FX | Monetary Policy & Inflation | Rates
G10 FX Weekly: BoC Pause Opens Up Further CAD Downside
- By Richard Jones
- 5 min read
Summary
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- The Bank of Canada (BoC) paused in its rate hiking cycle two weeks ago, the first major central bank to do so.
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Summary
- The Bank of Canada (BoC) paused in its rate hiking cycle two weeks ago, the first major central bank to do so.
- While the BoC’s commentary was hawkish, its actions were dovish, marking them out against other central banks, including the US Federal Reserve (Fed), the European Central Bank (ECB) and Bank of England (BoE).
Market Implications
- With the Fed still expected to tighten policy further, and the BoC on hold, expect modest upside in USD/CAD.
- With similar dynamics in play with the BoC and ECB, we also expect EUR/CAD to grind higher.
- Although we are less positive on sterling versus the euro and the dollar, expect GBP/CAD to also grind higher.
Introduction
Central banks across the globe have been engaged in concerted tightening of monetary policy. Most central banks are still expected to raise rates further.
One exception is the Bank of Canada, which held rates firm earlier this month, after eight rate rises since roughly this time last year. This is notable as the BoC became the first major central bank to pause its hiking cycle.
For the Canadian dollar, this could prove decisive, suggesting CAD downside in the coming weeks and months.
This is especially true against the euro, with EUR/CAD already at its highest level since September 2021.
Even GBP/CAD, despite our broadly negative view on the pound, will be an exception and probably trade higher. The currency pair is at a one year high, with more upside probably beckoning.
USD/CAD should also grind higher, even if recent price action has been less positive than in EUR/CAD and GBP/CAD. The Fed says it is probably not done tightening monetary policy. The market agrees. This should help USD/CAD push higher.
The BoC Has Had an Aggressive 12 Months
In sum, in a little over one year, the BoC has raised its policy interest rate from 0.25% to 4.5%.
The first hike, last March, was 25 basis points (bp), while the latest, in January, was also 25bp. In between, the bank was more aggressive, tightening 50bp on four occasions, 75bp once, and 100bp once.
The BoC’s rate hiking cycle has been aggressive and concerted, as it grapples with above-target inflation. That the bank paused this month is therefore notable, and the messaging from the central bank is important.
The BoC’s Latest Messaging
In the statement accompanying this month’s hold on rates, the BoC highlighted that global growth was continuing to slow, and that while inflation remains too high, it was coming down due primarily to lower energy prices.
Flat growth in the fourth quarter of 2022 was lower than the BoC projected, and weak economic growth is expected in the coming quarters, which should ease price pressures in product and labour markets. The BoC expects inflation to drop to 3% by mid-year.
Moderating wage growth and increased competitive pressures will make it more difficult for businesses to pass on higher costs to consumers.
Reading between the lines, the key takeaway from the BoC’s messaging is that although inflation is still too high, it has probably peaked and is heading in the right direction.
And, although the bank said it was prepared to tighten again if conditions warranted it, it is telling that they paused now, after acting so aggressively over the past year.
Actions speak louder than words, and the BoC’s pause speaks volumes. The urgency is gone and, according to market pricing, Canada’s rate hiking cycle has ended. The next move is priced as a rate cut, probably at the BoC’s July meeting.
The Fed, ECB and BoE Outlooks
Like the BoC, the Fed, the ECB and the BoE have raised policy rates aggressively and abandoned the zero interest rate policy (ZIRP) or negative interest rate policy (NIRP).
We examine current policy and where it is going in the US, euro area and the UK.
The Fed
The Fed hiked 25bp yesterday, despite ongoing concerns about the US banking system in the wake of recent turbulence.
Messaging from the Fed has been perceived as dovish, even with the rate hike yesterday.
The statement accompanying the policy tightening contained language that acknowledged the impact of recent issues in the US banking sector, highlighting the resulting elevated economic uncertainty.
