Canadian Dollar: Bank of Canada Meeting has Loonie on Edge

Above: File image of Governor Tiff Macklem (right). Image © Bank of Canada, Reproduced Under CC Licensing.

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The Bank of Canada (BoC) meeting due to be held on Wednesday promises to be one of the more interesting instalments from Canada's monetary authority for some time, given they have an important decision on quantitative easing to make.

The BoC has delivered one of the most forceful responses to the Covid-19 crisis of any of the world's major central banks, and it is now clearly intent on pulling the reins on this largesse.

The BoC's quantitative easing programme, which sees it create money to buy government and corporate bonds, means it now has a sizeable balance sheet relative to the overall size of the economy.

The consensus amongst analysts is that the BoC will ease its quantitative easing bond purchases by CAD1BN from CAD4BN a week to CAD3BN a week, while keeping the key rate at 0.25%.

However, an intention to withdraw some support and start shrinking its balance sheet comes just as Canada undergoes another wave of Covid-19 infections and tightening restrictions.

Does the BoC act now and 'taper' its quantitative easing programme, or does it maintain support a while longer to see through the resurgence of cases?

The uncertainty surrounding the decision is therefore relatively elevated when contrasted to previous BoC's appearances, creating conditions for a move in the Canadian Dollar.

"The recent spike in virus cases in Canada suggests it shouldn't surprise on the hawkish side, despite a more benign bond environment," says Francesco Pesole, FX Strategist at ING Bank.

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ING says the Canadian Dollar has been lagging other pro-cyclical currencies lately, largely due to the worsening contagion situation in Canada and fresh containment measures.

Given recent CAD underperformance, there is the potential for the Canadian Dollar to rediscover lost form were the BoC to opt for a decisive reduction in monetary support, by 'tapering' the quantitative easing programme.

"A tapering decision hangs in the balance today in Canada, potentially delivering a fillip to the CAD," says Kenneth Broux, an analyst at Société Générale.

The BoC still has reason to withdraw support notes Broux given the economy has proven more robust than policy makers had anticipated.

Both growth and employment have surpassed the BoC forecast for the first quarter, and the central bank's spring Business Outlook survey states that many firms "consider the impacts of the pandemic on their activities to be behind them".

Many companies report "difficulties in finding new employees at the current wage or that their workforce is now fully utilised".

"In other words, the output gap is closing, so the central bank can consider a gradual reduction in QE. Tapering comes before rate increases," says Broux.

Foreign exchange markets will also be interested in whether the BoC's guidance on lift-off for the policy rate will be brought forward from 2023 says the Soc Gen analyst.

Money market pricing shows expectations for at least two hikes in two years, "which is aggressive," says Broux.

Société Générale forecast USD/CAD to be at 1.22 by year-end.

ING's Pesole says a consensus move by the BoC would likely leave CAD vulnerable in the short term, but moving ahead, improvements in the country's virus situation should allow CAD to benefit from its exposure to a strong US recovery and the BoC scaling back asset purchases.