Macroeconomic Analysis of Canada: Implications for Forex Trading

Bank of Canada to continue data-driven monetary policy, adjusting interest rates based on inflation, growth, and risk. Timing depends on opposing economic forces.

Saturday, August 24, 2024, Week 34

Welcome to this comprehensive report on the macroeconomic landscape of Canada, designed to provide forex traders with valuable insights and actionable intelligence. In today's interconnected global economy, understanding the forces shaping a nation's economic trajectory is crucial for making informed trading decisions. This report delves into the key drivers of Canada's macroeconomic outlook, examining the interplay of geopolitics, fiscal policy, economic fundamentals, and monetary policy.

This report will equip you with a deep understanding of the key factors shaping Canada's economic trajectory, empowering you to make more informed trading decisions. We will explore the potential impact of the escalating US-China trade war, analyse Canada's delicate fiscal balancing act, and delve into the Bank of Canada's efforts to steer the economy towards a soft landing. We will also examine the potential impact of the upcoming US presidential election, which could significantly impact trade relations with Canada.

Geopolitical Risks on the Horizon

Important geopolitical events to monitor include potential retaliatory strikes against Israel and U.S. targets following the assassinations of senior Hezbollah official Fuad Shukr and Hamas political leader Ismail Haniyeh on July 30th and 31st, respectively. While Canada is not directly involved, any escalation in the Middle East could negatively impact global market sentiment and oil prices, indirectly affecting Canada's economy. As highlighted in the August 3rd Weekly Rundown, heightened regional tensions, vows of retaliation by Hamas, Hezbollah, and Iran, and the assassinations on July 30th and 31st indicate a high likelihood of retaliatory strikes in the near future.

In the mid-term (next six months), the U.S. presidential election in November and its potential impact on trade relations with Canada will be in focus. The return of a more protectionist administration could lead to renewed trade tensions and uncertainty, adversely affecting Canadian businesses and the overall economy.

Fiscal Policy of Canada

Canada's fiscal policy aims to strike a balance between ongoing investment in crucial areas like housing, healthcare, and clean energy while upholding fiscal sustainability. This equilibrium is closely monitored by market traders, as it profoundly influences Canada's economic growth and the value of its currency.

The government's dedication to fiscal responsibility is manifested through its efforts to reduce the federal debt-to-GDP ratio. As outlined in Budget 2024, the government strives to promote fairness for all generations by adhering to the fiscal objectives outlined in the fall economic statement, ultimately guiding both deficits and federal debt on a downward trajectory. This commitment is essential in maintaining Canada's AAA credit rating, which facilitates low borrowing costs and contributes to a stable macroeconomic environment.

However, the government recognizes the importance of sustained investment in key areas to bolster economic growth and enhance the well-being of Canadians. Budget 2024 proposes substantial investments in affordable housing, clean energy, and skills training, among other sectors. As stated by the Deputy Prime Minister in the Foreword to Budget 2024, the government's renewed focus is on unlocking opportunities for millions of younger Canadians to join the middle class, reducing life costs, and driving the economy toward inclusive growth. These investments are vital for addressing long-term structural challenges and ensuring Canada's competitiveness and prosperity.

Fiscal Policy in Focus

In the immediate term (the next six weeks), the primary focus will be implementing the new Canada Carbon Rebate for Small Businesses, initiated on July 15th. This measure is designed to provide direct refunds to small and medium-sized businesses in provinces subject to the federal fuel charge, thus aiming to bolster business confidence and encourage investment.

In the intermediate term (the next six months), the government's attention will shift to finalizing negotiations with provinces and territories regarding the establishment of the new Canada Housing Infrastructure Fund. Announced in Budget 2024, this $6 billion fund is intended to accelerate the construction and enhancement of housing-related infrastructure, potentially increasing housing supply and alleviating affordability challenges.

Economics of Canada: A Story of Resilience and Challenges

While the nation has avoided a recession and inflation is moderating, high interest rates, elevated housing costs, and slowing global growth are weighing on economic activity. Market traders are closely monitoring these developments, as they will have a significant impact on the value of the Canadian dollar and the outlook for Canadian assets.

