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Loonie Falls As Bank of Canada Turns Dovish

As had been widely anticipated, the Bank of Canada held its benchmark overnight rate at 5 percent this morning, but language in the accompanying statement, Monetary Policy Report, and prepared comments tilted in a more clearly-dovish direction, helping lift market expectations for rate cuts in the first half of the year.

Policymakers attempted to navigate a difficult communications challenge: while acknowledging signs of weakness in the economy and expressing approval of declining inflation pressures, they also sought to avoid repeating last year’s mistake – triggering a sharp rise in home prices and aggregate demand by encouraging an unwarranted easing in financial conditions.

According to the statement, “the economy has stalled since the middle of 2023 and growth will likely remain close to zero through the first quarter of 2024,” with both of the country’s major growth engines frozen: “Consumers have pulled back their spending in response to higher prices and interest rates, and business investment has contracted”.

A rebound is expected. The Bank’s economists expect growth to hit 0.8 percent in 2024, and 2.4 percent in 2025, with household spending recovering in the second half of this year, and business investment ramping up on an increase in foreign demand. Government spending is seen offering continued support.

With rate-and policy-driven shelter costs remaining the “biggest contributor to above-target inflation,” the Bank expects price growth to remain elevated through the first half of the year before easing toward target by early 2025.

Perhaps most importantly, boilerplate language that was previously used to keep additional rate hikes on the table – a sentence that said “Governing Council is still concerned about risks to the outlook for inflation and remains prepared to raise the policy rate further if needed” – was removed, replaced by less hawkish wording. The statement now reads: “The Council is still concerned about risks to the outlook for inflation, particularly the persistence in underlying inflation. Governing Council wants to see further and sustained easing in core inflation and continues to focus on the balance between demand and supply in the economy, inflation expectations, wage growth, and corporate pricing behaviour”.

In prepared remarks released ahead of the press conference, Governor Tiff Macklem says “What came through in the deliberations is that Governing Council’s discussion about future policy is shifting from whether monetary policy is restrictive enough, to how long to maintain the current restrictive stance”. “If the economy evolves broadly in line with the projection we published today, I expect future discussions will be about how long we maintain the policy rate at 5 percent”.

The Canadian dollar is giving back earlier gains against the greenback as rate differentials widen slightly relative to the US, but many traders will keep their powder dry into the press conference at 10:30 – the initial reaction could easily reverse on a more hawkish stance from Macklem during the question-and-answer session.

Looking at the short term outlook, we think policy differentials could play a smaller role in setting currency direction – markets have moved away the extreme easing trajectory that was priced in last year, and the gap between US and Canadian yields has narrowed substantially, from more than 57 basis points in December to near 30 today. At some point, Canada’s more interest rate-sensitive economy should exhibit clearer signs of relative underperformance, but this could take months to emerge, particularly in the event of a short-term “melt up” in domestic housing markets.

Canada-US 2-year government bond rate differential, %

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