The race has begun – who is left holding the rates bag

FX and indices traders are now on notice – the race to restart economies is upon us. We have to-date seen Riksbank and SNB move policy but with the Bank of Canada (BoC) now entering the rate cut movement – the race is now well and truly on and the interest rate differentials that come into play with currencies will ramp up.

Potential for Further Cuts

In a move that surprised some analysts but aligned with market expectations, the Bank of Canada (BoC) has reduced its policy rate from 5.0% to 4.75%. It’s the first time the BoC has cut rates since March 2020. It is a clear shift in thinking and reflects a much more dovish stance than anticipated. It also sends a clear willingness to further lower rates if inflation continues to ease and confidence in reaching the 2% inflation target grows.

The impact on the CAD and Canadian bonds post the decision is stark.

USD/CAD

(source Refinitiv)

However the post-reaction even more interesting. The spike and then sell off is a clear recognition from FX traders and fund managers that if the BoC is moving rates the Fed is not far off it either. (More on this below)

A Dovish Turn

So what has led to the dovish turn from the BoC and what can been extrapolated to over similar geographics from the BoC Decision? 

Based on current domestic inflation data, headline Consumer Price Index (CPI) is expected to moderate, helped by factors such as easing mortgage costs. The primary reason for the rate cut was the slowing of core inflation and the reduction in broad-based inflation increases. We should point out that Europe, the UK and Canada are seeing this – Australia and the US not so much. 

There is uncertainty about whether core inflation will continue to improve as favourably in the coming months – and the more hawkish BoC watcher were keen to point this out The Canadian Federation of Independent Business (CFIB) suggest that core inflation might stabilize around 2.5-3% which is above the levels most would predict for further cuts.

However, history shows the BoC like most central banks never really goes ‘one and done’ it is normally coupled with two or three moves. Which again suggests CAD crosses against those economies that are not likely to see rate cuts in the coming months will benefit as the CAD falls.

South of the Board – US Economic Activity

A weakening US labour market and economic activity are expected to spill over to Canada, potentially impacting Canadian economic growth. This development is currently not in the BoC’s base case, which expects stronger growth in Canada this year.

BoC Governor Tiff Macklem’s comment that “there is room for growth even as inflation continues to recede” suggests that officials expect a scenario of stronger growth with easing inflation in the coming months. Any deviation from this expectation towards weaker growth would likely prompt more dovish policy actions. Recent data suggests Macklem and Co. might have to rethink this view

Data Dependence and Future Rate Decisions

Like all central bankers looking for their ‘get out of jail free card’ – BoC officials have consistently emphasised data dependence in their making decisions. Which is interesting as recent Canadian activity data, was showing strong job growth, yet this was somewhat downplayed in the decision – this could also feed into the reaction of the CAD in the hours post the decisions as the initial dovishness was evaluated with a hard lens. Employment is described as growing at a slower pace than the working-age population, a trend that has persisted even pre-pandemic.

If activity data continues to evolve as it has recently and core inflation picks up in May and June CPI data, the BoC may forego a rate cut in July. However, the base case scenario anticipates some slowing in activity and particularly weakening US data, which could result in updated growth forecasts in the July Monetary Policy Report (MPR) being less favourable than in April. This alone could lead the BoC to cut rates again in July.

Where does that leaves us?

The BoC cut to 4.75% marks a shift towards more accommodative monetary policy amidst a complex economic landscape. With inflation showing signs of moderation and potential headwinds from the US economy, the BoC remains vigilant and data dependent. Future rate decisions will hinge on the evolving economic conditions and inflation trends, with further cuts likely if the current trajectory of easing inflation and economic activity persists. 

CAD now very much sits in the dovish and weaker end of the G10 currencies. That bias is unlikely to change again the likes of the AUD which is clearly sitting at the higher end of the G10 spectrum.

So that’s Canada – what about Europe?

All things being equal – the European Central Bank (ECB) is poised to start cutting interest rates for the first time in nearly five years tonight. 

In a move well forecasted to the market it is expected to stimulate the eurozone economy that is now flirting with, or in some case already in recession. 

To put this decision into some context – the ECB had previously raised its benchmark deposit rate to a historic high of 4% to combat significant inflation caused by supply side issue out of COVID and the war in Ukraine. 

Consensus suggest that the scope of economic stimulus will depend almost purely on the extent of the total rate reductions rather than other programs the ECB has engaged in in the past. For example something that might hamper the economic recovery through rate cuts in Europe is rapid wage growth leading to high inflation limiting the number of cuts expected.

This is certainly impacting the thinking of traders, the EUR has a known cut cycle in front of it – yet its holding relatively well suggesting traders are not as dovish on rates as economist and the ECB is.

Thus it’s not the announcement that traders and investors will focus on. It’s the guidance from ECB president Christine Lagarde regarding future monetary policy.

The stated aims currently in lowering rates is to invigorate housing markets, business investment, and consumer spending, which have been restrained by high borrowing costs. Which have significantly impacted economic activity, but with inflation pressures now easing slightly, the bank sees an opportunity to support growth.

There is also a growing amount of evidence that is suggesting the economic behaviour of Europeans is already changing from the expected cuts. The public awareness of the cuts is boosting sentiment among households and businesses and may also mean rates don’t have to move as much to stimulate. 

The eurozone economy showed signs of recovery in early 2023, with a GDP increase of 0.3% in the first quarter, ending a period of stagnation. This growth was largely due to subsiding energy and food price shocks coupled with a global trade recovery. But it was also aided by the anticipated rate cuts lowering mortgage and corporate loan costs.

In Germany, house prices, which have dropped by 10% following the ECB’s rate increases, have started to stabilize as mortgage rates have fallen from nearly 4% to below 3.2%. This has led to a noticeable increase in mortgage financing demand, spurring a housing market upturn. 

Similarly, in the Netherlands, rising wages, housing shortages, and lower mortgage costs are expected to push house prices to new highs.

And as mentioned – the eurozone’s robust labour market is contributing to persistent inflation, with wage growth hitting a record pace and unemployment reaching a low of 6.4% in April. This strength may prompt the ECB to slightly adjust its inflation and GDP growth forecasts upward – which again supports the markets view that the EUR may perform better than against a CAD for example.

Thus the ECB is likely to proceed cautiously with rate cuts. Influential ECB officials suggest a gradual pace, with only a few cuts anticipated this year to maintain flexibility and ensure inflation continues to decline towards the 2% target. 

The ECB’s approach contrasts with previous rate cuts cycles in the zone, which were typically reactions to economic crises. This time, the cuts are being made in a context of improving economic conditions, suggesting a measured approach to avoid overheating the economy.

Overall, while the initial rate cut is seen as a certainty, the future path of ECB policy will depend on ongoing economic developments and inflation trends, with the bank aiming to balance stimulating growth and controlling inflation.

A tough fundamental backdrop for EUR traders.