One of the key strengths of the Canadian economy is its robust labour market. Despite recent softening, employment remains above pre-pandemic levels, and wage growth has outpaced inflation for the past 13 months. As noted in the 2024 Budget, "A strong labour market also matters for affordability. Wage growth has outpaced inflation for the past 13 months. On average, real wages—wages after accounting for inflation—are now higher than they were just prior to the pandemic, a positive sign that the purchasing power of Canadians has strengthened despite global economic hurdles." This strong labour market is supporting consumer spending and contributing to overall economic resilience.

However, the Canadian economy is also facing a number of challenges. High interest rates, implemented by the Bank of Canada to combat inflation, are weighing on consumer spending and business investment. Elevated housing costs, driven by a long-standing housing shortage, are also putting pressure on household budgets and contributing to affordability concerns. Additionally, slowing global growth, particularly in the United States, is weighing on Canadian exports and business investment. The 2024 Third-Quarter Forecast highlights this concern, stating that "US growth is expected to have slowed significantly to an average of 1½% over the first half of 2024, down from about 4% in the second half of 2023."

Economic Outlook

In the short term (next six weeks), the focus will be on the release of the August CPI inflation data on September 17th. This data will be closely watched by market participants for signs of continued moderation in inflation, which could support the Bank of Canada's decision to further cut interest rates. The importance of this data is highlighted in the Week Ahead report, which states that "From a policy perspective, a September rate cut is fully priced with greater interest over how the rate cutting cycle will proceed thereafter."

In the mid-term (next six months), the Canadian economy is expected to continue its gradual recovery, supported by easing interest rates, a robust labour market, and continued government investment in key areas. However, the outlook remains subject to a number of risks, including the potential for a sharper-than-expected slowdown in the US economy, further escalation in geopolitical tensions, and persistent inflationary pressures in certain sectors, such as housing. Key economic indicators to watch include GDP growth, CPI inflation, the unemployment rate, and housing starts.

Monetary Policy of Canada: Steering Towards Stability

Bank of Canada Head Office

The Bank of Canada's monetary policy is currently focused on steering the Canadian economy towards a soft landing, balancing the need to bring inflation back to its 2% target with the imperative of supporting economic growth. This delicate balancing act is being closely watched by market traders, as it will have a significant impact on the value of the Canadian dollar and the outlook for Canadian interest rates.

The Bank of Canada has been aggressively raising interest rates since early 2022 to combat inflation, which surged to a multi-decade high of 8.1% in June 2022. These rate hikes have been effective in cooling the economy and bringing inflation down, with the CPI inflation rate falling to 2.5% in July 2024. As stated in the July 24th Bank of Canada press release, "First, monetary policy is working to ease broad price pressures."

However, the Bank of Canada also recognizes the risks of overtightening monetary policy and potentially pushing the economy into a recession. With signs of slowing economic growth and easing inflationary pressures, the Bank of Canada cut its policy interest rate by 25 basis points to 4.5% in its July 24th meeting, following a similar move in June. As stated in the Bank of Canada's press release, "With broad price pressures continuing to ease and inflation expected to move closer to 2%, the Governing Council decided to reduce the policy interest rate by a further 25 basis points."

Ahead

In the short term (next six weeks), the focus will be on the release of the Bank of Canada's next full outlook for the economy and inflation, including risks to the projection, in the Monetary Policy Report on October 23rd. This report will provide further insights into the Bank's assessment of the economic outlook and its implications for future monetary policy decisions. The Bank of Canada has clearly signalled its intentions, stating that "If inflation continues to ease broadly in line with our forecast, it is reasonable to expect further cuts in our policy interest rate."

In the mid-term (next six months), the Bank of Canada is expected to continue its data-dependent approach to monetary policy, carefully monitoring incoming economic data and adjusting its policy stance as needed. The timing and magnitude of future interest rate cuts will depend on the evolution of inflation, economic growth, and the balance of risks to the outlook.

The Bank of Canada aims for a soft economic landing, balancing inflation control with growth support. After aggressive rate hikes, recent signs of slowing growth and easing inflation led to a more accommodative stance, with rate cuts in June and July. The Bank will continue its data-driven approach, adjusting policy as needed.

