Amidst all the negative talk about persistently high inflation in the markets, Canada at least delivered some upbeat news this week when the April consumer price index (CPI) report showed a further cooling off. With headline inflation dropping to 2.7% and core inflation falling to below 3%, the path towards reaching the Bank of Canada’s target of 2% by next year looks a lot more doable. As such, the probability that the Bank cuts interest rates this summer has increased, which would further widen the already negative spread between our rates and the U.S. The question is what impact this will have on the Canadian dollar and the performance of both bonds and equities north of the 49th parallel compared to the U.S.?

 

At this time in 2021, the Canadian dollar was trading close to 83 US cents.  As inflation began to pick up in both countries, the Loonie gradually slid lower and then fell sharply towards the end of 2022. This weakness was understandable given the move away from risk assets that year, but since then we have seen a floor around 72 cents, with the top of the range just above 76 cents.

 

 

The move in the Loonie from the end of last year into April reflected the about-turn in expectations regarding Federal Reserve policy, where the market went from pricing in perhaps 1-1/2 percentage points of easing this year to potentially nothing. A similar reversal in market pricing with respective to Bank of Canada policy also took place, however, the underlying fundamentals in Canada still looked weaker relative to the U.S. Even though recent weeks have seen a softening in some key U.S. indicators, thereby reducing the risk of any further rate hikes and putting back on the table a cut next quarter, market participants still see greater odds of rate relief in Canada. As I mentioned at the start, the Bank’s overnight rate target is 5% versus a 5.5% Fed funds target.  These have not budged for several months and while most economists expect the Bank to move sooner than the Fed, markets are looking to similar changes in rates by year-end.

 

This refers to the rates implied by the short-term interest rate futures markets in Canada and the U.S. In Canada, the price of the 3-month bankers’ acceptance (BA) futures contract for a given month is calculated by subtracting the annualized yield of the 3-month Canadian Dollar Offered Rate (CDOR).  For example, if the price of the contract say 12 months from now is 95, then this is implying a 3-month CDOR rate of 5% at that point in time. Currently, the June 2024 BAX contract is trading at 94.875 which would represent a 3-month CDOR rate of 5.125%, compared to about 5.25% today.  If it were 5%, then we would say that the price was implying close to a 100% probability of a quarter-point rate cut by the BoC. It’s not quite there, but that doesn’t mean such a move is not in the cards. Again, BAX futures are not forecasts but just show what is implied by the prices from current trading.

 

For the U.S. we do the same thing, by looking at the Fed funds futures market.  The interesting note, is that both markets are implying cumulative rate cuts for each country of about half a percent by the end of the year. Therefore, even though there is currently a negative spread between the Bank of Canada’s policy rate and that of the Federal Reserve, it is not viewed by the market as widening.

 

 

The current gap in rates and the fact that market participants expect it to widen is also a factor of the relative inflation performance down the road. It has been over 30 years since the Bank of Canada adopted an official inflation-targeting regime, with that target set at 2%. While the U.S. has a mandate of “stable prices” and talks about a 2% target, that level has never been enshrined in legislation like Canada. Over this period, Canadian inflation has been below the U.S. more times than not.  At the start of 2022, Canada’s rate was close to 2-1/2 percentage points lower than the U.S., but by August of last year it actually rose to being slightly higher, as the below chart indicates. After the April figures, Canada’s headline inflation is 0.7% below.

 

If both Canada and the U.S. follow comparable weakening economic paths, with inflation in both countries falling towards 2%, then the spread should return to near zero. That would also suggest a possible re-convergence in policy rates and, to the extent that current negative spreads and expectations of potential further widening in those spreads is behind this year’s weakness in the Loonie, then there is scope for a bounce against the U.S. dollar.

 

There are a host of other variables that will impact the near-term direction of the Canadian dollar, including commodity prices, the overall tone in risk assets and, of course, what happens with respect to the U.S. election in November. Looking beyond November, however, if lower rates in both countries support economic activity and commodity prices, then investors could be looking at a possible return to the 80-cent area or higher. In terms of an investors positioning in U.S. equities, they may be looking towards having increased Canadian-dollar hedged exposure.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle

 

 

CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.

 

Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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