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Financial Post 12/12/24

You might have thought the Bank of Canada‘s latest interest rate cut — a second consecutive 50-basis-point whopper — would have sent the loonie plunging, but you were wrong if you did.

In the immediate aftermath of the widely expected cut, the Canadian dollar firmed up by about a half of a U.S. cent, on the reasoning that it looks like the Bank of Canada could take a slower approach to future rate cuts and might even make some previously unexpected pauses.

“Bad news is, to a significant degree, already priced into the exchange rate, and traders have been bracing for a widening in the gap between U.S. policy rates and their Canadian equivalents for months,” Karl Schamotta, chief market strategist at Corpay Currency Research, said in a note following the Bank of Canada’s decision to slice its borrowing rate to 3.25 per cent from 3.75 per cent.

Economist David Rosenberg also weighed in.

“The loonie seems to think the (Bank of Canada) may pause as it has rallied in the aftermath of the move,” the founder of Rosenberg Research & Associates Inc. said in a note on Wednesday.

Derek Holt, vice-president and head of capital markets economics at the Bank of Nova Scotia, said in a note, the Canadian dollar was “among the strongest currencies on the day,” based on the Bank of Canada telegraphing uncertainty around future rate cuts.

The Canadian dollar has had a tough year versus its counterpart in the United States.

The loonie is down 6.5 per cent on the year, hovering just above 70 cents U.S., after starting the 2024 at nearly 75.5 cents U.S.

A variety of factors have pushed it down, including the ongoing strength in the U.S. economy and, more recently, a threat by Donald Trump that he would impose a 25 per cent tariff on all goods entering the U.S. from Canada and Mexico on day one of his presidency.

Diverging paths on interest rates haven’t helped, either.

The Bank of Canada has cut rates five consecutive times this year for a total of 175 basis points, while the U.S. Federal Reserve has trimmed rates twice by a more modest 75 basis points. Markets predict there is an 85 per cent chance the Fed will cut rates again when it meets next Wednesday.

A country’s policy rate affects the value of its currency because higher interest rates attract investors looking for a better return, which increases demand for that country’s currency and, therefore, its value.

The Bank of Canada on Wednesday indicated that future rate cuts are not guaranteed and upcoming decisions will be made on a case-by-case basis.

Nevertheless, economists are forecasting rates in Canada to land in the range of two per cent to 2.5 per cent by the end of the first half of 2025.

Markets are currently betting that the upper bound of the Fed target rate will fall to four per cent by mid-year from its current 4.75 per cent, meaning the interest rate differential between the loonie and the greenback won’t be narrowing anytime soon.

Traders may have priced in that divergence, but plenty of tripwires remain for the Canadian dollar in the longer term.

“The loonie’s risk profile remains highly asymmetric,” Schamotta said, citing the dangers posed by the “elevated” and growing debt among Canadian households and the potential for a trade war hanging over the economy.

An improvement in the Canadian economy and a deterioration south of the border could boost the loonie modestly, he said.

“Any upside will be limited, and downside exposures will remain significant,” he said of the Canadian dollar’s prospects.  

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