V2U Research

Experts warn that the Canadian dollar may see volatility in the future as a result of the Bank of Canada and the U.S. Federal Reserve's diverging monetary policies.

As per Allan Small, senior financial adviser at IA Private Wealth, the loonie may suffer if the Bank of Canada's rate drops much below the Federal Reserve's. Although he stressed that this isn't something that happens quickly, it would increase the cost of imports from the United States, Canada's largest trading partner, and push inflation higher.

He remarked, "I don't think that will be an issue if the Bank of Canada cuts a few times and the Fed stands pat."

However, "we could start to see significant divergence" if the Bank of Canada continues to make cuts and the Fed continues to hang on past the first quarter of 2019.

Given the nation's economy has fared better than anticipated in the face of rising borrowing costs and inflation, the Fed is generally expected to maintain its key interest rate on Wednesday.

In Canada, however, things are rather different. Following a sharp cycle of rate hikes intended to curb inflation, the Bank of Canada last week announced its first interest rate reduction in almost four years.

Governor Tiff Macklem stated the central bank is more confident that inflation is approaching its two percent target during a press conference on June 5 to discuss the rate drop.

"We're not close to those limits," he added, acknowledging that there are boundaries to how far the Bank of Canada can deviate from US interest rate policy.

While the U.S. federal funds rate is currently between 5.25 and 5.50 percent, the Bank of Canada lowered its benchmark lending rate by a quarter of a percentage point to 4.75 percent.

Mortgage lengths in Canada are five years, whereas in the United States they are thirty, which makes the Canadian economy more susceptible to changes in interest rates, according to Brianne Gardner, senior wealth manager at Raymond James Ltd.'s Velocity Investment Partners.

This indicates that a greater number of Canadian homeowners were forced to renew their mortgages during the rate-hike period, which caused them to cut back on their purchases.

According to Small, "it's really a tale of two economies."

According to Small, the Canadian economy is also more reliant on commodities like oil, whereas the U.S. financial markets are dominated by software businesses; in fact, a recent surge in equities has been driven by big tech names due to excitement about artificial intelligence.

"It has significantly contributed to the growth, earnings, and unquestionable advantage that the United States has," Small added.

Although there is occasionally a slight variation in the overnight rates between the two nations, Gardner noted that this is typically not a major one.

A "comfort zone" has traditionally been defined as a difference of 100 basis points, or one percentage point, according to her.

"We're still comfortable with that, if there is a window." We may need to reevaluate if it starts to go too far from that.

"I believe there's greater potential for variation than what most people believe," stated Gardner.

The two rates differed by 250 basis points for a while in the 1990s, which Gardner described as "quite a large spread."

Gardner noted that the rise of energy prices, however, supported the Canadian dollar throughout that time.

The rising cost of energy could act as a buffer for the Canadian currency.

Despite the Fed's own projection of three rate cuts, market observers believed at the start of 2024 that the rate may be lowered six times in a year. Over the past six months, as more and more economic data became available, those expectations were drastically lowered.

According to Gardner, the current odds point to a September first cut in the United States, but the economic statistics might reverse that.

Small thinks the likelihood that the Fed won't make any cuts until 2025 could depend on how the US economy performs throughout the year.

But as they awaited the central bank's decision later in the day on Wednesday morning, investors anticipating for lower rates received a boost of confidence. According to a recent survey, consumer price inflation in May decreased for the second consecutive month, coming in at 3.3% as opposed to the 3.4% that economists had predicted.

The Bank of Canada is making its interest rate decisions "one meeting at a time," according to Macklem's statement from last week.

"If inflation continues to ease, and our confidence that inflation is headed sustainably to the two per cent target continues to increase, it is reasonable to expect further cuts to our policy interest rate," he stated.

Small remarked, "The Bank of Canada says that they have a lot of room to diverge," however he clarified that the exact amount of room is unclear.

"If the United States does not begin cutting... it could definitely present some difficulties at some point."

utilising Associated Press files

The Canadian Press released this piece for the first time on June 12, 2024.