USD/CAD Expected to Rise with Canadian Rate Cut

Bank of Canada Eyes Early Rate Cut Amid Global Economic Shifts

by Faruk Imamovic
USD/CAD Expected to Rise with Canadian Rate Cut
© Getty Images/Katherine KY Cheng

Central banks are constantly navigating complex data and geopolitical dynamics to make critical decisions. Recently, the question on many analysts' minds is whether the Bank of Canada (BoC) might be the first to implement a rate cut among major central banks, potentially setting a precedent that could influence others like the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of England (BoE).

Canada's Economic Outlook

The BoC's potential move towards a rate cut is underpinned by the latest Consumer Price Index (CPI) report, which met expectations with a headline inflation rate of 2.7%. More importantly, every significant measure of core inflation also fell within the BoC's tolerance band of 1%-3%, indicating broad-based disinflation across various sectors including durables and services. This consistent trend suggests that the criteria set by BoC Governor Tiff Macklem in April, which required prolonged subdued inflation readings before considering rate cuts, have been met.

Given this context, the BoC is now in a position to consider a rate cut as early as June, potentially ahead of the Fed, BoE, and ECB. Despite robust employment growth, the central bank may overlook this factor due to the high unemployment rate and the predominance of part-time job gains, which might only superficially reflect labor market strength. Additionally, Canada's economic activity has largely plateaued, as evidenced by various surveys including PMIs and the BoC's Business Outlook Survey.

Implications for USD/CAD

With the possibility of a rate cut, the Canadian dollar (CAD) is expected to experience fluctuations. Analysts predict that the USD/CAD could rise to 1.40 by the end of the year. This forecast is based on the anticipated widening of two-year yield spreads between the US and Canada, possibly reaching 100 basis points from the current 70 basis points. This differential reflects the divergent monetary policies of the two countries, with the US economy projected to grow at a faster pace than Canada’s in the coming quarters.

Implications for USD/CAD
Implications for USD/CAD© Getty Images/Matt Cardy

Global Economic Context

While Canada considers its monetary policy moves, the global economic environment remains volatile. In the US, attention is on the upcoming Federal Open Market Committee (FOMC) minutes, where insights into the Fed's long-term policy outlook will be closely scrutinized. The FOMC's consensus is expected to lean towards a "high for long" interest rate scenario, without a firm timeline for cuts, reflecting a cautious approach to managing inflation.

In the UK, the latest CPI report for April exceeded expectations, highlighting persistent inflationary pressures, particularly in the services sector. This development has shifted market expectations, with traders now seeing a lower probability of a rate cut from the BoE in June. The UK’s inflation dynamics, compounded by higher wage growth and sticky service prices, suggest that the BoE's hawkish stance might persist, delaying any potential rate cuts.

Geopolitical Tensions and Market Sentiment

Adding to the economic uncertainties are the escalating geopolitical tensions, particularly between China and the West. China's recent actions, including freezing properties of US military companies and considering tariffs on European luxury auto imports, have strained its commercial relationships with both the US and the EU. These developments have dampened market sentiment, impacting risk-taking behaviors and influencing global financial markets.

In Asia, despite some positive signals from China's property market following the rollout of an official property-purchase program, gains were subdued due to the broader geopolitical landscape. The West's increasing distance from China, both economically and strategically, underscores the complex environment in which central banks are operating.

Chile's Monetary Policy Dynamics

Shifting focus to South America, Chile's central bank, Banco Central de Chile (BCCh), is also making cautious moves in its monetary policy. The BCCh is expected to slow the pace of its rate cuts, with possibilities ranging from a 25 basis points (bps) to a 50bps cut. The rationale for a smaller cut includes stabilized inflation and firming economic activity. The recent rally in the Chilean peso (CLP) offers some flexibility, but the consensus leans towards a more conservative approach.

Chile’s economic narrative is further buoyed by structural trends such as fiscal responsibility and the potential for upgraded growth forecasts. The country's links to the global energy transition, especially as a major copper producer, also play a crucial role. Rising copper prices, driven by supply constraints and increased demand for electricity generation and transmission, enhance Chile’s terms of trade and its economic outlook.

As central banks around the world navigate through complex economic data and geopolitical uncertainties, the Bank of Canada’s potential rate cut could mark a significant shift in global monetary policy. While the BoC may lead the way, other major central banks like the Fed, BoE, and ECB will continue to tread cautiously, balancing their domestic economic conditions with the broader global economic environment. In this interconnected world, the decisions made by these financial institutions will have far-reaching implications, influencing not only currency markets but also broader economic trends and geopolitical relations.