BofA Merrill Lynch Inc. says it expects the Bank of Canada to cut its key interest rate another 75 basis points to stave off recession as the Eurozone sovereign crisis grows.

“With the Eurozone sovereign debt and banking crisis showing no sign of containment, we think the Bank of Canada will cut rates back to the effective lower bound of 25 bps early next year from 1.0% currently,” it says in a new report.

“Liquidity measures to ensure smooth funding in the Canada financial system will be employed first; and likely by the end of the year. Rate cuts will follow shortly thereafter, however, employed as shock therapy for the economy as uncertainty moves in with fuller force to weigh on consumer discretionary spending and business investment decisions,” Merrill says.

Merrill says that its now expecting a hard-landing for the European economy that will shave at least 0.3 percentage points off 2012 GDP growth in Canada, with the economy “flirting with outright contraction” in the first half of the year. Despite the cooler growth outlook, it also expects inflation to generally remain above the Bank’s 2% target.

The firm predicts that, to bolster confidence, the Bank will likely cut the overnight rate by 50 bps at the January 17 meeting, followed by the final 25 bps on March 8. “The markets are clearly under-pricing the Bank’s fear of deeper recession in Europe, even though it dominates most communiqué lately,” it says.

Additionally, Merrill has lowered its estimates for S&P/TSX earnings growth in 2012 down to 6.4% from 7.6% previously. However, it’s also are raising our 2013 earnings growth to 7.7% from 4.3% previously; implying a fair value S&P/TSX target of 13,650 in 2011 and 14,700 in 2012.

“Sovereign debt issues out of Europe continue to translate into elevated risk premiums globally and we do not expect this to subside anytime soon,” Merrill adds. “Indeed, as a European recession becomes more evident in the months ahead, risk premiums could spike even further, putting our previous 2011 13,700 end of year fair value target well out of reach. However, we believe as the European economy recovers in the back half of 2012, some of the risk premium will come out of the market moving the S&P/TSX closer to our fair value target by the end of 2012.”