On Wednesday, the Bank of Canada will announce its interest rate decision at 23:00. At this meeting, the market expects a 70%-75% probability of raising interest rates by 25 basis points. However, Bloomberg Economists expect the Bank of Canada to keep rates unchanged. Analysts see the case for the first-rate hike as solid and likely to send a clear signal of imminent action from the central bank. Therefore, investors are most concerned about whether Canada's interest rate hike cycle will start at this meeting？
The Bank of Canada has “released hawks” multiple times
Although the markets are prepared for a “hawkish” stance from the Bank of Canada, the depth of its hawkish tone still surprised the financial markets. During the pandemic, the Bank of Canada injected hundreds of billions of Canadian dollars into the financial system through its quantitative easing program. In addition, it increased its bond holdings by about 350 billion Canadian dollars.
However, in October 2021, the Bank of Canada suddenly abandoned its quantitative easing policy. The BoC unexpectedly announced the end of QE ahead of schedule, making Canada the first G7 economy to end QE.
Policymakers, led by the Bank of Canada Governor Tiff Macklem, announced they would stop building up their holdings of Canadian government bonds, ending the quantitative easing program. However, the Bank of Canada later said that after the end of QE, it would enter a reinvestment phase. As a result, the central bank will only buy the same amount of Canadian government bonds to replace maturing bonds, thus keeping its overall holdings unchanged.
However, the Bank of Canada failed to become the first G7 country to raise interest rates. It only upped its interest rate hike expectations to the second quarter of 2022. Many now expect the central bank to raise interest rates in the second quarter. The Bank of Montreal moved forward its forecast for the first-rate hike to March from April, while Scotiabank said the Bank of Canada might not wait much longer.
Why is it so urgent to raise interest rates？
Global inflation is currently soaring due to massive government spending, supply chain disruptions and surging demand for consumer goods, causing prices to rise sharply. The latest inflation data from Canada shows why austerity measures have become imperative in Canada.
According to the latest data from Statistics Canada, Canada's consumer price index (CPI) in December 2021 accelerated slightly year-on-year to 4.8%, the highest level since September 1991, and has risen for 19 consecutive months. As a result, the country's inflation rate has been above the Bank of Canada's inflation target of around 2% for nine consecutive months, adding pressure on the Bank of Canada to curb inflation by raising interest rates.
Due to high inflation, Canada's transportation, housing, and food costs have all risen. As a result, Canada's December food and daily necessities prices rose 5.7% year-on-year, the largest increase since November 2011. In addition, commodity prices rose 4.7%, service prices rose 2.3%, and gasoline prices rose 31.2%, the highest since 1981.
In terms of the employment rate, Statistics Canada data shows that the unemployment rate in Canada in December 2021 was 5.9%, slightly lower than the 6% in November. In December, the total number of unemployed people was 1.21 million, almost the same as in November. But that was up from 1.15 million in February 2020 before the pandemic began. That means the country's job market is returning to pre-pandemic levels, creating the right conditions for a rate hike.
How will rate hikes affect the Canadian dollar？
The Canadian economy has met the necessary conditions for raising interest rates in terms of employment and inflation. So the market has been expecting the Bank of Canada to raise interest rates earlier than the Fed. Therefore, if the latest monetary policy meeting decides that Canada will initiate the interest rate hiking cycle, it will support a rebound in the Canadian dollar. In addition, the Canadian dollar is a currency that is positively correlated to oil prices. Due to the continued supply shortages, international oil prices have been bullish this year, and oil prices have kept rising. In the past month, the price of Brent crude oil has risen sharply by 34%, almost reaching a seven-year high, contributing to the Canadian dollars rebound.
However, some market analysts believe that the Canadian dollar is still under significant pressure in the first quarter of 2022. Due to the global spread of the COVID-19 pandemic, the Canadian dollar fell to a nearly one-year low earlier. At present, the pandemic is still spreading in various countries. Therefore, the Federal Reserve may decide to start raising interest rates in the first quarter of this year. The US dollar‘s rise will indirectly exert downward pressure on the Canadian dollar. In the long run, the impact of oil prices and the Bank of Canada’s “hawkish” policies on the Canadian dollar is expected to reverse the decline that has been in place since late December 2021. However, the Fed's tightening policy prospects are more dominant as interest rates and balance sheet shrinkage could support a US dollar rally limiting the Canadian dollar.
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