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Loonie Weaker on Risk; Fed Interest Rate Ahead

Loonie Weaker on Risk; Fed Interest Rate Ahead

  • The CAD finished the week on the back foot. The drop reflects a larger comeback in the dollar amid signs of ongoing inflationary pressures, raising the prospect of the Fed appearing more hawkish at its policy meeting this week, potentially setting the stage for a more aggressive rate hike in the months ahead. Rising US yields have depressed equity markets, adding to the CAD's impact.

Canadian households over extended

  • The CAD had already slumped heavily in response to the Bank of Canada's Financial System Review before last Friday's US CPI data. Last week's FSR observed that rising interest rates could put a strain on household budgets and that the property market was weakening. Markets interpreted this as a negative for the CAD, but these flaws were exposed as the Bank of Canada raised interest rates to combat inflation. There is no reason to believe that overextended households or falling house prices will prevent the Bank from tightening policy further in the months ahead, as Governor Macklem stated following the release of the Review; "more forceful" policy settings—which he defined as "quicker, larger, or more persistent increases in interest rates—will be implemented.

Loonie remains coupled to market sentiment

  • To conclude the previous week, domestic data continues to be favorable, indicating that domestic GDP is expected to be reasonably high. Despite typically high commodity prices, terms of trade remain favorable. It's worth noting that spot is trading near to fair value estimates, implying that there's little room for CAD decline at the present. It should be highlighted that the CAD remains tethered to the risk backdrop, and strong fundamentals will be irrelevant if equity markets continue to collapse, as appears to be the case in the current scenario.

FOMC will be the highlight of the week

  • The FOMC meeting on Wednesday will take up the most of the week's agenda. A half-point increase in rates is generally predicted, and the USD has already been fully factored in. The crucial question is how the Fed portrays the outlook and responds to any inquiries about speeding up the size/scale of monetary tightening in reaction to higher-than-expected inflation. Chairman Powell is expected to stick to his narrative that suggests 50 basis point rate hikes are likely in June and July before reassessing future rate hikes. Markets are definitely expecting another 50-basis point Fed raise in September, but we should note that US data reports are generally showing lower-than-expected results, implying that US Q2 GDP growth would fall short of forecasts. Weaker data may heighten growth slowdown concerns and cause the Fed to temper rate future rate hikes.

USD/CAD extension over 1.28 seems highly likely in the days ahead.

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