The Macroeconomic Outlook of Canada

The macroeconomic outlook for Canada is for a gradual recovery over the mid-term, supported by easing interest rates, a robust labour market, and continued government investment in key areas. However, the outlook remains subject to a number of risks, both domestic and global, that could derail this trajectory.

The Bank of Canada's July 24th Monetary Policy Report projects GDP growth of 1.2% in 2024, 2.1% in 2025, and 2.4% in 2026. This growth is expected to be driven by stronger exports, a recovery in household spending, and robust residential investment. The Bank also expects inflation to continue moderating, with CPI inflation forecast to settle sustainably around the 2% target next year. The Bank of Canada states that "Looking ahead, we expect inflation to moderate further, though progress over the next year will likely be uneven."

However, the Bank acknowledges that there are risks to this outlook. Globally, geopolitical uncertainty remains high, and a sharper-than-expected slowdown in the US economy could weigh on Canadian exports and business investment. Domestically, the biggest downside risk is that household spending could be weaker than expected, particularly if labour market conditions deteriorate.

Risks to the Outlook

Several factors could derail Canada's macroeconomic outlook. Geopolitical risks, such as further escalation in the conflict in Ukraine or a significant disruption to global supply chains, could lead to higher commodity prices, renewed inflationary pressures, and weaker global growth, negatively impacting the Canadian economy. The 2024 Third-Quarter Forecast highlights this risk, stating that "New international trade disruptions stemming from geopolitical tensions and conflicts, including wars in the Middle East and in Ukraine, could impact global commodity prices and impede the supply of traded goods."

Fiscal policy risks are also present. While the government's commitment to fiscal responsibility is positive, the potential for increased spending pressures or a failure to implement planned fiscal consolidation measures could lead to higher debt levels and increased borrowing costs, weighing on economic growth.

Economic risks include the possibility of a sharper-than-expected slowdown in the US economy, which could negatively impact Canadian exports and business investment. Additionally, persistent inflationary pressures in certain sectors, such as housing, could erode consumer purchasing power and weigh on economic activity. The Bank of Canada acknowledges this risk, stating that "Here in Canada, the biggest downside risk is that household spending could be weaker than expected."

Monetary policy risks are also present. While the Bank of Canada is expected to continue its data-dependent approach to monetary policy, the potential for over-tightening or a misjudgment of the economic outlook could lead to a recession or a resurgence of inflation.

The macroeconomic outlook for Canada is for a gradual recovery over the mid-term, supported by easing interest rates, a robust labour market, and continued government investment in key areas. However, the outlook remains subject to a number of risks, both domestic and global, that could derail this trajectory. Market traders are closely monitoring these developments, as they will have a significant impact on the value of the Canadian dollar and the outlook for Canadian assets.

Economic Indicators of Canada

Economic Growth

• Real Gross Domestic Product (GDP): Increased 0.4% in the first quarter of 2024, following no change in the fourth quarter of 2023. Projected to expand by 1.5% in the second quarter of 2024. The Bank of Canada forecasts GDP growth of 1.2% in 2024, 2.1% in 2025, and 2.4% in 2026. In the short term, GDP growth is expected to pick up in the second half of 2024, driven by stronger exports and a recovery in household spending. In the mid-term, GDP growth is projected to moderate to around 2% in 2025 and 2.5% in 2026.

• Business capital investment: Rose 0.8% in the first quarter of 2024, driven by increased spending on engineering structures. Expected to strengthen further in the second half of 2024 and average 4¼% over the projection horizon.

• Housing investment: Edged up 0.3% in the first quarter of 2024. Expected to rise to almost 8% on average over 2025 and moderate to 4% by the end of 2026.

Price Changes (Inflation)

• Consumer Price Index (CPI): Rose 2.5% year over year in July 2024, down from 2.7% in June. Projected to fall below 2.5% in the second half of 2024 and settle sustainably around the 2% target next year. In the short term, CPI inflation is expected to ease to about 2% by the end of 2024, but upside risks to inflation persist, particularly in the housing market. In the mid-term, inflation is expected to remain close to the Bank of Canada's 2% target.

• CPI-common: 2.2% in July 2024.

• CPI-median: 2.4% in July 2024.

• CPI-trim: 2.7% in July 2024.

