Canadian Dollar Retreats after Bank of Canada Strikes a Cautious Tone; USD/CAD Headed Higher

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“There appear ample reasons for central bankers to remain on the sidelines. As a result, we're sticking to our call that the BoC only hikes interest rates once more in 2018."

The Canadian Dollar pared broad-based gains over its international rivals Wednesday after the Bank of Canada held its cash rate steady in March and warned of uncertainty created by Washington’s increasingly belligerent trade policy.

Governing council members voted to hold the cash rate at 1.25%, as was widely expected by the market, in order to further observe the economic effect of the BoC’s decision to raise rates for a third time in nine months back in January.

“Cooling growth left little reason for central bankers to rush another rate hike, but US steel and aluminum tariffs sealed the deal,” says Royce Mendes, an economist at CIBC Capital Markets. “Governor Poloz decided the outlook warranted a cautious approach, leaving rates unchanged and striking a dovish tone in his communique.”

The BoC says global growth remains on a firm footing and that tax cuts, as well as higher government spending, south of the border are expected to lift economic activity both at the global level as well as in Canada over the coming months.

“However, trade policy developments are an important and growing source of uncertainty for the global and Canadian outlooks,” the BoC says.

Rate setters note the Canadian economy grew by a healthy 3% in 2017, which was in line with the bank’s earlier projections, although they also flag that recent economic data have been disappointing.

Canadian economic momentum slowed toward the end of 2017, with the pace of GDP growth ticking down a touch in December while consumer spending retreated further from its earlier peaks.

“In the fourth quarter, GDP growth was slower than expected, largely due to higher imports, while exports made only a partial recovery from their third-quarter decline. The gain in imports mainly reflected stronger business investment, which adds to the economy’s capacity,” the BoC says in its statement.

Moreover, the labour market gave back some of its recent strong gains once into January, with the unemployment rate notching higher to 5.9% while jobless claims picked up by 88,000.

That said, inflation has continued to trend higher at the start of the year, coming in at 1.7% in January, which takes the consumer price index closer to the midpoint of the BoC’s 1% to 3% target range.

“Inflation is running close to the 2 per cent target and the Bank’s core measures of inflation have edged up, consistent with an economy operating near capacity. Wage growth has firmed, but remains lower than would be typical in an economy with no labour market slack,” the BoC says in its statement.

Market implied probabilities of further BoC rates hikes this year have been headed in the wrong direction of late, as market confidence in the bank’s ability to push the cash rate higher has waned.

Interest rate derivatives market pricing on January 17, the day when the BoC last raised rates, implied an October 2018 cash rate of 1.783%. However, this implied rate had fallen to just 1.671% by 08:00 on March 07.

“While inflation will outstrip the Bank's own forecasts early this year, there appear ample reason for central bankers to remain on the sidelines. As a result, we're sticking to our call that the BoC only hikes interest rates once more in 2018,” CIBC’s Mendes says.

Above: USD/CAD rate shown at hourly intervals.

USD/CAD was quoted 0.09% lower at 1.2939 following the release, after having pared an earlier 0.29% loss, while the Pound was quoted 0.28% lower at 1.7947 after also partially reversing an earlier 0.57% loss. This still left the Canadian Dollar trading higher against all of its G10 rivals barring the Australian Dollar.

Above: Pound-to-Canadian-Dollar rate shown at hourly intervals.

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NAFTA Risk and Looming Trade War Threaten the CAD

A so-far fruitless effort to renegotiate the North American Free Trade Agreement have been at the top of policymakers’ list of worries for some time, although this has become a more pressing subject since President Donald Trump’s threat to impose new tariffs on imports of aluminium and steel.

Reserve Bank of Australia governor Philip Lowe spoke out against the plan for tariffs in a speech to the Australian Business Review summit in Sydney on Wednesday, saying they are "highly regrettable and bad policy.” It remains to be seen whether the BoC will be so bold and just how the market might react.

“The recent sharper tone from the US and the uncertain outcome of the negotiations should initially deter the BoC from raising the key interest rate further, while the Fed will remain on course. The CAD is therefore likely to lose out on the dollar in the short term,” says Antje Praefcke, an analyst at Commerzbank.

Washington says the tariff move is intended to protect American steel producers, and jobs, from dumping by state-subsidised foreign producers although it is thought they will be applied to imports across the board, from all countries.

“Canada is the largest steel and aluminium supplier to the USA. The mood must have been correspondingly frosty during the seventh round of [NAFTA] negotiations, in which the news of the new tariffs certainly hit like a bomb,” Praefcke adds.

The rub for Canada is President Trump’s trade measures could hit exports to its nearest and largest market, the United States, while the increasing tendency toward protectionism in Washington only adds to the risks facing Canada and the NAFTA pact.

“Under the current circumstances, it is clear that there will hardly be any agreement on the major points of contention in the near future and that the possibility of the negotiations failing cannot be ruled out any longer. And the economies of Canada and Mexico would suffer quite harshly from a trade war with the USA because of their close trade ties,” Praefcke says.

President Trump said when on the campaign trail that NAFTA is “the worst deal in history” and pledged to withdraw America from it if more acceptable terms cannot be negotiated.

There are a number of aspects to the existing agreement the US President has taken issue with. Analysts have speculated that a US withdrawal from the pact could lead to a double digit devaluation of the Canadian Dollar.

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