FX Watch – CAD: Rate hikes priced in

by: Georgette Boele

In this publication:  The pricing in of the Bank of Canada’s monetary policy tightening has resulted in a strong rally in the Canadian dollar. Financial markets expect three 25bp rate hikes before end of 2018 and this is also our view. If the Bank of Canada delivers and oil prices start rising in positive investor climate the Canadian dollar should outperform.

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Recent developments

Between 5 May and 27 July, USD/CAD dropped by more than 9%, from close to 1.38 to 1.25. The recovery of the Canadian dollar started as a positive spill-over from higher oil prices at the start of May. At that time, the Canadian dollar was oversold and the recovery in oil prices was used to take profit on speculative Canadian dollar shorts. In June, an official of the Bank of Canada hinted that official interest rates could be hiked. This was the start shot of an impressive rally in the Canadian dollar. On 7 July the Bank of Canada raised rates by 25 bp to 0.75% and financial markets moved fast forward in pricing in further rate hikes. Currently, market consensus (analysts) is for one more 25bp rate hike in 2017 (October) and two 25bp rate hikes in 2018. Financial markets (futures) are even more aggressive in expecting rate hikes. The Bank Acceptance futures show a rate of 1.46% for the end of 2017 and 1.72% for the end of 2018. Recently, the Canadian dollar has given back gains versus the US dollar because of a deterioration in investor sentiment and a modest recovery of the US dollar.

Bank of Canada possible rate hikes priced in…

As mentioned above, financial markets have aggressively priced in a total of three more rate hikes (of 25bp) between now and the end of 2018 and they even err on more instead of less. We also think that three rate hikes are likely. However, this will unlikely provide any strong support to the Canadian dollar because investors are already positioned for it. Meanwhile, we expect financial markets to re-focus on Fed rate hikes and US data in the near-term. US data has come in better than expected but financial markets continue to be more dovish than what the Fed has communicated up to know. If financial markets move slightly into the direction of the Fed, the US dollar has room to recover across the board, also versus the Canadian dollar. We expect the USD/CAD recovery to move towards 1.30 in Q3 and then to lose momentum. Subsequently, we expect the Canadian dollar to strengthen again versus the US dollar, also helped by a higher oil price. However, if oil prices were to slide sharply and/or investor sentiment were to deteriorate, the Canadian dollar will suffer versus the US dollar. This is not our base case scenario.

…and EUR/CAD to top out around 1.50

Financial markets may have fully priced in three rate hikes by the Bank of Canada before the end of 2018. They have also moved fast forward in expecting a rate hike by the ECB in 2018.  We expect ECB President Mario Draghi to dampen expectations about early rate hikes. The ECB is concerned that tapering will trigger an early tightening of financial conditions and seems focused on tapering without triggering a tantrum. This should weigh on the euro across the board. If the Bank of Canada delivers the rate hikes that financial markets are expecting, this should be neutral for the Canadian dollar. However, if ECB Draghi calms down expectations about an ECB rate hike, the euro will likely come under some pressure. This would result in a lower EUR/CAD. The higher oil price we expect will be another argument for a higher Canadian dollar versus the euro.