By Ketki Saxena
Investing.com – The Canadian dollar has been on the back foot against its US counterpart in recent weeks, with one factor in the loonie’s losses being the divergence of monetary policy expectations between the US Federal Reserve and the Canadian dollar.
The Bank of Canada has previously announced a conditional pause, and looks likely to maintain its policy rate at 4.5% today - at or close to the Canadian central bank’s projected terminal rate.
The US Federal Reserve meanwhile, is leaning more hawkish than has been priced into markets so far, following testimony to Congress from Fed Chair Jerome Powell. Markets are now pricing in a 66% probability that the central bank will lift its benchmark overnight interest rate to the 5.00%-5.25% range on March 22, from the current 4.50%-4.75% range - up from the 30% chance seen before Powell’s testimony before the Senate Banking Committee.
As markets await tomorrow’s continued Fed testimony, and the Bank of Canada’s monetary policy announcement, here are 3 scenarios for potential rate moves and the likely impact on the Canadian dollar, outlined by analysts at RBC (TSX:RY).
Scenario 1: Bank of Canada Leans Hawkish, Raises Rates (10% chance)
Even as the Bank of Canada seeks to cool the economy and prevent a wage price spiral with interest rate hikes, the Canadian job market remains red-hot. January’s blockbuster labour market report - which showed 150K jobs added vs. expectations for 15 K jobs - is a key indicator the Bank may cite if it does choose to hike interest rates again.
RBC notes that in this scenario, “Bank lifts overnight rate to 4.75%, abandoning its conditional pause. Statement notes that overheated labour market has introduced upside risks to its outlook, and that pace of job growth has cleared the high bar for additional tightening. New guidance does not rule out further hikes. USD/CAD -0.80%”
Scenario 2: BoC Holds Rates But Moves Away from "Conditional Pause" Rhetoric (10% chance)
RBC sees an equal 10% chance that the Bank leaves the interest rate unchanged tomorrow, but moves away from its conditional pause, again citing hotter than expected labour markets.
However, in this scenario, the Bank would still err on the side of under tightening vs. overtightening in the immediate future, citing the stall in fourth quarter Canadian GDP as a rationale for why no more rate hikes are needed for the moment.
Canadian GDP grew 0% in the fourth quarter of 2022, well below expectations for a 1.3% gain, indicating that the Canadian economy is slowing more than expected by the BoC as interest rate hikes slowly begin to trickle through the economy.
In this scenario, RBC notes, “Bank leaves overnight rate unchanged at 4.50%, with outlook evolving in line with January MPR. Statement notes flat print on Q4 GDP, but economy remains in excess demand. Bank also notes that surging labour market has lowered bar to resume tightening, and shifts its guidance from a conditional pause to a more balanced data-dependent stance. USD/CAD -0.20%”
Scenario 3: Bank of Canada Holds Rates Steady, Leans Dovish (80%)
The last and most likely option that RBC outlines is that the Bank of Canada leaves its policy rate unchanged tomorrow, and continues to hold to its forward guidance of a conditional pause - though of course with the caveat that policymakers will remain data dependent and not hesitate to tighten aggressively should the need arise.
In this scenario, the Bank would cite the stalled economy, and also point to easing inflation pressures as indicators that monetary policy, is for the moment, sufficiently restrictive.
Canadian inflation moderated to 5.9% in January, the first time since February 2022 that the Consumer Price Index has ticked in below 6%. The reading was cooler than the 6.3% seen in December and the 6.1% year over year increase expected by analysts. The average of two of the central bank’s core measures of underlying inflation, CPI-median and CPI-trim, came in at 5.1% compared to a 5.3% reading in December.
In this scenario, RBC notes, “Bank leaves the overnight rate unchanged at 4.50%, with a short policy statement that echos its message from January. Bank cites flat print on Q4 GDP as evidence that higher rates are working to slow demand. Bank also notes that inflation outlook has evolved in line with MPR, with only a cursory mention of labour market strength. Minor tweaks to forward guidance to amplify conditional nature of pause. USD/CAD +0.10%”