Fiscal support, stabilising financial conditions, and a historic surge in immigration are helping the Canadian economy – and the loonie – defy bearish expectations. Continued labour market tightness, rebounding housing markets, and high levels of consumer consumption have combined to deliver remarkably-robust growth rates.

Although the Bank of Canada’s latest Business Outlook Survey showed excess demand and labour shortages coming down to pre-pandemic levels, its Consumer Expectations Survey revealed an improvement in household confidence, with many respondents expecting wages to rise, interest rates to fall, and home prices to climb over the coming year.

The central bank has responded to signs of excess demand-fuelled inflation with a second round of rate hikes, and investors are currently putting 45-percent odds on another move by the October meeting – with rate cuts seen coming later, and at a more measured cadence than in the United States. Interest rate differentials have narrowed sharply from their peaks, and – although its gains look less impressive in nominal terms – the loonie is outperforming many of its counterparts against the greenback.

Annual change in total population, %

Many things could go right for the Canadian economy in the months ahead. Housing markets have the potential to go from strength to strength as immigration flows lift demand and elevated financing rates limit the supply response from builders and existing homeowners. High and stable equity market valuations may support household wealth effects. Aggregate nominal household incomes might keep rising as persistent labour market imbalances put upward pressure on wages. And exports could hold up, particularly if the US consumption engine keeps running and a comprehensive stimulus effort from Chinese policymakers supports global commodity demand.

The Bank of Canada – which already sounds more confident than many of its global counterparts – could cut rates more gradually than the Federal Reserve in 2024, contributing to a narrowing in relative rate differentials and providing additional support to the currency.

US government bond yield minus Canadian government bond yield, %

Canada’s incredibly-indebted private non-financial sector remains its biggest point of vulnerability. With long-term rates ratcheting higher and the burden on mortgage holders continuing to increase, debt service ratios are set to climb well above records set just before the pandemic. We think this will reduce consumer spending power and business investment at a time when real income growth is fading and lending conditions are tightening. A recent recovery in real estate values is likely to pull new listings into the market, just as rising carrying costs cool demand. This should limit further price appreciation and reduce the likelihood of a “melt-up” in housing activity that leads to overheating in the wider economy.

Private sector debt service ratio, %

Taken in sum, a prolonged period of calm could see the Canadian dollar rally in the short term, outperforming regions that are facing more obvious structural challenges – like the United Kingdom, the euro area, Japan, and China – in capitalizing on dollar weakness. But growth risks, comparatively low yields, and volatility sensitivities – particularly relative to US equity markets – should represent serious headwinds for the exchange rate beyond the early autumn.

Rolling 30-day CADUSD correlations, correlation coefficient