The Canadian Dollar Rises after Bank of Canada Hikes Rates and Sounds the Alarm on White House Trade Policy

-Canadian Dollar rises after fourth BoC rate rise in 12 months. 

-BoC signals rate rises will continue but warns of "trade war" risks. 

-Analysts say CAD gains to be short-lived as hike already "priced in".

© Bank of Canada

The Canadian Dollar rose sharply against its developed world counterparts Wednesday after the Bank of Canada (BoC) raised its interest rate for the fourth time in the last 12 months and signalled its intention to continue withdrawing stimulus from the Canadian economy over the coming quarters. 

BoC officials raised Canada's main interest rate by 25 basis points to 1.5% Wednesday and cheered a resilient performance from both Canadian as well as global economies, although they also warned that President Donald Trump's trade policy poses a mounting threat to global economic growth. 

"The Bank expects the global economy to grow by about 3 ¾ per cent in 2018," says Stephen Poloz, governor at the Bank of Canada. "The US economy is proving stronger than expected, reinforcing market expectations of higher policy rates and pushing up the US dollar. This is contributing to financial stresses in some emerging market economies. Meanwhile, oil prices have risen. Yet, the Canadian dollar is lower, reflecting broad-based US dollar strength and concerns about trade actions. The possibility of more trade protectionism is the most important threat to global prospects."

Most measures of Canadian inflation are already at or above the BoC's 2% target and the Bank said Wednesday its expects this to remain the case out until at least 2020. They also said wage growth in Canada remains sluggish, citing it as grounds to think there is more "slack" in Canada's labour market than previously thought, which is an almost "dovish" comment that could be taken as a hint of caution about the prospect of further interest rate rises this year.

"Canada’s economy continues to operate close to its capacity and the composition of growth is shifting," Poloz adds. "Business investment is growing in response to solid demand growth and capacity pressures, although trade tensions are weighing on investment in some sectors. Overall, the Bank still expects average growth of close to 2 per cent over 2018-2020."

Above: USD/CAD rate shown at hourly intervals.

The USD/CAD rate was quoted 0.59% lower at 1.3066 following the announcement while the Pound-to-Canadian-Dollar rate was 0.54% lower at 1.7334. Canada's unit was also quoted higher against all other developed world currencies. 

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

"There are worries ahead, growth hasn't been stellar, but the backdrop has been just good enough for the Bank of Canada to nudge rates a quarter point higher," says Avery Shenfeld, chief economist at Toronto-based CIBC Capital Markets. "Overall, with the statement retaining the call for gradually higher interest rates ahead, guided by upcoming data, there isn't anything surprising to us in the message, but those who somehow thought the Bank could sound dovish while hiking rates on the same day may be a bit disappointed. That could take the C$ and short term bond yields a touch higher." 


Where Next for the Canadian Dollar?

The USD/CAD rate has risen by 4.4% so far in 2018 and the Pound-to-Canadian-Dollar rate is up by 2.7%, with both performances representing heavy losses for the Loonie, particularly after taking into account that Canada's Loonie was up by a similar measure against the greenback and Sterling until late around the end of the first-quarter. 

Pricing in overnight index swaps markets ahead of the Wednesday decision implied a July 11 cash rate of 1.48%, which suggested an almost 100% probability of a rate hike this month. As a result, much of the good news for the Loonie was seen as already in the price, so some said tupside for the currency following the decision would be short-lived. This may still prove to be the case.

"In the context of global trade tensions and the weakening macro story in Canada, we doubt the hike will do the loonie any favors. We think much of the good news is priced in and don't see the Bank hiking again this year, leaving us long USDCAD into the meeting," says Mark McCormick, North American head of FX strategy at TD Securities, in a note to clients ahead of the announcement.

The TD Securities FX team have advocated that clients of the bank bet on another increase in the USD/CAD rate during the next month or so, citing a likely slowdown in the pace at which the Bank of Canada raises rates in future, as well as the so called trade war and North American Free Trade Agreement negotiations that have dominated the headlines in recent months. They are targeting a move up to 1.35 and have a stop-loss set at 1.2880.

"We have long been proponents of the view that the BoC is effectively running a “managed float” in USDCAD, keeping the cross within a broad 1.25-1.35 range. We don’t think today’s meeting will give strong reasons to end this regime, but whereas in the past we were leaning in favor of dovish surprises, we think the bias for policy surprises might be about to move in a somewhat more hawkish direction," says Alvise Marino, an FX strategist at Credit Suisse. "This could be consistent with a test of the key 1.30 psychological support level for the first time since June."

The Loonie and Bank of Canada are caught between a rock and a hard place at the moment. On the one hand, Canada's economy has shown signs of recovering from a first-quarter lull, but growth is still expected to remain below the elevated pace seen in 2017. On the other hand, President Trump's "trade war" and approach toward the NAFTA agreement are have weighed on the Loonie as well as activity in some segments of the economy. 

Officials from both sides of the US-Canada border have been attempting, without success, to renegotiate the North American Free Trade Agreement for nearly a year now. TD Securities previously estimated that a US withdrawal from NAFTA could see the Canadian Dollar fall by 20%, while the BoC has also frequently flagged the trade saga as a significant risk to its own outlook for the economy.

Talks are now seen dragging on through the rest of 2018, which is negative for the Loonie, so long as the White House avoids the nuclear option of simply announcing a US withdrawal from the pact. 

"Since the talks to reform NAFTA were adjourned without significant progress in June (in coincidence with the imposition of tariffs on steel and aluminium), the topic has moved to the backburner of US policy," says Marino at Credit Suisse. "Despite benign early statements, we remain firmly of the view that any form of agreement between NAFTA countries is unlikely unless the US tones down its requests in sensitive areas such as labour costs (the US proposed increasing wages for Mexican auto industry workers to $16/hour), rules of origin, dispute resolution and sunset clause."

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