Canadian growth shocker confirms central bank to pause
Canada experienced an unexpected decline in its economy during the second quarter. This decline was due to a significant decrease in consumer spending and a collapse in residential investment. Additionally, there has been a slowdown in the job market. As a result, the Bank of Canada's concerns about inflation should lessen, leading to the decision to keep things as they are on September 6th. However, the increase in the value of the US dollar compared to the Canadian dollar seems exaggerated, and we anticipate that there will be a correction in the near future.
Before the release of the latest data, most analysts predicted that there would be no change in interest rates. Only three out of 32 economists surveyed by Bloomberg expected a 0.25% increase, and overnight index swaps indicated that the market believed there was only a 15% probability of a hike. This prediction was made even though headline inflation exceeded expectations in July and the Bank of Canada (BoC) indicated in their July policy meeting that they still believed inflation would only reach 2% by mid-2025, leaving room for potential future rate increases.
The recent GDP data and manufacturing PMI numbers have further solidified the expectation that there will be no change. The market is now estimating a less than 1% chance of an increase after the economy declined by 0.2% in the second quarter, compared to expectations of a 1.2% growth. Additionally, the GDP growth in the first quarter was adjusted downward from 3.1% to 2.6%. Consumer spending only increased by 1%, while residential investment experienced a significant contraction of 8.2% for the fifth consecutive time. Net trade also had a negative impact, but there was some positive news with non-residential investment growing by 10.3%. On the other hand, the manufacturing PMI dropped from 49.6 to 48.0, marking the fourth consecutive sub-50 reading, indicating contraction.
Based on the fact that the economy lost jobs in July, we agree that the Bank of Canada (BoC) will not change interest rates this month. They had previously started raising rates in June and July after a break since January. However, the BoC is likely to keep rates unchanged in a way that suggests they are still concerned about inflation staying consistently at 2%. At the very least, we will hear that rates will remain higher for a longer period of time. But considering the unstable state of the Canadian housing market and signs of weakness spreading globally, we anticipate that rate cuts will be considered by March of next year.
The value of the US dollar in relation to the Canadian dollar has increased by 3% since the beginning of August, which is consistent with the overall strength of the US dollar. However, this increase is not in line with the short-term rate difference between the US dollar and the Canadian dollar. Despite the USD/CAD rate rising from 1.32 to 1.36 in the past month, the rate difference between the two currencies remained relatively stable at around -50/-40 basis points throughout August. It only tightened to around -30/-35 basis points after Canada's disappointing second-quarter GDP report.
Our brief assessment method, which considers the differences in swap rates as an internal variable, indicates that the USD/CAD currency pair is currently being traded at a value that is more than 2% higher than its actual worth. This level of mispricing is quite unusual for this particular pair. Interestingly, data from the CFTC reveals that speculators have recently shifted back towards a pessimistic stance on the Canadian dollar, with the total of their open positions now amounting to 9% in short positions.
We don't anticipate the Bank of Canada to change the situation for the Canadian dollar, but the recent decline in value seems excessive, and indicators show that a recovery is likely. Our prediction remains that the USD/CAD exchange rate will be around 1.30 by the end of the year, as the Canadian dollar should gain from having the best potential return with adjusted risk in the G10, without needing any additional interest rate increases from the Bank of Canada.
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