The Bank of Canada (BoC) is at a crossroads as it prepares for a pivotal decision next week regarding interest rates, with market expectations split between 25-basis points (bps) and a more aggressive 50 bps cut.
This would mark the fourth consecutive reduction following three earlier cuts.
The BoC’s decision is complicated by mixed signals from inflation data, a shifting labor market, and an evolving economic outlook.
In September, Canada’s consumer price inflation fell to 1.6% year-on-year, dipping below the 2% target for the first time since February 2021.
A significant contributor to this residual inflation is housing costs; excluding these, inflation could potentially drop below 1%.
However, the BoC cannot selectively disregard components, which has made policymakers cautious about easing too aggressively. A major concern is the risk of renewed price pressures if monetary conditions become overly relaxed.
Source: Think.ing
Growth outlook improves despite cooling inflation
Despite moderating inflation, Canada’s economic growth appears resilient.
The latest Business Outlook survey indicates improved sentiment among businesses, with recent GDP and retail sales figures surpassing forecasts.
However, the labor market presents a complex picture: unemployment has increased to 6.5%, up from 4.8% in July 2022.
This rise is not due to job losses but a surge in labor force participation driven by recent immigration.
This increased labor supply could alleviate wage pressures, offering the BoC room to pursue its gradual rate-cutting strategy.
The central bank aims to balance maintaining a neutral policy stance with supporting economic expansion.
Financial markets signal a 50 bps cut with high certainty
The financial markets are leaning towards a more aggressive stance, pricing in a high likelihood of a 50 bps cut for the upcoming policy meeting.
If enacted, this cut would contribute to a total of 83bps of reductions anticipated by the end of December.
In contrast, market expectations for 60 bps of cuts just a week ago highlight the evolving sentiment among investors.
A 50 bps reduction would widen the interest rate differential between the BoC and the US Federal Reserve, creating a spread of 125 bps.
This could exert further pressure on the Canadian dollar (CAD), making imports more expensive and raising concerns among some BoC members about pursuing a larger rate reduction.
Source: Think.ing
Wider US-Canada rate differential could sway BoC’s decision
The potential widening of the interest rate differential between Canada and the US is a crucial factor in the BoC’s decision-making process.
A 50bps cut would amplify this spread, potentially leading to additional downward pressure on the CAD.
A weaker CAD could heighten import costs, adding inflationary pressures that complicate the BoC’s goal of achieving price stability.
Given these dynamics, a 25bps cut may emerge as a more prudent option.
This approach would signal a continuation of easing while mitigating the risk of a sharp decline in the CAD.
However, the decision remains finely balanced, with a 50bps cut still a plausible path depending on the BoC’s inflation outlook.
Dovish expectations drive USD/CAD higher as markets await BoC decision
Since the start of October, the gap between the USD and CAD two-year swap rate has widened from 50bps to 80bps.
This shift reflects dovish rate expectations in Canada against a backdrop of hawkish sentiment in the US.
The widening spread has pushed the USD/CAD rate to 1.38, hindering the loonie’s potential gains amid relative stability among currency crosses, particularly as some market participants position themselves ahead of the upcoming US elections.
The market’s anticipation of a 50bps cut leaves the CAD vulnerable to re-pricing should the BoC opt for only a 25bps reduction.
In this scenario, a short-term appreciation of the loonie is possible as investors adjust to a less aggressive easing path than initially expected.
What will the Bank of Canada decide: a 25 bps or 50 bps cut?
Ultimately, the BoC’s choice between a 25 bps and a 50 bps cut hinges on its assessment of inflation risks, economic momentum, and the impact of a weaker CAD on the broader economy.
A cautious approach would favor a 25 bps cut, allowing the bank to maintain flexibility for future adjustments.
Conversely, a more decisive 50 bps cut could signal a stronger commitment to supporting economic growth.
The upcoming policy meeting will be closely monitored by markets, with significant implications for the CAD and Canada’s economic outlook.
Investors and analysts remain poised for potential volatility as the central bank navigates this challenging environment.
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