The Bank of Canada (BoC) has completed a 180-degree turn from its goldilocks outlook on inflation from seven months ago. In its October Monetary Policy Report, the BoC lamented that “progress to the 2% [inflation] target is slow.” Governor Tiff Macklem’s opening statement for the accompanying press conference displayed a healthy amount of concern about inflationary pressures (emphasis mine): “further easing in inflation is likely to be slow, and inflationary risks have increased.”

The Bank of Canada is worried about higher energy prices, “structural pressures” in the housing market primarily related to supply shortages (which it acknowledged must first be addressed on the supply side), and “persistence in underlying inflation.” This underlying inflation consists of elevated “near-term inflation expectations and wage growth” and corporate pricing decisions that are “normalizing only slowly.” Core inflation on a year-over-year basis has come down, but the 3-month view shows little downward momentum. Accordingly, the Bank of Canada put the country on notice that it is leaving the door open to future rate hikes because of the stubborn uncertainty in getting inflationary pressures down.

Yet, the BoC did not proceed with a rate hike. Counterbalances to the increased inflation risks remain. Overall supply and demand in the Canadian economy is almost in balance with the trend favoring excess supply. The BoC also downgraded its outlook for economic growth because the economy slowed more than expected back in July; less excess demand exists than expected.

So while the BoC hiked its expectation for inflation from 3% to 3.5% for next year, the central bank is sticking to its longer-run projection of 2% in 2025. Thus, Macklem felt confident in reassuring Canadians: “with clearer evidence that monetary policy is working, Governing Council’s collective judgment was that we could be patient and hold the policy rate at 5%.“ Interest rates will stay higher for longer and the inflation target remains in sight.

Corporate and Government Behavior Working Against Monetary Policy

Companies and Canadian governments in aggregate are not cooperating with the objectives of monetary policy.

Canadian companies are still passing along price increases to consumers faster than normal. From the Monetary Policy Report:

“Corporate pricing behaviour has yet to normalize. Businesses continue to increase prices more frequently and by a larger amount than normal… This may indicate that households and businesses are, respectively, expecting to pay more and charge more for goods and services. High inflation expectations could also feed into wages.”

I assume this dynamic also comes from lingering excess demand which makes consumers less price sensitive. The coming era of excess supply should work counter to this effect.

During the Q&A Macklem pointed out that the fiscal spending plans are working against monetary policy. Aggregate government plans will grow spending by 500 basis points greater than the potential growth of the Canadian economy. Thus, the economy will add more demand than supply. In the past year, growth in government spending was below 2%. Macklem indicated that it would be helpful if fiscal and monetary policy were “rowing together.” The BoC’s forecasts take into account the potential future inflationary pressure from government spending.

The Canadian Dollar Trade

The bump higher in hawkish rhetoric did not benefit the Canadian dollar, perhaps because the BoC maintained its longer-term expectation for inflation. Weakness in the currency Invesco CurrencyShares Canadian Dollar Trust (FXC) or strength in USD/CAD continued until the Federal Reserve’s last policy announcement. Financial markets painted a dovish interpretation to the accompanying news even though it read like nothing materially changed.

I did not expect the drift higher (with high volatility) in USD/CAD as I accumulated a short position. I continue to hold the position as I see two main factors working against my thesis reaching their own individual extremes.

The biggest shift against my original setup was a big increase in the spread on 10-year yields between U.S. and Canadian bonds. Just over a month ago this spread sat at a level that looked like a potential bottom. Shortly thereafter, the bottom dropped out. The spread was last this wide back in March, 2019. This large spread serves advantage to the U.S. dollar over the Canadian dollar. From World Government Bonds:

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Oil has also worked against my original thesis. Oil did not stabilize. While it soon spiked higher in response to Hamas’s attack on Israel, selling in oil resumed in about 10 days. Last week, the United States Oil Fund, LP (USO) hit a 3+ month low. While this decline should reduce the Bank of Canada’s fear that higher energy prices will bleed their way into pressures on core inflation, it also works against the Canadian dollar as a commodity currency. I have dropped any expectation on oil although I am net short USO. From TradingView.com:

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From a technical perspective, USD/CAD remains well-supported by its uptrending 50-day moving average (DMA) (the red line below). I still expect this uptrend to break to the downside as the extremes working against the Canadian dollar lose steam. To the upside on USD/CAD I have a clear stop loss point above the peak created by the reaction to the Federal Reserve’s November 1st announcement on monetary policy. From TradingView.com:

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Be careful out there!

More By This Author:

Why The Excitement? A Q&A On Monetary Policy With Generative AI
Opportunity Grows From A Triple Whammy Against The Canadian Dollar
A Stall In Canada’s Core Inflation Narrative