Canadian Dollar Eyes October Forecast Review after BoC Flags Risks to Recovery

- CAD an underperformer after latest BoC decision
- BoC notes underwhelming data & risks to outlook
- Forecast review key for QE, rate timelines & CAD

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

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The Canadian Dollar traded with dampened spirit Wednesday after the Bank of Canada (BoC) noted international headwinds and coronavirus-related risks to the economic recovery, leaving the Loonie with little incentive to reverse its nascent underperformance ahead of next month's forecast review.

Canada’s Dollar ceded ground to the U.S. Dollar and Pound when the BoC left its cash rate and quantitative easing purchase target unchanged at 0.25% and C$2BN per week respectively for September, in line with market expectations.

Losses were limited but nonetheless enough to confirm increased uncertainty in the market over the likely timing of future changes to policy including the BoC’s next incremental reduction to the amount of government bonds it buys each week, and an eventual increase in the cash rate.

“It had to acknowledge that growth appears weaker than it had previously assumed, although it noted that the contraction in Q2 was "largely" due to weakness in exports stemming from supply chain disruptions,” says Royce Mendes, an economist at CIBC Capital Markets.

“Investors will now be eyeing Governor Macklem's speech tomorrow, entitled "QE and the reinvestment phase" for details as to how the Bank will continue to wind down this programme,” Mendes adds.

While the BoC largely reiterated its earlier guidance, Wednesday’s statement also acknowledged that recent economic data has been weaker than was envisaged in July’s forecasts, creating uncertainty about if that guidance will be maintained in October.

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

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July’s forecasts had suggested the economy is likely to be sustainably delivering the 2% inflation target by the second half of next year, implying that the bank could become minded to begin lifting Canadian interest rates around that time.

The above referenced forecasts will be revised next month however, and the danger is that they and the BoC’s expectations have been tempered by the surprise second quarter economic contraction announced last week.

While much of this was the result of international headwinds, a further decline in GDP for July has already been telegraphed as likely by Statistics Canada, and another wave of coronavirus infections is also now stoking further uncertainty about the outlook for the recovery.

“The Q2 GDP figures were a notable disappointment, leaving a significant gap between the realized levels and the BoC's forecast,” says Mark McCormick, global head of FX strategy at TD Securities, who sees the Canadian Dollar as a likely laggard among major currencies in the weeks ahead.

“And between the disappointment on Q2 and the impending Q3 downgrade, we now look for 2021 growth somewhere in the vicinity of 5.0%, compared to the 6.0% in the July MPR,” McCormick writes in a Wednesday note.

The BoC already downgraded its forecast for the economy back in July and since then market expectations have shifted against the Canadian Dollar.

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“The Bank continues to expect the economy to strengthen in the second half of 2021, although the fourth wave of COVID-19 infections and ongoing supply bottlenecks could weigh on the recovery,” the BoC said on Wednesday.

Previously, pricing in certain financial markets had indicated before July’s decision that investors saw the BoC as highly likely to lift its cash rate as soon as April 2022, but since then it’s shifted to imply that rate rise is more likely to come toward the end of the year.

This marked the beginning of an ongoing period of underperformance by the Canadian Dollar, which was previously the best performing major currency in the G10 segment for 2021, but has since ceded that mantle to Sterling.

The Canadian Dollar ceded ground to all major counterparts on Wednesday and had also fallen against each for the recent month, although it remained the second best performing major currency for 2021.

The Pound-to-Canadian Dollar rate tested 1.75 following the BoC’s announcement on Wednesday and was comfortably above the 1.7380 breakeven threshold for 2021 that determines whether the Canadian Dollar or Pound holds the top spot for the year among major currencies.

“Despite a fairly sanguine tone today, we continue to see risk that the BoC delays its next QE tapering step (to $1B per week from $2B currently) beyond October. There is plenty of data between now and then to help the Governing Council judge the “strength and durability” of the recovery but the onus is clearly on economic indicators improving,” says Josh Nye, a senior economist at RBC Capital Markets.

Above: Pound-to-Canadian Dollar rate shown at daily intervals alongside USD/CAD.