BoC Huge Rate Cut Shakes the Loonie: Outlook Hinges on Q3 GDP
Wednesday, October 23, 2024 (Week 43)
The Canadian dollar (CAD), also known as the loonie, faces a confluence of conflicting forces. The TSX's surge to new record highs signals economic strength and attracts foreign investment, a boon for the CAD. But a resurgent USD, fuelled by persistent US inflation, presents a significant headwind. Further complicating the picture, slowing inflation in Canada itself raises the spectre of additional BoC rate cuts. This could potentially weaken the CAD. It's a delicate balancing act.
Canada, a G7 economy heavily reliant on natural resources, particularly oil, has seen its currency closely tied to commodity price fluctuations. The most significant recent event impacting the CAD was the BoC's surprise 50 bps rate cut to 3.75% on October 23rd. This move, prompted by softening inflation and labour market weakness, has injected uncertainty into the loonie's near-term trajectory. Looking ahead, the Q3 GDP release on October 31st will be critical.
This fundamental analysis report offers crucial insights into the Canadian dollar (CAD) for forex traders. It examines economic indicators, monetary policy, market sentiment, global dynamics, and geopolitical risks to help traders make informed decisions.
Market Themes: The dominant theme influencing the CAD is the tension between record highs on the TSX and concerns about the BoC's policy direction. The TSX’s strength, fueled by robust commodity prices and strong financial sector performance, should support the CAD. However, uncertainty about the BoC's next move, given softening inflation and rising unemployment, creates volatility. The market is currently pricing in further rate cuts, which could weigh on the loonie. The performance of the Canadian economy in the coming weeks, particularly as revealed in upcoming retail sales and GDP data, will be crucial for determining the direction of the CAD.
Investment Thesis
Upcoming Week: Neutral. The main event this week was the BoC rate cut to 3.75%. Expect continued volatility as the market digests this information and looks for further clues in upcoming BoC communications. The GDP data release on October 31st will be another significant driver. Weaker-than-expected GDP growth could pressure the CAD.
Upcoming Month: Cautiously Bullish. The medium-term outlook hinges on upcoming economic data. If retail sales and GDP figures for Q3 point to continued growth, it could temper expectations for aggressive easing and potentially lift the CAD. However, the risk of a US recession or further escalation of geopolitical tensions could offset any positive domestic developments.
Canadian Financial Markets
Canadian financial markets have been in the limelight due to the TSX's record run, driven by strong earnings and global trends. However, the recent BoC rate cut and oil price volatility added uncertainty. Q3 GDP data on October 31st will be crucial. The CAD appreciated, supported by the TSX and commodity prices. The BoC rate cut to 3.75% was significant, and August retail sales data on October 25th will provide further insights. The 10-year bond yield is around 3%, and the TSX is near all-time highs, reflecting optimism. The recent drop in oil prices to $73.500 per barrel is a concern.
Stock Market: The TSX has repeatedly hit record highs throughout September and October. This bullish run, fueled by positive earnings reports and a generally risk-on environment, has supported the CAD by attracting foreign investment. This positive momentum could continue into November, provided global market conditions remain favourable and the Canadian economy shows resilience. Key risks to watch include a potential downturn in the US and the ongoing impact of higher interest rates.
Bond Market: Canadian bond yields have been sensitive to both domestic monetary policy and US Treasury yields. The BoC's October 23rd rate cut initially pushed yields lower, but they later rebounded as there was a repricing of Fed rate cut expectations. This volatility is expected to continue in the coming month, with the market closely watching economic data and central bank communications.
Commodity Market: Oil, a major influence on the Canadian economy and its currency, has seen significant price swings. Geopolitical tensions initially drove WTI above $77.000 per barrel, but concerns about global demand and rising OPEC+ supply pushed prices lower. On Friday, October 25, WTI closed at $73.500 per barrel. This weakness in oil poses a near-term challenge for the CAD. However, a resurgence of geopolitical tensions could trigger a rebound.
The Canadian Economy
Canada's economy faces challenges. Strong Q2 GDP growth (2.1% annualized) contrasts with August's stagnation (zero growth). The BoC rate cut to 3.75% on October 23rd was a notable event. Key industries include energy, mining, and a struggling manufacturing sector. The US is Canada's major trading partner. The trade deficit widened in August. The upcoming Q3 GDP release on October 31st is significant.
GDP: The Canadian economy's trajectory is a key focus. While Q2 GDP growth surprised to the upside at an annualised 2.1%, more recent monthly data reveals a concerning slowdown. Zero growth in August, following a modest 0.2% expansion in July, raises questions about the strength of the recovery (Statistics Canada). This weaker momentum, especially given the BoC’s forecast for moderating growth in Q3, could pressure the CAD in November. The upcoming Q3 GDP release on October 31st will be a pivotal event.
