BANK OF CANADA HIKING BORROWING COST AND TAPPERED BOND PURCHASE

The BoC has begun hiking borrowing costs ahead of the Fed twice since the start of the millennium - in 2002, following the 2001 recession in the United States, and in 2010, after the global financial crisis. In both cases it reversed all of the tightening before a new rate-hike cycle began. In a move that surprised some investors last week, Canada’s central bank sharply upgraded its forecasts for economic growth and changed its guidance to show it could start raising its benchmark interest rate from a record low of 0.25% in late 2022.

It also tapered its bond purchases, becoming the first major central bank to cut back on pandemic-era money-printing stimulus programs. The U.S. central bank’s current guidance is to leave interest rates on hold until at least 2024. The gap between Canada’s 2-year bond yield and that of its U.S. equivalent has widened by 14 basis points since January to 16 basis points in favour of the Canadian bond, while money markets expect two BoC rate hikes in 2022, as opposed to one from the Fed, reflecting the Canadian central bank’s more hawkish stance.

Interest rate differentials are a major driver of currency markets. Too strong a currency could reduce the competitiveness of Canada’s exports, slowing economic growth. Canada sends about 75% of its exports to the United States. If the bank maintains its current trajectory and keeps communications as they are, and then we see currency appreciation, which hurts the exports sector. Lonnie’s fair value is 1.2650 per U.S. dollar, or 79.05 U.S. cents. It was trading at 1.2280 on Friday and is up 3.7% since the start of the year. That is the second biggest gain among Group of 10 currencies, after the Norwegian crown.

Canada’s economic outlook, fuelling the Lonnie’s appreciation. Canadian GDP likely grew by 6.5% in the first quarter, But that economic optimism could waver if the currency strengthens too much.