Labor

• Unemployment rate: Unchanged at 6.4% in July 2024. Projected to rise to a peak of 6.5% in the fourth quarter of this year and average 6.3% in 2024. In the short term, the unemployment rate is expected to remain elevated as the economy slows. In the mid-term, the unemployment rate is projected to gradually decline as economic growth picks up.

• Employment: Little changed in July 2024 (-2,800; -0.0%). Up by 346,000 (+1.7%) on a year-over-year basis.

• Average hourly wages: Increased 5.2% year over year in July 2024, following growth of 5.4% in June. Wage growth is expected to moderate in the mid-term as the labour market cools.

Housing

• Housing starts: Surged by 16% month over month to 279,500 units in July 2024, the highest since June 2023. Housing starts are expected to remain elevated in the short term, supported by strong demand and government incentives. In the mid-term, housing starts are projected to moderate as interest rates rise and population growth slows.

• New Housing Price Index: Increased 0.2% month over month in July 2024, following a -0.2% decline in June. House prices are expected to continue rising in the short term, but the pace of growth is likely to slow as interest rates rise. In the mid-term, house price growth is projected to moderate further.

Business Confidence

• Ivey Purchasing Managers Index: Eased to 57.6 in July 2024 from 62.5 in June. This marks the 12th consecutive month of solid economic growth, though it has slowed. Business confidence is expected to remain solid in the short term, but could weaken if economic growth slows or inflation remains elevated.

Consumer Sentiment

• Canadian Survey of Consumer Expectations: Household inflation expectations fell sharply in the second quarter of 2024 after having stalled for close to one year. Consumer sentiment is expected to improve in the short term as inflation moderates and interest rates ease. However, sentiment could weaken if economic growth slows or unemployment rises.

Trade

• Balance of Trade: Recorded a surplus of CAD 0.64 billion in June 2024, the first since February. The trade balance is expected to remain volatile in the short term, influenced by fluctuations in commodity prices and global demand. In the mid-term, the trade balance is projected to move into a deficit as imports grow faster than exports.

• Exports: Increased 5.5% to CAD 66.640 billion in June, the strongest increase since February.

• Imports: Rose by 1.9% in June, nearly matching the record high of June 2022.

Conclusion: Charting a Course Through Canada's Macroeconomic Waters

This report has provided a comprehensive overview of Canada's macroeconomic landscape, highlighting the key drivers and risks shaping the nation's economic trajectory. As a forex trader, understanding these dynamics is crucial for making informed trading decisions and capitalising on emerging opportunities.

Key Takeaways:

• September 4th: Monitor the release of Canadian international trade in services data for July for insights into the health of the services sector.

• September 6th: The US jobs report could influence the Federal Reserve's decision on the magnitude of a potential rate cut, impacting the Canadian dollar and interest rate differentials.

• September 17th: The release of August CPI inflation data will be crucial for assessing the Bank of Canada's future monetary policy decisions.

• October 23rd: The Bank of Canada's Monetary Policy Report will provide further insights into the Bank's assessment of the economic outlook and its implications for future monetary policy decisions.

• November (US Presidential Election): The outcome of the US presidential election could significantly impact trade relations with Canada, creating either opportunities or challenges for the Canadian economy.

Canada's economy is currently navigating a complex landscape characterised by both resilience and challenges. The nation's robust labour market and moderating inflation are positive signs, but high interest rates, elevated housing costs, and slowing global growth are weighing on economic activity. The outlook for the mid-term is for a gradual recovery, but a number of risks could derail this trajectory.

The Bank of Canada is expected to continue its data-dependent approach to monetary policy, carefully monitoring incoming economic data and adjusting its policy stance as needed. The timing and magnitude of future interest rate cuts will depend on the evolution of inflation, economic growth, and the balance of risks to the outlook. As the Bank of Canada stated in its July 24th press release, "The timing will depend on how we see these opposing forces playing out. In other words, we will be taking our monetary policy decisions one at a time."

Sources

• Bank of Canada

• Statistics Canada

• Department of Finance Canada

• 2024 Third-Quarter Forecast

• 2024 Canadian Federal Budget

• S&P Global

• Ivey Business School

• Trading Economics

• Bloomberg

• Reuters

• Week Ahead report from Newsquawk

• Stratfor