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BoC kept rates unchanged but case for tapering remains strong

Canada's central bank kept rates unchanged as weaker activity readings, the election and Covid-19 creates uncertainty. However, with inflation pressures on the rise, the case for tapering remains strong and most expect more tapering in October. The undervalued CAD may struggle to recover before the vote but should show strength in October.

Cautious optimism from BoC

The Bank of Canada did not change monetary policy with the overnight rate held at the effective lower bound of ¼ percent and weekly QE asset purchases remaining at $2bn per week. A move was hardly likely given the recent shock GDP contraction, and the Bank wants to avoid any possibility of being seen to influence or to be taking a view on the 20 September federal election.

The commentary remains cautiously optimistic, though. The negative GDP was caused primarily by supply chain disruptions hitting exports, but the underlying story remains good. Indeed the BoC “continues to expect the economy to strengthen in the second half of 2021, although the fourth wave of COVID-19 infections and ongoing supply bottlenecks could weigh on the recovery.”

More tapering next month with rate hikes in 2022

The case for further QE tapering is strong despite the Covid-19 uncertainty. As elsewhere, supply chain issues, higher energy costs and re-opening challenges mean inflation is likely to stay elevated for quite some time. With employment levels just 1% lower than February 2020, wage and inflation expectations may push higher, which means annual CPI rates could linger at around 4% for a while, double the BoC’s target.

Vaccination rates are also looking strong, with 67.6% of the population fully vaccinated and an additional 6.3% partially, hopefully limiting the upside for hospitalizations. Consequently, this will allow the economy to remain largely open even if case numbers continue to rise.

The economy is also receiving ongoing fiscal support with stimulus checks still being paid. In an environment where inflation is already above target, and Canada’s booming housing market (prices are up around 25% since the start of the pandemic) is leading to fears surrounding financial stability, there is still a strong case for dialling back the stimulus again on October 27th. Most favour QE being reduced to $1bn per week at that policy meeting and expect the BoC to start raising interest rates late next year with two rate hikes pencilled in before the end of 2022.

CAD - Canadian Dollar forecast

Political uncertainty was one of the factors contributing to CAD’s underperformance lately and may well limit any ability of the loonie to stage a solid recovery if other factors improve. At the same time, that CAD is trading quite cheaply according to short-term fair value models. This suggests that most of the negatives are in the price and dissipation in political risk combined with the Bank of Canada stepping in with more tapering in October may see some CAD strength with most expecting USD/CAD to consistently trade well below 1.25 in 4Q21.

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