Canadian Dollar Outlook: Bank of Canada Risks "Breaking the Camel's Back"

• CAD to benefit on 25bp hike: Barclays
• But NBC warns this will "break the camel's back"
• BofA says CAD to struggle this week
• BoC impact on CAD to be shortlived says ING

Above: BoC Governor Macklem takes centre stage Wednesday at 15:00 GMT. Image © Bank of Canada, Reproduced Under CC Licensing.

The Bank of Canada could be about to deliver its final interest rate hike in the current cycle, but economists are split as to how the central bank's decision will impact the Canadian Dollar with some saying the economy is already in a precarious position.

Analysts at Barclays anticipate a 25 basis point interest rate hike which they say will play in the Canadian Dollar's favour this week, given the market is expecting a 20bp move.

"Governor Macklem's warning that under-tightening is still a greater risk than over-tightening makes a hawkish surprise on Thursday the path of least resistance," says a weekly currency research briefing from the currency strategy desk at Barclays.

The Canadian Dollar has underperformed over recent weeks owing to a number of factors that include Canada's soft links to the Chinese economy where a post-Covid reopening has boosted the likes of the Australian Dollar and Euro.

The Canadian Dollar's strong association with the U.S. economy and a positive correlation with the S&P 500 stock index, which has underperformed other major indices of late, are also cited by Barclays as reasons for underperformance.

The Bank of Canada's apparent desire to slow down and eventually end its rate hiking cycle ahead of other central banks is also widely cited by analysts as another factor behind the Canadian Dollar's underperformance.

"The global interest rate environment and interest rate expectations in the market remain key drivers for CAD exchange rates," says Elisabeth Andreae, FX Analyst at Commerzbank. "We maintain our outlook and see limited CAD recovery potential in the medium term."

But Barclays thinks a near-term boost is possible as the Bank of Canada can afford to tighten interest rates further as the economy has been more resilient than anticipated by the central bank at the time of their last MPR and the data trend has improved.

In particular, analysts say labour market releases have surprised to the upside, core inflation remains sticky above 5% and near-term inflation expectations are elevated.

But researchers at National Bank of Canada (NBC) warn that the Bank of Canada would be wise to forgo another rate hike as "another could be the straw that breaks the camel's back."

"The most aggressive policy rate increase in a generation is taking its toll on the economy. Canadian housing is in recession with cumulative price declines now exceeding what was observed in 2008-09. But even more broadly, the latest BOS and CSCE also showed businesses and consumers are generally becoming more cautious/pessimistic," says Matthieu Arseneau, Deputy Chief Economist at NBC's financial markets unit.

Another 25 basis points increase might seem relatively benign given the frantic run of eight hikes that were delivered in 2022, but NBC argues at this stage of the business cycle the impact of further hikes is not linear.

"In other words, the marginal increase could be the straw that breaks the camel’s back," says Arseneau.

NBC says the Bank of Canada won't be too concerned about disappointing against market expectations as five of 2022's eight decisions were surprises:

Carlos Capistran, Canada and Mexico Economist at Bank of America, says the Bank of Canada will go with a final 25bp hike, even if "the domestic part of the economy has clearly decelerated".

The central bank will note that although headline inflation has peaked other measures of inflation are still not trending down, resulting in another hike.

But Bank of America says Wednesday's hike will be the last in the cycle, and this could undermine the Canadian Dollar.

"We believe the BoC will pause after this hike to wait and see how the economy and inflation evolves," says Capistran.

Bank of America is bullish the Canadian Dollar over the medium term, "but for this week CAD may see some weakness on the back of a rate hike pause communication by the BoC," says Adarsh Sinha, FX Strategist at Bank of America.

Economists at ING Bank also see a final 25bp hike incoming while also forecasting the prospect of a rate cut later in the year.

"Economic activity is slowing and inflation is coming down and what is likely to be characterised as a pause for assessment is set to mark the peak for rates. Rate cuts will be on the agenda later in 2023. The initial CAD reaction may be rather contained," says James Knightley, Chief International Economist at ING.

"Barring a very dovish outcome (no hike and claiming that rates have peaked) or a very hawkish one (hike and signal more hikes), the impact on CAD may prove rather short-lived," says Francesco Pesole, FX Strategist at ING.