacturing sector shedding more than 10% of its workforce since 2002, with most of the job losses in Ontario. With exports to the U.S. accounting for 33% of Canada’s GDP, Ontario is looking at the potential loss of another 50,000 manufacturing jobs.

“Surging energy and resource prices have pushed the Canadian dollar well beyond the tolerance of much of the Canadian economy,” notes Jeff Rubin, chief economist and chief strategist, CIBC World Markets. “While this has significantly benefited Alberta and other western provinces it has hurt central Canada. With inflation not a real concern, we expect the Bank of Canada to make as many as four 25 bps rate cuts over the next 12 months to try to restrain the loonie and revive a deteriorating central Canadian economy.”

The CIBC World Markets report forecasts the U.S. Federal Reserve Board will only make three 25 bps cuts in the same period. As Canadian rates continue to fall relative to the U.S., negative interest rate differentials will balloon to 125 bps in the overnight market by the end of 2007.

In response to the multiple Bank of Canada cuts, Rubin expects that holders of long Canada bonds can look forward to as much as a 10-point rally in the price of their bonds, as benchmark long bond yields decline by as much as 50 bps from current levels.

The report also predicts that the TSX will set a new record high north of 13,000 within the next 12 months. Almost 40% of the TSX is in interest-sensitive financials, telecoms and utilities, and another third of market capitalization is in energy and base metals.

“While the TSX will have to ride out near-term weakness in the North American economy, Bank of Canada rate cuts will help high-dividend paying financial stocks, while rising crude and uranium prices will support valuations in much of the energy sector,” notes Rubin. “As the North American economy pulls out of a mid-cycle slowdown, we expect to see the composite index hit a new high.”