Inflation: September's 1.6% inflation figure, a three-year low, bolsters the case for additional BoC rate cuts, a potential headwind for the CAD (Statistics Canada). However, rising food prices, now at 2.8%, signal persistent inflationary pressures in certain sectors. This mixed picture adds to the uncertainty surrounding the BoC’s policy outlook, which will be a key factor for the CAD’s trajectory.
Labour Market: Canada's labour market remains a puzzle. While September's 6.5% unemployment rate defied expectations by decreasing slightly after reaching a multi-year high of 6.6% in August, the overall picture is clouded by volatile employment growth (Statistics Canada). The recent 46.7K increase in jobs contrasts sharply with declines seen earlier in the summer. If labour market weakness persists, it could reinforce the case for a more dovish BoC, putting further pressure on the CAD.
Consumer & Business Sentiment: September saw a surge in business confidence to a decade high, as measured by the Ivey PMI, which could support business investment and contribute to CAD strength (Ivey Business School). However, consumer confidence remains relatively subdued, despite a slight increase to a six-month high in August. This divergence adds complexity to the outlook. Weak consumer spending could weigh on economic growth, while a more confident business sector could lend some support to the loonie.
Key Economic Data Releases: The October 31st Q3 GDP release, the November 8th labour market report (including unemployment and employment change), and the November 18th Housing Starts figure are the key data releases to watch in the upcoming month. These indicators will be crucial for assessing the health of the Canadian economy and providing direction for the CAD.
Monetary Policy in Canada
The Bank of Canada cut rates by 50 bps to 3.75% on October 23rd, prompting market volatility. Governor Macklem's cautious tone has left investors uncertain about the central bank's next move. Economic data and the November 6th Summary of Deliberations will be closely watched for further clues.
Monetary Policy Developments: The BoC's 50 bps rate cut to 3.75% on October 23rd has been a game-changer. While this cut reflected immediate concerns about slowing growth and falling inflation, Governor Macklem’s subsequent comments suggest a wait-and-see approach for future decisions. The BoC is clearly in data-dependent mode, with upcoming economic indicators, especially GDP and retail sales, now holding even greater significance for monetary policy direction. This uncertainty makes the CAD's near-term trajectory particularly sensitive to incoming data.
Canadian Geopolitics
Canada's stable political system under Prime Minister Trudeau's leadership benefits the CAD. The government's budget priorities include affordable housing and clean energy. No major political risks are expected soon.
Geopolitical, Fiscal & Sovereign Developments: Canada's geopolitical landscape is stable. The government’s fiscal policy, aimed at supporting economic recovery while maintaining fiscal prudence, is viewed favourably by markets. Canada boasts a AAA sovereign credit rating. These factors underpin confidence in the CAD. No significant geopolitical events are anticipated in the near term.
The Canadian Dollar (CAD)
The Canadian dollar (CAD), influenced by oil prices and global risk appetite, has seen recent appreciation due to a strong TSX and weak USD. However, the BoC rate cut to 3.75% added uncertainty. The upcoming retail sales release on October 25th will be closely watched.
Fundamental Strength and Valuation: The CAD appears slightly overvalued against the USD when considering recent economic data and interest rate differentials. While the TSX's record highs and easing inflation should theoretically strengthen the currency, concerns about slowing economic momentum and the potential for further BoC rate cuts create downward pressure. The CAD's performance in the coming month hinges on upcoming economic releases. If retail sales and GDP data surprise to the upside, it could trigger a correction and lift the loonie. However, continued weak data would likely exacerbate the overvaluation and pressure the currency. External factors, particularly a potential US recession and heightened geopolitical risks, also pose a threat to the CAD's strength.
Conclusion
The outlook for the Canadian dollar is clouded by uncertainty. While the TSX’s strength and easing inflation are positives, concerns linger about the economy’s trajectory and the potential for further BoC rate cuts. The global economic landscape and geopolitical tensions further complicate the outlook.
Key Takeaways:
BoC’s Stance: Monitor upcoming BoC communications, particularly the Summary of Deliberations, for any change in tone that could signal shifts in the bank's outlook. This will be critical for assessing the CAD’s trajectory.
Economic Data's Impact: Focus on the upcoming releases of Q3 GDP and the September jobs report. Weaker-than-expected data could increase bets on more aggressive BoC easing, pressuring the CAD. Conversely, stronger data could limit the downside.
External Risks: Be mindful of external risks, particularly the potential for a US recession and the ongoing geopolitical tensions in the Middle East. These factors could introduce significant volatility for the CAD.
Sources:
Bank of Canada
Statistics Canada
Trading Economics
Bloomberg
Ivey Business School
ANZ-Roy Morgan