The Canadian dollar has hit a 7-month low against the US dollar following a statement from the Bank of Canada (BoC) that reduced the likelihood of a soft landing. This has caused concern among CAD bulls and highlighted the speed at which the economy is cooling. The BoC faces a dilemma as it wants to avoid triggering financial instability by raising interest rates, but inflation remains elevated. Inflation in Canada peaked at 8% in 2022 but has since slowed to 3.8% in September, with predictions that consumer prices will increase by an average of 3.5% until mid-2024.
Canadian households have more debt than American ones, and their mortgages mature faster. As a result, the Canadian economy is more sensitive to monetary tightening by the BoC than the US is to an increase in the federal funds rate. The BoC paused its rate-hiking cycle earlier this year before resuming it in June and July, and then pausing again for two central bank meetings. Capital Economics believes that the BoC has now finished raising rates, and while it still maintains a tightening bias, the accompanying statement suggests that the cycle is over. The derivatives market has reduced the chances of a monetary tightening cycle resuming from 60% to 44%.
The BoC’s message indicates a potential stagflation scenario for Canada. The regulator has cut its GDP growth forecasts for 2023 and 2024, and this divergence in monetary policy with the US no longer matters. US bond yields are likely to remain higher than Canadian yields, resulting in a flow of capital to US markets and a continuation of the USDCAD rally.
In addition to monetary policy considerations, the Canadian dollar is no longer well supported by the oil market. The correlation between the Canadian dollar and Brent oil has weakened, and geopolitical tensions in the Middle East have supported the US dollar more than the Canadian dollar.
Furthermore, the Canadian GDP growth is slowing down due to factors beyond monetary tightening. The US economy, which accounts for nearly 80% of Canadian exports, is also at risk of slowing down.
Given these factors, it appears that the Canadian dollar has lost its previous advantages. The growth gap between the US and Canada is likely to support the USDCAD rally, with potential targets at 1.391 and 1.404. It is suggested to consider buying until the pair goes below 1.376.