Canadian Dollar Risks Taunting the BoC into an Interest Rate Cut 

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- CAD to strengthen further says MUFG, but gains unsustainable.  

- BoC seen joining counterparts by cutting interest rate by year-end.

- Currency strength could trigger BoC pivot says BMO Capital Markets.

The Canadian Dollar saw a mixed performance Thursday but is on course to extend its 2019 gains in the months ahead according MUFG, although this strength is part of what could force the Bank of Canada (BoC) into an interest rate cut before year-end.

Canada's Dollar traded higher against around half the G10 basket Thursday after a 'dovish' interest rate statement from the Bank of Canada failed to knock the currency off its perch as the developed world's best performing currency in July and for 2019 overall. 

Thursday's performance came amid further modest losses for the U.S. Dollar and as financial markets prepare for what could be a landmark shift in Federal Reserve (Fed) interest rate policy, which is expected to get underway on July 31 with the first rate cut since the aftermath of the financial crisis.

That cut will bring an end to the rate hiking cycle that helped the U.S. Dollar dominate most rivals last year and speculation about it has already forced the USD/CAD rate, which is Canada's most important exchange rate, back down to levels not seen since before the oil collapse of late 2018. 

MUFG, the world's fifth largest bank and a significant currency dealer, says Loonie is likely to go on rising for a while yet because market expectations of the Federal Reserve are leading U.S. bond yields to fall while the BoC's policy keeping Canadian yields buoyant, which means that returns are improving for investors who sell U.S. assets and buy Canadian alternatives.

Above: Canadian Dollar performance Vs G10 rivals in 2019.

"The BoC also displayed a more dovish tone at yesterday’s policy meeting although it had only a fleeting negative impact on the Canadian dollar," says Lee Hardman, an analyst at MUFG. "It is clear though that the BoC currently does not have the same policy reaction function as the Fed. They still remain comfortable to leave monetary policy unchanged for now despite building downside risks to the outlook."

Canada's central bank left its interest rate unchanged at 1.75% Wednesday, in line with expectations, but played up risks to both the domestic and global economic outlooks emanating from the U.S. trade war with China. Governor Stephen Poloz said the BoC will pay particular attention to "developments in the energy sector and the impact of trade conflicts on the prospects for Canadian growth and inflation" when making future interest rate decisions.

The statement was perceived as an effort to prevent further Canadian Dollar strength at a time when strong economic figures and rising inflation are making it difficult for the BoC to justify following in the footsteps of the Federal Reserve. Inflation surged to 2.4% in May, far above the BoC's 2% target, and recent data has suggested the economy grew at a robust pace in the second-quarter which could mean even higher inflation further down the line. 

However, Governor Poloz said much of the strength seen in the last quarter was the result of "temporary" factors and that global economic uncertainty is now threatening the Canadian outlook. Forecasts of global and major economy GDP growth in 2019 have been downgraded repeatedly this year, with President Donald Trump's May decision to raise tariffs on Chinese exports to the U.S. from 10% to 25% having aggravated fears for the outlook even further. 

 "Yield spreads have moved sharply in favour of the Canadian dollar recently and will continue to place downward pressure on USD/CAD in the near-term (click here). A test and break below the 1.3000-level remains on the cards after yesterday’s BoC and Fed policy updates. However, we remain sceptical that the policy divergence can be sustained, and expect the BoC to begin lowering rates later this year," Hardman says. 

Above: USD/CAD rate at daily intervals alongside U.S.-CA 2-year 'yield spread' (orange line, left axis).

MUFG is not alone in looking for financial markets to drive the USD/CAD rate even lower over the coming months as the Fed begins to cut rates as the analyst team at BMO Capital Markets also offered a similar view on Wednesday.

BMO says a break below the 1.30 level could be enough to force the BoC into a rethink of its interest rate stance. It's FX strategists are waiting for lower levels in USD/CAD from which they can begin betting on a correction lower by the Canadian Dollar, or a rise in USD/CAD.

If the BoC doesn't eventually follow the lead of its G10 counterparts then the Loonie could strengthen further. That would make imports cheaper for Canadians to buy, which could eventually reduce inflation, and also risk slowing the economy by making exports more expensive for other countries to buy. 

"We're in no rush to get long at levels north of 1.3100," says Stephen Gallo at BMO Capital Markets. "We are mindful of the fact that USDCAD is a "pressure point" which the FX market could use to force the BoC to eventually turn more dovish (i.e. by causing a run through 1.30 and into the high 1.20s). As such, our medium-term disposition would still be to look for buying opportunities in USDCAD but also to wait and see if lower levels in the pair emerge first."

Changes in rates are normally made in relation to the outlook for inflation, which is sensitive to economic growth, but impact currencies because of the influence they have over capital flows and the decisions of short-term speculators.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

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