Thoughts

October 25, 2024 | 14:55

Loonie at Risk

Economist

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal nearly two decades. He is re-sponsible for the Canadian macro-econom... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal nearly two decades. He is re-sponsible for the Canadian macro-econom... (Read more)

The Bank of Canada cut policy rates 50 bps this week to 3.75%, 125 bps from the peak of 5%. The upsized move was driven by meaningful forecast misses by the BoC for both Q3 GDP and CPI. That weaker backdrop left the Bank with a larger output gap than expected and a lower starting point for inflation, which put policymakers somewhat behind the curve, prompting the 50 bp cut. That reasoning suggests the BoC isn’t necessarily keen on another 50 bps in December, which was our takeaway from Governor Macklem’s remarks. Indeed, we anticipate that a string of weaker data is needed to drive such a move; otherwise, it’s back to 25 bps.

The Bank’s bigger cut drove the policy rate about 100 bps below the current level of fed funds, sparking conversation about how far this divergence can go. The Fed is poised to continue cutting rates further this year and into 2025, but the impressive resilience of the U.S. economy has prompted some chatter that there may not be as much policy easing as expected. Meantime, there are exactly no signs that the Canadian economy is gaining momentum, keeping a steady stream of rate cuts on the agenda. Moreover, the government’s latest change to immigration targets points to even less inflation pressure in 2025 (specifically from housing) and somewhat slower growth (though potential growth should dip too), on balance, suggesting rates could fall even further. We do not rule out Canada-U.S. spreads hitting new extremes, but those kinds of forecasts should not be bandied about lightly.

The diverging economic backdrop driving Canadian interest rates to trade on the order of 100 bps below comparable U.S. rates could persist and even deepen. Thus far, the Canadian dollar has weathered the sharp move in rates relatively well, holding in the broader range seen through most of this year. However, we’d expect that range to break if Canada-U.S. spreads move to fresh extremes (Chart 1). Indeed, the loonie would likely come under significant pressure to depreciate in that environment. The last time Canada overnight rates traded meaningfully more than 100 bps below the U.S., in the mid/late-1990s, spreads went from around -50 bps to -250 bps in a ten-month span, and the loonie trended weaker for most of two straight years. The currency depreciated about 15% in the period, with the BoC needing to swoop in to provide support with a 100 bp rate hike in August 1998. That type of depreciation isn’t an imminent risk, but it also shouldn’t be ignored.

An added layer of concern for the Canadian dollar is the U.S. election. Former President Trump has threatened to tariff the world, and both he and VP Harris are likely to trigger the USMCA re-negotiation clause. That might not bode well for the Canadian economy and, by extension, the loonie. Indeed, the currency would surely weaken on the back of any broad tariff action, or even the threat of increased friction in Canada-U.S. trade. In addition, the possibility of a disorderly election result cannot be dismissed, and the likely resulting risk-off move would probably hit the loonie.

Key Takeaway: One clear message from the Bank of Canada this week is that more rate cuts are ahead. That contrasts a surprisingly resilient U.S. economy and a potentially more patient Fed. Markets are already pricing in a meaningful policy divergence, and we wouldn’t rule out a further push on that front. Unfortunately, that puts the loonie at risk of weakening to levels only seen during large economic shocks over the past few decades. The BoC needs to tread carefully as a weaker currency could re-spark inflation pressures which have only just been put to bed.