G10 FX Weekly: Bank of Canada U-Turn Will Not Be CAD Game Changer

Summary

• The Bank of Canada (BoC) unexpectedly hiked its policy rate last week by 25 basis points (bp) to 4.75%, after keeping rates on hold since January.
• By yearend, the BoC is now expected to raise rates by another ~30bp, while Canada’s headline CPI is amongst the lowest in the G10.
• This shift from the BoC will not lead to material gains for the Canadian dollar (CAD) in the second half (H2) of this year, with existing year-to-date (YTD) ranges expected to broadly remain intact for the major CAD pairs.

Market Implications

• Bearish CAD. The Deutsche Bank CAD trade-weighted index (TWI) currently trades near its YTD high. A pullback is in order after recent strength.
• Bullish USD/CAD. The pair trades near the bottom of its YTD range and should also retrace recent CAD strength and trade nearer the middle of that range in 2H 2023.
• Bullish EUR/CAD. Expect similar dynamics, with the pair to trade towards the middle of the established YTD range in the coming months.
• Bearish GBP/CAD. It trades near the middle of its ~1.61/1.72 YTD range. We think that GBP/CAD has scope to fall and will trade near the existing YTD low by year-end.

Introduction

Last week, the BoC unexpectedly hiked rates again, pushing the CAD TWI to the highest level since November.

When we last wrote about the Canadian dollar in March, the BoC had just paused its rate hiking cycle. We had expected CAD would trade lower in the coming months, as the market then priced the next BoC moves as rate cuts, with the other major central banks still expected to continue hiking rates.

That CAD prognosis turned out to be incorrect, with the currency appreciating in the weeks that followed.

Despite the recent CAD strength, we do not see the BoC’s recent policy move as a game-changer for the Canadian dollar. Looking ahead, we think that the currency is overdue a correction, and that the CAD TWI should reverse some of its recent gains.

Accordingly, the Canadian dollar will give ground against both the US dollar and euro. We do, however, see some scope for CAD to gain versus the British pound in the second half of 2023.

CAD So Far This Year

The Deutsche Bank CAD TWI is up about 1.6% this year, having traded in a ~3.8% range YTD. The Canadian dollar is the third strongest of the G10 currencies against the US dollar in 2023, trailing only the British pound and Swiss franc.

In terms of the rest of the G10, the CAD has performed best against the Norwegian krone (CAD/NOK is up ~9% in 2023), the Japanese yen (CAD/JPY is up ~8.8%) and the Swedish Krona (CAD/SEK is up ~4.6%).

BoC Expectations Have Shifted in Recent Months

Back in March, the central bank had just paused its rate hiking cycle, having raised rates eight times since March 2022 to bring the policy rate from 0.25% to 4.5%. Following the BoC’s pause, markets priced a little under 100bp of easing by yearend, with the BoC policy rate expected to be reduced to ~3.6%.

For context, this was when the SVB collapse and turmoil in the US banking sector was at its highest, and expectations for G10 central banks were at their most dovish.

At the time, messaging from Canadian policymakers was cautious. We thought the key takeaway from the BoC’s March statement was that, although inflation was still too high, it had probably peaked and was heading in the right direction.

Fast forward to last week, and the BoC surprised the markets by hiking its policy rate by 25bp to 4.75%. The probability of a rate hike at the close of business on 6 June, the day before the rate rise, was ~45%. The move, therefore, was not widely anticipated.

In the statement accompanying last week’s policy move, the BoC said ‘[o]verall, excess demand in the economy looks to be more persistent than anticipated’ and ‘that monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.’

Policymakers also noted the slight uptick in year-on-year (YoY) headline inflation, from 4.3% in March to 4.4% in April. This was the first time since June last year that inflation edged higher than the previous reading.

Nonetheless, on a relative basis, headline inflation in Canada is relatively subdued compared to other G10 readings.

Given the headline number in Canada, the BoC’s recent rate rise looks more like an insurance measure than a panicked move.

The market sees a little over 30bp of additional tightening by yearend, with the next full 25bp hike priced for September.

