The market believes that the conditions for the Bank of Canada to begin cutting interest rates are being formed, but will the Canadian currency hinder this?

The market generally expected the Bank of Canada to act before the Federal Reserve. This put pressure on the Canadian dollar, and the exchange rate against the US dollar fell 1.7%. As of press release, the USD/CAD exchange rate is currently reported at 1.3704.

(USD/CAD exchange rate chart source: eHuitong)

The Canadian dollar fell again yesterday after weak retail sales data came out, which increased the possibility of interest rate cuts. As the gap between the two central banks' policy paths widens, the outlook for the Canadian dollar looks bleak.

Although the Bank of Canada is expected to cut interest rates in June or July, the Fed's first rate cut forecast has been postponed to December, and some people question whether the Fed will cut interest rates this year.

The Bank of Canada is expected to cut its 5% interest rate by 100 to 125 basis points this year; the Federal Reserve will only cut interest rates by 25 basis points.

The extent to which this gap will widen is a key question for the Canadian dollar.

Bank of America Global Research has lowered expectations for the Canadian dollar due to signs that the differences will be greater than previously anticipated.

Now, Bank of America predicts that the Canadian dollar will fall to 72.99 cents in the second quarter of this year and reach 75.75 cents by the end of 2025, lower than the previous forecast of 76.9 cents.

A weaker Canadian dollar will increase the risk of inflation as imported goods become more expensive. Bank of America estimates that for every sharp drop in the Canadian dollar by one unit, the consumer price index may rise by 15 basis points. They said that if the gap between the two central banks is large enough, lowering the Canadian dollar to 69 cents may increase the inflation rate by a full percentage point.

“Currently, we think the Bank of Canada may tolerate some short-term weakening of the Canadian dollar as it tries to begin a cycle of interest rate cuts,” Bank of America strategist Howard Du (Howard Du) and economist Carlos Capistran (Carlos Capistran) said.

“But if the Bank of Canada's interest rate cut causes the Canadian dollar to sell off sharply or fall for a long time, the foreign exchange market may begin to worry about whether the risk of inflation in Canada will reappear and the impact of a strong dollar on the rest of the world, including Canada.”

This may raise concerns about how deep cuts the Bank of Canada can make or whether policymakers will be forced to suspend in order for the Federal Reserve to catch up.

Central Bank Governor Tiff McClum said at the final decision meeting on April 10 that policymakers are watching currency trends.

“If the Canadian dollar does fluctuate, that will be a factor we will consider in our outlook,” he told reporters.

Bank of America researchers say the Bank of Canada has intervened before. After the 1997 Asian financial crisis, the Canadian dollar was hit by a strong dollar and falling oil prices. Between August and September 1998, the Bank of Canada raised its policy interest rate by 100 basis points and directly intervened in the foreign exchange market.

“The current macro context is far from crisis levels, and the risk of central bank intervention is low,” Howard Du and Carlos Capistran said.

“But if the Canadian dollar sees excessive weakening after the Bank of Canada begins a cycle of interest rate cuts, this is a risk that the market should not ignore, we believe.”

Not all economists agree. Royal Bank of Canada Assistant Chief Economist Nathan Janzen (Nathan Janzen) believes that money has not “driven” inflation in the past.

More than half of Canada's consumer spending is spent on services, and goods come from more sources than the US. Canada's weak economy has also made it harder for businesses to pass on price increases.

But Bank of Montreal's chief economist Sal Guatieri (Sal Guatieri) believes that the Canadian dollar may become an issue for the central bank.

“The weak Canadian dollar has so far provided welcome support to the economy without threatening price stability. But if it falls further sharply, the situation may change,” he said.