The Bank of Canada expected to cut interest rates by 25 bps in September

• The Bank of Canada (BoC) cuts its policy rate to 4.25%.
• The Canadian dollar started the month on the back foot against the US dollar.
• Headline inflation in Canada fell further in July.
• Swap markets are seeing about 36 bps of easing this week.

There is a widespread expectation that the Bank of Canada (BoC) will cut its policy rate for the third consecutive meeting on September 4. Mirroring the central bank’s previous decisions, this move would most likely be 25 basis points, taking the benchmark interest rate. at 4.25%.

Since the start of the year, the Canadian dollar (CAD) has weakened against the US dollar (USD), taking USD/CAD to new highs near 1.3950 in early August. Since then, however, the Canadian currency has embarked on a period of sharp appreciation, dragging the pair around 5 cents below the previous month’s high.

In July, the annual rate of domestic inflation, as measured by the Consumer Price Index (CPI), fell further to 2.5% from the same month in 2023, and the BoC’s core CPI fell further below its target of 2.0%, recording a 1.7% Increase over the last twelve months. The central bank’s expected interest rate cut appears to be tied to continued declines in consumer prices and an anticipated easing of Canada’s labor market.

Inflation has remained below 3% since January, in line with the central bank’s forecast for the first half of 2024, with key consumer price readings also pointing to a consistent decline. In addition, the BoC is likely to continue basing future rate decisions on economic data. Current swap markets suggest about 36 basis points of easing in September.

The BoC could maintain its dovish narrative

Despite the anticipated interest rate cut, the central bank’s overall stance is expected to tilt to the bearish side, especially against the backdrop of lower inflation (suggesting headline CPI could hit the bank’s target soon) and growing slack of the labor market.

Following July’s rate cut, BoC Governor Tiff Macklem argued the economy was facing excess supply, with a weakening labor market contributing to downward pressure on inflation. He explained that their assessment already indicates sufficient oversupply in the economy, and the necessary conditions are increasing to bring inflation back to the 2% target. He also stressed that instead of needing more excess supply, growth and job creation need to start picking up to absorb the excess supply and achieve a sustainable return to target of inflation.

Macklem added that the central bank aims to balance risks on both sides, expressing determination to return inflation to 2 percent without excessively weakening the economy and causing inflation to fall below target. He noted that these considerations will be carefully weighed in advance, and decisions will be made one meeting at a time.

In light of the BoC’s upcoming interest rate decision, National Bank of Canada’s Taylor Schleich and Warren Lovely said:

“The Bank of Canada is set to cut its overnight rate target by 25 basis points on Wednesday, its third such move in as many meetings. The one data point that had the potential to derail a tapering – July’s CPI report – provided encouraging news on the core inflation front, allowing policymakers to relax without controversy.

“Meanwhile, even though July’s employment report showed an unchanged unemployment rate, the outlook for the labor market remains challenged. Consensus expectations for the unemployment rate (and those implied by the Bank of Canada’s rosy growth forecasts) are too bullish and we continue to see the unemployment rate reaching ~7% by the end of the year.”

When will the BoC release its monetary policy decision and how could it affect USD/CAD?

The Bank of Canada will announce its policy decision at 13:45 GMT on Wednesday, September 4, followed by Governor Macklem’s press conference at 14:30 GMT.

Barring any potential surprises, the impact on the Canadian currency is expected to come mainly from the bank’s message rather than the interest rate move itself. Taking a conservative approach may lead to more support for the CAD and further decline in USD/CAD. If the bank indicates that it intends to cut interest rates further, the Canadian dollar could suffer and open the door for further gains in USD/CAD.

According to Pablo Piovano, senior analyst at FXStreet.com, “USD/CAD has been on a strong downward trajectory since early August, hitting monthly lows near 1.3640 last week. The recovery since then has mainly come off the back of the US dollar (USD) recovery, prompting the pair to recover the 1.3500 barrier and more so far.

Pablo adds:

“The immediate target appears at the 200-day SMA, currently at 1.3589. Once this region is cleared, the pair could revisit the 1.3665-1.3680 band, where the intermediate 55-day and 100-day SMAs converge. Above, there are no notable resistance levels until the 2024 peak at 1.3946 recorded on August 6.

“If the bears regain the initiative, USD/CAD could retake the August low of 1.3436 (August 28) before the March low of 1.3419 (March 8). A deeper decline beyond the latter exposes a move to the December 2023 low of 1.3177 (December 27),” Pablo concludes.