And even though the Fed still cited its resolve in containing inflation risks, the fact that yields are lower across the curve today point to the market’s dovish read of the Fed statement.
Nonetheless, even though traders are expecting rate cuts in the second half of this year, they still price a ~40% probability that the Fed hikes rates another 25bp at its next meeting on 3 May.
The ECB
After a larger-than-expected 50bp rate rise last week, market pricing is pointing towards additional tightening of monetary policy.
The market is assigns a ~90% probability of another 25bp hike by the ECB at its next meeting on 4 May, with another 25bp virtually fully priced beyond May, likely at the meeting on 27 July.
Comments from ECB officials have also suggested that the central bank has not completed its tightening cycle.
Yesterday, ECB President Christine Lagarde said that ‘bringing inflation back to 2% over the medium-term is non-negotiable’ and that the ECB ‘will do so by following a robust strategy.’
Lagarde’s colleague on the ECB Governing Council, Bundesbank President Joachim Nagel, said that ‘there’s still some way to go … there’s certainly no mistaking that price pressures are strong and broad-based … we will have to be more stubborn.’
With the market and ECB policymakers aligned, expect the central bank to continue raising rates, which will exert upside pressure on EUR/CAD.
The BoE
The BoE today raised rates by 25bp, as expected, in a split vote of 7-2 on the Monetary Policy Committee (MPC).
In its statement, the MPC highlighted the latest unexpected increase in the latest CPI release as a reason for today’s hike, although the central bank expects inflation to fall sharply the rest of this year.
The BoE also highlighted a tight about market, while at the same time noting that uncertainties around the financial and economic outlook have risen.
The MPC is monitoring inflation pressures closely and said it will adjust rates as necessary to return inflation to the 2% target sustainably in the medium term.
A Look at Three CAD Pairs
Three of the most heavily traded and closely followed Canadian dollar pairs are USD/CAD, EUR/CAD and GBP/CAD. We look at each of them in greater detail below.
USD/CAD
Of the three pairs, price action in USD/CAD is the least convincing in terms of further upside.
Since the BoC hold on rates, USD/CAD has traded lower (from ~1.3830 to ~1.3650), even after the Fed rate rise last night. This is partly to do with the market’s dovish reaction to the Fed.
Nonetheless, should the BoC remain on hold over the next few months, and Fed expectations for further (modest) tightening remain priced, expect USD/CAD to grind back towards its October high near 1.40.
EUR/CAD
Upside in EUR/CAD is much more convincing than in USD/CAD, which should perhaps not be surprising given our bullish EUR/USD view.
The pair has hit an ~18-month high this week, trading above 1.49 for the first time since September 2021.
Given the contrasting pricing expectations for central bank policy between the euro area and Canada – the ECB is still expected to hike twice, the BoC is expected to cut by the autumn – further upside for EUR/CAD beckons.
The first (psychological, round-number) resistance will come at 1.50, but the ~1.52 high from April 2021 could also very easily come into sharper focus.
GBP/CAD
Following the consensus 25bp hike from the BoE today, there is now another full 25bp hike priced into the UK curve for the June meeting, with a ~33% probability of another 25bp hike at the following meeting in August.
Given the expectation of further tightening, GBP/CAD can probably rise to the 1.70 psychological, round-number resistance, and may even make it to a 1.73 handle, last seen in February 2022.
Conclusion
Contrasting expectations for monetary policy going forward for the BoC, Fed, the ECB and the BoE mean further downside for the Canadian dollar in the coming months.
A comparatively dovish prognosis for Canadian monetary policy is counterposed, to varying degrees, with the more hawkish pricing for US, euro area and UK monetary policy.
For USD/CAD, the upside is probably more limited than in EUR/CAD and GBP/CAD. Recent price action in all three pairs points to clear upside for EUR/CAD and, to a slightly lesser degree, GBP/CAD. In USD/CAD, upside can be expected, but it less convincing than in the other two pairs.