Photo by Michelle Spollen on Unsplash

The last month has not been kind to the Canadian dollar as a variety of different domestic and international developments combined to weaken the loonie. Since the start of 2024, the USD/CAD has appreciated by 7.5%. Worried Canadians travellers, especially at this time of year, and portfolio managers alike have seen the floor drop out from under the loonie. The currencyvolatility has increased and has shed its customary stability. What lies behind this nervousness? 

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Interest rate differentials. The primary force behind the CAD decline is the very wide interest rate differential between the two countries. The BoC’s policy rate sits at 3.25%, after its second successive 50 bps cut in December. The central bank indicates that it will continue its downward path, although with future rates cuts of ¼ %. Canadian banks have adopted a prime rate of 5.45% in response to the latest BoC moves. The Fed just set its Fed funds rate at 4.25%-4.5%. More significantly, US prime rate remains relatively high at 7.75%. 

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The BoC has moved aggressively in response to slower growth and a rising unemployment rate. Moreover, November’s CPI clocked in at 1.9%, not only below target, but a continuation of several months of disinflationary conditions. On a purely macro level, the BoC was justified in taking this pro-active stance.

 The most recent Fed deliberations suggest that it was no hurry to lower rates in 2025, signalling to the markets It is concerned with inflation continuing above the 2% target.Nonetheless, the widening interest differential leaves the CAD is a somewhat vulnerable position should the two economies continue to experience different rates of inflation and growth performance.

No G-7 country has cut its rate more than Canada----175 bps in total. And, the BoC has signalled that it is headed towards further cuts on the way to a rate of 2.75% by year- end 2025. Should the Fed move reluctantly as the BoC reaches the 2.75% target rate, the CAD could depreciate even further. 

US tariff threats. President-elect Trump has made it widely know that he indicates to use tariffs as a means to change the patterns of North American trade and immigration flows. Promising to hit Canada with an across-the-board 25% tariff, the incoming US administration has introduced further anxiety amongst currency traders.Tradershave attachedas much as2% risk premium, over and above the market factors such as interest rate differentials and lower commodities prices. Canadians recall in 2018 Trump introduced protectionist threats, but virtually nothing much came of the changes to the North American free trade environment. However, this time around Canadian authorities at the federal and provincial levels view these threats more seriously.

 Political turmoil. Finance minster Freeland resigned just hours before she was to deliver the Fall Economic Statement. Her resignation and the revelation that the federal deficit has ballooned to C$62bn from its original forecast of C$40bn resulted in calls for Prime Minister Trudeau’s resignation and an early election. For those familiar with Canadian politics, this comes as no surprise since the PM and his Liberal Party are about 20 points behind the Conservative party in every national poll. At the time of writing, the PM is under great pressure to resign and many anticipate that decision early in the new year before Parliament resumes in late January. While the outcome of this crisis is far from clear, the CAD will be traded under a cloud of political uncertainty.

In sum, the CAD is in the midst of a perfect storm due to political and economic conditions and will experience unusual volatility until it reaches calmer waters.

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