BoC cautious on economic weakness and inflation slowdown

On Wednesday, the Bank of Canada (BoC) further relaxed its monetary policy by lowering its key interest rate by 25 basis points to 4.25%. This reduction marks the third consecutive rate cut, positioning the BoC as the first central bank among the Group of Seven (G7) countries to undertake a series of rate cuts of this nature. The last instance of the BoC implementing three consecutive rate reductions was during the global financial crisis in 2009.

Yesterday’s decision was made in light of inflation seeming to be cooling off. However, BoC’s officials have also indicated worries about the weakening Canadian economy and housing market affordability.

Canada's inflationary pressures ease significantly

Although inflation remains slightly above the Bank of Canada's target of 2%, the pace of growth has been modest for several quarters. Canada's inflation rate, as measured by the Consumer Price Index (CPI), reached a 40-month low of 2.5% in July 2024.

The July figures confirm expectations of a continued slowdown, with the BoC’s preferred measures of core inflation also averaging around 2.5%. Additionally, the proportion of CPI components growing above 3% has returned to its historical average.

Despite the overall slowdown, high shelter costs continue to be a significant driver of inflation, although this pressure is beginning to ease. Inflationary pressures also persist in some other service sectors, indicating that while progress is being made, certain areas of the economy are still experiencing elevated price growth.

Canadian growth could be slowing down

In recent months, Canada's economic growth has shown notable fluctuations, reflecting a mix of resilience and emerging challenges. In the second quarter of 2024, the economy expanded at an annualised rate of 2.1%, exceeding the Bank of Canada's July projection of 1.5%.

This growth was primarily driven by increased government spending and robust business investment. The stronger-than-expected performance in the second quarter follows a 1.8% growth in the first quarter, resulting in an overall economic expansion of approximately 2% for the first half of the year. This marks a significant rebound from the near-zero growth experienced in the latter half of 2023.

However, despite this positive momentum, recent data suggests some underlying weaknesses.

Preliminary indicators point to softer economic activity in June and July, indicating that the pace of growth may be losing steam as we move into the latter half of the year.

Additionally, the labour market, which has been a key driver of economic strength, is showing signs of deceleration. Employment growth has stagnated, with little change observed in recent months, although wage growth continues to outpace productivity gains. The Canadian unemployment rate is at 6.4% in July 2024 for the second month in a row, not far from its highest level of 6.5% of January 2022. Since January 2024, the unemployment rate has increased 0.7 percentage points.

The BoC's July forecast anticipated further strengthening in economic growth for the second half of 2024, with a 3rd quarter annualised growth of 2.8%. However, the recent slowdown in economic activity and the stalling of employment gains introduce some downside risks to this optimistic outlook.

As such, while Canada’s economy has demonstrated robust growth in the first half of 2024, the potential for continued expansion may be tempered by emerging signs of softness in key economic indicators.

High interest rates have stifled the Canadian housing market

The Canadian housing market has shown little sign of significant improvement in recent months, despite a series of interest rate cuts. Even with expectations for further rate reductions, home prices are projected to see only minimal growth in the near future. According to August Reuters’ forecasts, prices will rise by just 2.8% in 2025 and 3.0% in 2026, reflecting the persistent challenges within the market.

During the COVID-19 pandemic, home prices in Canada soared nearly 55%, but since reaching a peak in early 2022, they have only declined by 14%. This modest decrease occurred despite the Bank of Canada raising interest rates by 475 basis points through July 2023. As a result, housing affordability remains highly constrained, with the BoC’s own index indicating that affordability is near its worst levels since 1990.

Two recent 25-basis-point rate cuts, coupled with expectations of additional reductions later this year and into 2025, have not sparked a significant rebound in demand. Although there are some signs of improved housing supply, these have not been enough to counterbalance the market's sluggishness. The failure of interest rate cuts to significantly boost the housing market suggests that the underlying issues, such as stretched affordability, continue to weigh heavily on potential buyers.

Will the USD/CAD keep falling?

The Bank of Canada's rate cut comes a week before the US Federal Reserve’s meeting of September 18. Expectations that the Fed will lower its key interest rates for the first time since 2020 at its upcoming meeting are growing.

This potential Fed rate cut could significantly influence the USD/CAD currency pair, particularly if the Fed's accompanying rhetoric suggests a more dovish (or hawkish) stance.

While much of the anticipated Fed rate cut has already been priced into the market, a surprising speech or outlook from the Fed could trigger increased volatility in the USD/CAD pair. Such a development could disrupt the current supply and demand imbalances in the currency market.

Source: USD/CAD Daily Chart on TradingView with ActivTrades’ data

The daily chart of the USD/CAD pair from Wednesday 4 September shows that the pair lost around 0.20% on the day of the BoC’s monetary policy decision, after 6 bullish days. A week ago, prices rebounded from the lower band of the Bollinger Bands indicator, but they are still below the moving average. The Relative Strength Index (RSI) has been moving upward since prices bounced back, but they are still under the neutral level of 50.

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