The CAD weakened substantially over the last month, with the USDCAD rising despite the Fed’s rate cut. The disparity in economic performance between the countries has been widening the divide. But if inflation forces the BOC to halt rate cuts, but the Fed continues to ease, that would cause the interest rate gap to close. But, will it mean the USDCAD will turn around?
The uncertainty of the US government shutdown, limiting US data releases, combined with the prolonged trade negotiations between the US and Canada, makes forecasting extremely difficult. As a result, the currency pair is likely to show more volatility. Traders might have difficulty putting the upcoming data release into context, with the market reaction more unpredictable.
What To Look Out For
Canada’s September CPI will come out on Tuesday, and is expected to jump to 2.2% from 1.9%. Rising energy costs are having an impact on consumer prices in Canada. But, more importantly for monetary policy, the BOC’s preferred measure, the Trimmed-Mean, is expected to rise to 3.1% from 3.0%. That pushes it above the target 1-3% range.
Despite the sluggish performance in the Canadian economy, it will become increasingly hard for the BOC to justify further easing if inflation continues to rise above target. BOC officials have largely insisted that the uncertainty around trade negotiations with the US means the economy will underperform. Thus, an easing bias is justified.
Why Is There Inflation?
Usually, inflation correlates with economic activity. Faster economic growth means accelerated monetary circulation, and vice versa. So, if the Canadian economy is underperforming, it’s logical to presume that inflation would go down as well. But that’s not happening.
Part of it can be blamed on the trade war. Unlike other countries that reached deals with the US after Trump imposed his “reciprocal” tariffs and didn’t apply tariffs of their own, Canada tariffed US goods that the USMCA doesn’t cover. Similar to what the Trump Administration did to Canada. While it’s widely speculated that tariffs raise domestic prices, that seems to be the case for Canada, with its significant economic dependence on its southern neighbor.
What Will the BOC Do?
As we enter the October/November central bank meeting cycle, the Fed is widely expected to ease rates. The BOC is also likely to ease at its October 29 meeting. If all goes well, that would mean the interest rate gap between the two countries would remain the same. The relative weakness in the CAD likely prices in this scenario, with investors shy of Canadian investments due to its economic underperformance.
But if inflation goes well above target, then the BOC might have to turn more hawkish by necessity. It might still deliver the rate cut as anticipated, but could signal that further easing will be on hold for a while. That might have the effect of giving the CAD a boost, at least in the short term. However, higher rates mean slower economic growth in the long run, so gains for the CAD might be short-lived.