Bank of Canada’s divergence from U.S. Federal Reserve puts loonie in spotlight

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The Bank of Canada trimmed its policy interest rate by 0.25 per cent this week, but with the United States Federal Reserve expected to hold overnight rates steady until the fall, questions are being raised about how wide the gap between the two countries’ key lending rates will grow.

Sadiq Adatia, chief investment officer at BMO Global Asset Management, said Canadian and U.S. rates have diverged by 50 basis points or more over the years but could exceed that range, given the unique economic growth and inflation pictures in each country.

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This divergence is likely to cause the Canadian dollar to decline, he said, and there are some concerns this could stoke inflation.

Philip Petursson, chief investment strategist at IG Wealth Management, wrote in a note this week that there is a risk of the Canadian dollar falling to between 70 and 72 cents US if the Bank of Canada cuts rates by 50 basis points more than the Fed in 2024.

“That will erode our purchasing power and cause money to move to other parts of the world where the rate differential is much better,” BMO’s Adatia said. “If the divergence is really big and occurs fast we could see heightened inflation.”

He put a low probability on this outcome, however, noting that a large divergence is not his base case scenario.

The loonie was trading just below 73 cents US on Friday.

I don’t think we’re close to that limit

Tiff Macklem

Tiff Macklem, governor of the Bank of Canada, downplayed currency concerns during a news conference Wednesday, noting that the two countries’ overnight rates have diverged in the past with no long-lasting harm to their economies or markets.

Acknowledging that there is a point at which such divergence could have negative impacts, he said: “I don’t think we’re close to that limit.”

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Macklem added that there is no “bright line” for determining a tolerable size for the gap, and added that there have been periods of “significant” divergence in the past.

Doug Porter, chief economist at Bank of Montreal, said the “outer limit” on the Canada-U.S. overnight interest rate gap for most of the past 20 years has been 100 basis points, or one percentage point with either the Canadian or U.S. rate on the higher end, though he added that the divergence was even greater at times during the 1980s and 1990s.

“Unless there was some other factor at play — such as strong commodity prices, or a broadly weak U.S. dollar — an interest rate gap of more than 100 basis points would likely put some serious downward pressure on the loonie,” Porter said.

However, he suggested that the Bank of Canada’s willingness to loosen monetary policy shows central bankers don’t appear to be especially concerned about the potential for further softening in the currency. Moreover, Porter noted that past prognostications about the impact of the gap haven’t been borne out.

In 2003, for instance, the biggest surge in the Canadian dollar in a single year — more than 20 per cent — coincided with a 200 basis point spread between Canadian and U.S. rates, yet didn’t have the predicted impact on inflation.

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“It did dip, but not nearly to the extent the models expected inflation to fall in the face of a 21 per cent rise in the loonie,” Porter said.

And why didn’t the economy react more strongly to the huge move?

“I believe that firms are much more sophisticated now in hedging currency risks than in the 1970s-1990s,” he said.

“Especially after the big swings in the 1990s, they really learned how to deal with FX (foreign exchange) volatility.”

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