Bank of Canada’s Final 2023 Policy Update on the Canadian Dollar and Future Monetary Landscape

The Bank of Canada’s final policy update for 2023, as reported by Bloomberg, had a relatively subdued impact on the performance of the Canadian dollar, especially when compared to the discernible market reactions following prior BoC policy decisions throughout the year.

Within the first 30 minutes following the announcement, the USD/CAD pair experienced a modest move of -0.06%, marking the smallest percentage change in this currency pair in response to a BoC policy decision in the current calendar year.

Despite the release of updated policy guidance, which did not bring about significant alterations to market expectations, there persists a prevailing sentiment that the Bank of Canada is likely to embark on a rate-cutting cycle in the coming year. Market participants in the Canadian rate market continue to fully price in the probability of the first-rate cut occurring at the April policy meeting. Furthermore, there is an anticipation of a cumulative reduction of around 110 basis points in interest rates by the end of the following year. Interestingly, this aligns with similar expectations for the Federal Reserve, reflecting a historical trend where the Bank of Canada and the Fed have tended to make policy adjustments concurrently.

The Bank of Canada’s policy guidance continues to signal a willingness to raise the policy rate if deemed necessary. However, recent economic indicators, including signs of slowing inflation and weak economic growth, have cast doubt on the necessity of maintaining the current restrictive policy rate. At its current standing of 5.00%, the policy rate already surpasses the Bank of Canada’s estimated neutral rate range of 2.00% to 3.00%. In its updated policy statement, the Bank of Canada acknowledged that higher interest rates are impeding spending, with consumption growth near zero in the last two quarters and business investment essentially flat over the past year. This data provides the Bank of Canada with increased confidence that Canada’s economy has shifted into a state of modest excess supply in Q4, a trend expected to persist through most of 2024, as previously forecasted in the October Monetary Policy Rate.

This economic development is anticipated to have a dampening effect on inflation pressures in the coming year. The updated policy statement acknowledges that the economic slowdown is reducing inflationary pressures across a broader range of goods and services prices. Headline inflation, which retreated to 3.1% in October, is projected to fall back within the Bank of Canada’s target range of 1.0% to 3.0% in the coming months. The Governing Council, however, remains cautious and expresses the need to witness further and sustained easing in core inflation before becoming more confident in considering a reversal of the current restrictive policy stance. This cautious approach renders the Canadian dollar vulnerable to potential weakness in the early part of the next year if evidence of a slowdown in both economic growth and inflation continues to accumulate.

Shifting our focus to the foreign exchange market, after an unsuccessful attempt to breach the 1.3900-level at the beginning of November, the USD/CAD pair has retraced and is currently hovering around the 1.3500-level. This recent movement aligns with our short-valuation model estimate, indicating that the current valuation of the pair is reasonable based on crucial fundamental drivers. However, it’s noteworthy that the model’s fair value for USD/CAD has been gradually increasing since the summer. This upward trend is primarily attributed to the ongoing decline in oil prices and the building expectations for more assertive rate cuts by the Bank of Canada in the future.

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