A Look at Three CAD Pairs

The three biggest constituent currency pairs in the CAD TWI are USD/CAD, EUR/CAD and GBP/CAD.

USD/CAD

So far in 2023, USD/CAD is marginally lower, down about 1.5%. The pair has traded in a ~1.32/1.39 YTD range, printing at the top of the range on 10 March, following the low on 2 February. The pair currently trades about 1% above the YTD low.

We think the pair is due for a reversal of the YTD drop, with USD/CAD trading back towards the middle of the 2023 range in the coming months. While a new marginal low cannot entirely be ruled out, any break below the current YTD trough should be shallow and short-lived.

Looking only at the interest rate differential, you could argue for a USD/CAD bounce in the second half of 2023. The BoC is priced to raise rates further this year, by about 30bp, while the market prices the Fed as very close to the end of its current tightening cycle. To that end, the market presently does not fully price another Fed rate hike by year-end.

Given how closely aligned the US and Canadian economies are and if, as market pricing suggests, the Fed is done (or nearly done) tightening rates, the BoC will struggle to aggressively ‘outhike’ the Fed.

Going forward, we expect both central banks to be closely aligned, especially as the threat of recession looms large over both economies. As a result, purely based on interest rate differentials, expect USD/CAD to settle back into range trading in H2.

EUR/CAD

EUR/CAD has traded in a ~1.42/1.51 range in 2023, with the high printing on 26 April followed by the low on 1 June. Currently, the pair trades about 1% above the lower end of the range and is lower by ~0.5% this year.

Last week, we argued that improving Eurozone inflation dynamics and a still aggressive ECB improve the euro’s prospects. We have argued this mostly in the context of EUR/USD and EUR/GBP, but this can also be applied to EUR/CAD.

Again, looking purely at interest rate differentials, after the ECB rate hike today, there is still further tightening priced into the EUR curve by yearend. While this is also the case with the BoC, you could argue interest rate differentials will not materially favour one currency over the other. There is little in it.

In general, if we are right and the euro stages a modest comeback against the dollar in H2, this should also feed into EUR/CAD.

And, in terms of central bank credibility, economists broadly think that the ECB is on a ‘Goldilocks’ rate path at present. According to a Bloomberg survey, roughly 75% of economists do not think that the ECB will either tighten too far, or stop tightening too early.

GBP/CAD

GBP/CAD has traded in a ~1.61/1.72 range so far this year, hitting its high on 4 May and its low on 7 February. The pair trades about 1.5% above the middle of the range, up about 3% YTD.

The BoC and Bank of England (BoE) are in very different positions for controlling inflation, and the BoC’s superior position points to further downside in GBP/CAD. While the BoC, has fared relatively well against inflation, the BoE has struggled, and the UK stands out in the G10 as the upside inflation outlier.

The BoE is wrestling with persistently high (and still rising core) inflation, even after a concerted hiking cycle. Much more hiking (ca. 125bp) is expected over the next five BoE meetings.

While this should see interest rate differentials move in favour of sterling, the impression exists that the BoE does not have inflation under control. Put another way, the central bank is behind the curve.

In our piece two weeks ago, we argued that this is undermining the BoE’s credibility and that the UK is in danger of entering a period of stagflation. Our conclusion was that this would weigh on the pound.

We think, therefore, that GBP/CAD, together with other GBP currency pairs, are set for downside in H2.

Conclusion

The initial knee-jerk market reaction to the BoC’s surprise rate hike last week was to take the CAD TWI to a YTD high.

We think Canadian dollar strength will unwind somewhat in H2, with the major CAD pairs remaining within the established YTD ranges.

For USD/CAD and EUR/CAD, this means that both pairs have upside potential in the coming weeks and months. Expect both pairs to trade nearer the middle of their 2023 ranges.

GBP/CAD will buck this trend, however. Given the challenges facing the BoE in curbing domestic inflation as a probable recession approaches, the threat of stagflation in the UK should lead GBP/CAD to trade down towards the lower end of its 2023 range.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)