'Consistently Stronger' Canadian Dollar Forecast as Bank of Canada Heads Towards Interest Rate Rises

Above: BoC Governor Macklem. Image © Bank of Canada, Reproduced Under CC Licensing

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The Canadian Dollar is tipped to trade consistently below a key level against the U.S. Dollar in the second half of 2021 as the Bank of Canada continues to offer a supportive impulse.

Such a prediction on the U.S. Dollar-Canadian Dollar exchange rate (USD/CAD) will likely spill into other CAD-based pairs, including the Pound-to-Canadian Dollar exchange rate (GBP/CAD) which could break to fresh 2021 lows.

The Bank of Canada (BoC) on Wednesday June 09 left policy settings unchanged with interest rates maintained at 0.25% and the weekly quantitative easing purchase rate set at C$3BN per month.

This outcome was always expected given it was at the previous meeting that the BoC 'tapered' the quantitative easing rate from C$4BN/week to the current level.

The foreign exchange market was therefore always likely to be more interested in the guidance on offer as this would set up expectations for further tapering measures and ultimately the timing of the first interest rate.

"With economic conditions improving, all indications are that the BoC will need to continue gradually normalizing its monetary policy over the next few quarters. Further reductions in quantitative purchases in the financial markets are therefore to be expected, perhaps as early as July," says Benoit P. Durocher, Senior Economist at Desjardins Bank.

Foreign exchange markets are presently focussed on how central banks are diverging from each other in terms of monetary policy; some are moving to normalise policy settings faster than others.

Those that are ahead of the curve tend to see their currencies appreciating.

On this count the BoC is certainly ahead of the curve given its decision to taper in April and this helps explain why the Canadian Dollar is the best performing major currency of 2021.

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James Knightley, Chief International Economist at ING Bank says the BoC continues to walk a tightening path and this could keep the Canadian Dollar supported near the top of the currency performance board.

"The Bank of Canada left policy unchanged, but offered hints that we should expect further QE tapering soon with a rate hike firmly on the agenda for the second half of next year," says Knightley.

ING expects the strong growth outlook means that both all of the lost GDP output and jobs could be fully recovered in the third quarter.

This vigorous growth story, supported by additional fiscal support, together with supply constraints implies the potential for more inflation pressures which in turn justifies a 'hawkish' BoC stance.

What does this mean for the Canadian Dollar outlook?

Francesco Pesole, FX Strategist at ING says the notion that the Bank of Canada remains a hawkish stand-out in G10 is set to continue providing support to the Canadian dollar.

"In particular, the diverging patterns in monetary policy in Canada and in the US should applying pressure on USD/CAD," says Pesole.

A break below the key 1.2000 level in USD/CAD has been avoided by a stubborn U.S. Dollar, but the strategist says it should ultimately give way.

"But, in line with our view that the BoC will continue to taper asset purchases in 2021 while not denting market confidence about a rate hike in 2022, we think the fundamentals for a break below 1.2000 are there, and we continue to expect USD/CAD to stay on a depreciating trend in 2H21 and touch 1.16 in 4Q21," says Pesole.

For those watching Sterling, such a turn of strength in USD/CAD could open the door to new 2021 lows in GBP/CAD.

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