Canadian Dollar Draws More Sellers after BoC Shifts to Neutral Interest Rate Stance, Creates Scope for Cuts

Image © Bank of Canada, Reproduced Under CC Licensing

- CAD clobbered as BoC holds rate at 1.75%, shifts into neutral.

- Next move could be up or down, BoC ever more data-dependent.

- Market is buying USD/CAD, analysts are looking for further gains.

The Canadian Dollar weakened against rivals Wednesday after the Bank of Canada (BoC) abandoned the 'tightening bias' that would have eventually have seen it go on lifting interest rates over the coming quarters, before shifting to a so-called neutral bias.

The Bank of Canada left its overnight rate unchanged at 1.75% on Wednesday, as was expected by the market, although the contents of the accompanying statement and quarterly forecast pack contained a litany of numbers and statements that must have left a sour taste in the mouths of investors.

"Global economic growth has slowed by more than the Bank forecast in its January Monetary Policy Report (MPR). Ongoing uncertainty related to trade conflicts has undermined business sentiment and activity, contributing to a synchronous slowdown across many countries," the BoC statement reads.

The commodity-exposed Antipodean as well as the Eurozone economies all slowed sharply in 2018 after the Chinese economy was damaged in President Donald Trump's trade war, with many other countries also experiencing a loss of momentum, albeit to a lesser extent. 

"In Canada, growth during the first half of 2019 is now expected to be slower than was anticipated in January. Last year’s oil price decline and ongoing transportation constraints have curbed investment and exports in the energy sector. Investment and exports outside the energy sector, meanwhile, have been negatively affected by trade policy uncertainty," the BoC says. 

Markets have been repeatedly assured by U.S. officials that a deal to end the tariff fight between the world's two largest economies is on the way, although this has been the case since the beginning of March and the world is yet to clap eyes on any firm proposals for the future relationship. 

The BoC's above assessment was behind the new monetary policy guidance issued Wednesday, which is that the outlook means the Canadian economy still needs an interest rate that is below the so-called 'neutral' range where monetary policy is neither restrictive nor stimulative.

That statement alone could have hurt the Loonie if the market had been unprepared for it but Wednesday's injury came from the shift to what economists describe as a "neutral bias", which means that Canadian interest rates could now go either up or down in the next change.  

"That was about as dovish an outcome within reasonable expectations for today," says Bipan Rai, a macro strategist at CIBC Capital Markets. "Removal of hiking bias? Check. Lower neutral rate estimate? Check. 2019 GDP revised lower? Check. Estimate for the output gap is wider? Check." 

Central banks in Australia and New Zealand have both shifted into neutral during recent quarters, and the Reserve Bank of New Zealand subsequently shifted even further across the spectrum to an outright 'easing bias that has seen it tell markets the next change in rates will be a cut. 

Interest rate decisions are normally made in relation to the outlook for inflation but impact currencies because of the push and pull influence they have over capital flows and due to the opportunity they provide short-term speculators.

"Birds of a feather flock together, and the Bank of Canada followed its dovish global counterparts in abandoning its hiking bias and seeing a significantly slower pace of growth ahead," says Royce Mendes, an economist at CIBC. 

Above: Pound-to-Canadian-Dollar rate shown at daily intervals. 

The Pound-to-Canadian-Dollar rate was 0.58% higher at 1.7475 following the release and has risen 0.42% this year. Canada's Dollar was lower against all G10 currencies other than the Aussie and Kiwi Dollars following the BoC announcement.

"Our subjective odds of a rate cut for this year are closer to 25%," says CIBC's Rai. "Fundamentally, we’ve liked being short CAD for a while, and now technically the stars are aligning for long USD/CAD as the setup is too strong to ignore."

The USD/CAD rate was quoted 0.45% higher at 1.3490 following the statement but has fallen -1.1% for 2019. CIBC's Rai has told clients they should consider buying the USD/CAD rate at 1.3475 and targetting a move up to 1.41 over the coming months. 

CIBC is not the only Canadian firm eyeing bets on USD/CAD though.

"What is already priced into the OIS curve and the CAD seems quite “fair” in our opinion, and so we wouldn’t be rushing to buy USDCAD this far north (1.3450) of 1.3400 just yet.  But the tone in the USD, the global backdrop and what is likely to spring from the BoC rate decision still signal that dips in the pair should be bought," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

RBC Capital Markets also told clients on Tuesday to bet on an increase in the USD/CAD pair, targeting a move up to 1.3560 this week. The Toronto-headquartered firm entered the trade at 1.3366 but will close and walk away from it if the market falls to 1.3235.

Above: USD/CAD rate shown at daily intervals.

"While we agree with the BoC that Canadian GDP growth should pick up in the coming quarters, we don’t expect activity will be strong enough on a sustained basis for the central bank to get back to raising interest rates," says Josh Nye, an economist at RBC.

Nye and the RBC team are forecasting a steady Canadian cash rate through this year and next, although the market may have different ideas about the outlook for Canadian interest rate policy, not least of all because of the shift into neutral and an uncertain outlook for the global economy.

In the short, the bank has gone from warning of "increased uncertainty about the timing of future rate increases" back in March, to assuring financial markets and Canadian citizens that "We will continue to evaluate the appropriate degree of monetary policy accommodation as new data arrive." 

In central bank speak this change is significant because of the new monetary policy possibilities it puts on the table.

That guidance does not rule out more rate hikes further down the road, but it does create scope for the BoC to judge at some stage that a greater degree of "accommodation" than is already provided by the current policy is for some reason required by the economy. 

Interest rates are the primary tool used by policymakers and in order to provide the Canadian economy with more "accommodation" the BoC would have little choice other than to cut its cash rate, which might then come as a surprise to some forecasters. 

"Bank of Canada has become the latest global central bank to officially put its tightening cycle on hold, although we aren't convinced that this latest dovishness will translate into the rate cuts investors are beginning to price in," says James Smith, an economist at ING Group. "That said, we don't expect a rate hike over the course of 2019 either."

The Bank of Canada already gave a taste back in March of what may be to come on Wednesday when it first told markets "the outlook continues to warrant a policy interest rate that is below its neutral range." 

That was part of a u-turn by the BoC on its earlier forward guidance, which suggested in October that rates could rise as many as three times in 2019, taking the cash rate up to within its so-called neutral range.  

Canada's neutral range, which is where monetary policy is neither restrictive nor stimulative for the economy and inflation remains at the 2% target, was previously estimated to be between 2.5% and 3.5% until the BoC slashed it Wednesday to between 2.25% and 3.25%.

The Bank of Canada began to abandon its 'hawkish' interest rate guidance in December after a slowdown in the global economy led North American central bankers at the Federal Reserve and BoC to fear blow-back that would ultimately hurt their own growth prospects.


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