Pound-Canadian Dollar Recovery Gains Traction after BoC Leaves 'Hawkish' Market at Altar

- GBP/CAD recovery gains traction with Loonie in post-BoC slip
- BoC tapers QE, snips GDP forecast, maintains rate guidance
- GBP/CAD extends rally, aided by UK inflation & GBP strength

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

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The Pound-to-Canadian Dollar rate recovery appeared to gain traction in the mid-week session after the Bank of Canada tapered its quantitative easing programme but left disappointed those investors who’d hoped it would adapt its guidance on interest rates in a more ‘hawkish’ way.

Bank of Canada (BoC) policymakers adjusted their weekly bond purchases from C$3BN per week to C$2BN in the third reduction since November, which leaves the BoC on course to potentially end the programme around year-end or early in the New Year if the pace of tapering seen so far is sustained.

But they also snipped their projection for Canada’s 2021 recovery lower by a tad to 6%, from 6.5%, citing a second quarter wave of coronavirus infections that saw restrictions on activity either tightened or prolonged in key economic hubs.

Inflation forecasts were revised higher right the way along the forecast horizon while the bank also continued to warn about the uneven nature of the global economic recovery, and risks posed by derivatives of the coronavirus.

“These new forecasts are very consistent with our own set of projections,” says Royce Mendes, an economist at CIBC Capital Markets.

“The statement suggested that the current increase in inflation is largely the result of transitory factors, and should ease back towards the 2% target in 2022, leaving scope for rates to remain on hold,” Mendes says.

Above: Pound-Canadian Dollar rate shown at 15-minute intervals alongside USD/CAD.

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It’s inflation which central banks are attempting to manage in the context of a predefined target whenever they tinker with interest rates or change other monetary policies, although price pressures are themselves sensitive to changes in economic growth as well as many other factors.

The BoC retained its guidance on the cash rate on Wednesday and said nothing to indulge investors who’ve wagered increasingly in recent weeks that the BoC could be willing to begin lifting Canadian borrowing costs as soon as April next year.

“We remain committed to holding the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In the Bank’s July projections, this happens sometime in the second half of 2022,” the BoC reiterated in reference to its cash rate, which was left unchanged at 0.25% in line with market expectations.

The Canadian Dollar tumbled following the announcement and CIBC’s Mendes says this could be because some market participants were likely “looking for a more hawkish turn from Canadian central bankers,” while others previously noted that market expectations for the BoC are on the verge of becoming excessive. 

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The BoC’s QE programme was the most aggressive of all major economy central banks when measured as a percentage of the overall government balance sheet, and its paring back has been a key contributor to the Canadian Dollar’s outperformance of other major currencies this year, although more recently market expectations of a 2022 interest rate rise from the bank have also been widely cited as supporting the Loonie.

“We're bumping up against the limits of what is reasonably possible for BoC rate hike pricing,” says Benjamin Reitzes, a Canadian rates & macro strategist at BMO Capital Markets in a note ahead of the decision.

“The economy weathered the third wave shockingly well, with only modest declines in April & May GDP, reinforcing the view that activity remains resilient. Despite the broadly upbeat tone, there will remain some caution driven by variants and the slower relative pace of vaccination through significant parts of the world,” Reitzes says.

The Loonie had strengthened tepidly in the initial moments following the BoC’s decision before being overcome by apparent selling which saw the Pound-to-Canadian Dollar rate and USD/CAD rising, though with the Sterling exchange rate out in front.

Above: Pound-Canadian Dollar rate at daily intervals with key moving-averages and Fibonacci retracements of 2021 fall.

Wednesday’s currency market reaction played out against a backdrop of widespread weakness in the U.S. Dollar and broad strength in Sterling exchange rates, with the latter certainly accounting for much of the intraday performance by GBP/CAD.

Pound Sterling exchange rates were mostly higher throughout the session after UK inflation figures surprised on the upside of economists’ expectations, taking both the main measure of inflation as well as the core metric further above the 2% target of the Bank of England (BoE) and potentially leading some in the market to anticipate that the BoE may turn ‘hawkish’ over the coming months.

The BoE has for its part said that above-target inflation levels are likely to be “transitory” and has recently assumed the consumer price index will decline after reaching 3% later in the year.

BoE Deputy Governor Jon Cunliffe was reported to have said on Wednesday that the BoE will assess at its next meeting the extent to which these price pressures are likely to be sustained beyond the short-term.

Sterling would be sensitive in the months ahead to any data which suggests the inflation overshoot will be larger or longer-lived than the Bank expects.

“Inflation is now firmly above the BOE’s 2% inflation target, and with the economy reopening (starting Monday), there is a chance we could see a more hawkish pivot by the BOE. However, similar to the US, many of the factors contributing to inflation are likely to be temporary, and given some of the government support initiatives will soon be wound down, it seems likely the BOE – like the Fed – will remain cautious,” says Dominic Bunning, head of European FX research at HSBC.