The Bank of Canada may be on the verge of raising interest rates for the last time this cycle, but economists are divided on how the bank’s decision will affect the Canadian dollar. Some say Canada’s economy is already in jeopardy.
Barclays analysts expect Canada to raise interest rates by 25 basis points on January 25, greater than market expectations of 20 basis points, which will be positive for the Canadian dollar.
“Governor Macklem’s warning that the risk of undertightening remains greater than overtightening makes Wednesday’s resolution vulnerable to unexpected hawkish stances,” Barclays FX Strategy said in a FX research note.
Barclays believes that the Canadian dollar is closely related to the U.S. economy and is positively correlated with the S&P 500 Index, which has underperformed other major stock indexes recently, which is why the Canadian dollar has underperformed the U.S. economy.
The Bank of Canada’s apparent desire to slow down ahead of other central banks and finally end its cycle of rate hikes is also widely cited by analysts as another factor in the loonie’s underperformance.
“The global interest rate environment and market rate expectations remain the main drivers of the Canadian dollar,” said Elisabeth Andreae, FX analyst at Commerzbank.We maintain our forecast for CAD, seeing limited recovery potential in the medium term。”
However, Barclays believes the Canadian dollar could be boosted in the near term by the Bank of Canada’s ability to tighten rates further as the Canadian economy is more resilient than expected at the time of the central bank’s last decision and data trends have improved.
In particular, analysts said Canadian labor market data unexpectedly turned upward, core inflation remained above 5% and short-term inflation expectations rose.
But researchers at the National Bank of Canada (NBC) warned that the Bank of Canada would be wise to forego another rate hike because “another rate hike may be the straw that breaks the camel’s back.”
“The most aggressive policy rate hikes in decades are taking their toll on the economy. Canadian real estate is in a recession,” said Matthieu Arseneau, deputy chief economist for Financial Markets at National Bank of Canada.
As the chart below shows, the Bank of Canada raised rates five times in eight decisions in 2022
Bank of America Canada and Mexico economist Carlos Capistran predicts that the Bank of Canada will eventually raise interest rates by 25 basis points on Wednesday, even if there is a “significant slowdown in the domestic economy.”
The central bank will note that while headline inflation has peaked, other measures of inflation have not yet trended downward, which would lead to another rate hike.
But Bank of America said Wednesday’s rate hike by the Bank of Canada would be the last in this cycle, which could weaken the Canadian dollar.
“We think the BoC will take a pause on rate hikes after this one and see how the economy and inflation develop,” Capistran said.
Bank of America FX Strategist Adarsh Sinha said Bank of America is bullish on the Canadian dollar in the medium term, but could see some weakness in the Canadian dollar this week as the Bank of Canada paused its rate hike communication.
Economists at ING Bank also expect the ECB to raise interest rates by a final quarter point of 25 basis points on Wednesday, while also predicting a possible rate cut later in 2023.
“Barring a very dovish outcome (no rate hike and claiming rates have peaked) or a very hawkish outcome (raise rate and signal further rate hikes), the Bank of Canada’s decision to raise interest rates is unlikely,” said Francesco Pesole, currency strategist at ING. The dollar’s impact is likely to be fairly short-lived.”
USD/CAD daily chart
At 10:10 on January 25th, Beijing time, USD/CAD was at 1.3356/59