Bank of Canada Preview: Three CAD-shaking things to watch out for beyond the 50 bps hike

• The Bank of Canada is set to raise rates by 50 bps to 1%, and may signal two such moves.
• Reinvestment of principal from expiring bonds may end shortly, an active sell-off of bonds is eyed.
• Comments about the US Fed's policy and its impact on Canada are also critical.

Aggressive Canadians? That may sound like an oxymoron but after anti-lockdown protests in Ottawa, the Bank of Canada, based in the capital, may also take a tough stance against inflation. A 50 bps rate hike is on the table.

While that is double the standard increase in borrowing costs, markets have fully priced it in. The main reason is inflation, which has significantly risen in Canada. It isn't only volatile food and energy prices, but also Core CPI, which hit 4.8% YoY in March, and is off the charts.

Source: FXStreet

Apart from global supply-chain issues, another driver of price rises is the nation's record-low unemployment rate of 5.3%, better than pre-pandemic and the pre-2008 crisis era. The Canadian economy is on fire, similar to its larger neighbor to the south. Given this, the BOC is set to cool the economy and prevent it from overheating and suffering an inflationary spiral that would end in a recession.

As mentioned, Governor Tiff Macklem and his colleagues already signaled a 50 bps rate hike, which would be in line with the upcoming decision from the US Federal Reserve's parallel move. That is already priced into the Canadian dollar.

What is next? Here are three factors to watch out for.

1) A trio of 50 bps moves? 

One of the factors boosting the US dollar has been speculation about two back-to-back 50 bps hikes, in May and in June. For the BOC, it could turn into a series of three double-dose increases. If officials signal unease with inflation that warrants an interest rate of 2% before summer ends, it could boost the loonie.

At the moment, the second 50 bps move is still not a given, so there is room for the loonie to fall if the bank indicates that it will condition further increases to borrow costs according to developments. Focusing on Russia's war in Ukraine, for example, would indicate hesitation and could weigh on the loonie

2) Quantitative Tightening

Before embarking on raising interest rates, the Ottawa-based institution ended its bond-buying – and did so abruptly. The jump from buying C$2 billion per month worth of bonds to nothing sent the Canadian dollar higher at the time.

The BOC currently maintains its balance sheet stable – buying a new bond for each one that expires – but that may end as well. If Macklem only announces that it would allow a natural squeeze of its assets by letting bonds expire, the Canadian dollar would suffer. That would be seen as a cautious form of Quantitative Tightening (QT), the opposite of Quantitative Easing (QE). 

However, if he sets the stage for an active sell-off of Canadian government debt, it would mean pulling money out of markets and thus boosting the currency. It is the opposite of printing money.

3) The outlook, especially for America

While the Canadian dollar is seen as a commodity currency linked to oil, the local economy mostly depends on that of the US. Some 75% of exports go south of the border – and the BOC's monetary policy also tends to be tightly linked with that of the Federal Reserve. 

Comments about the roaring yet inflationary US economy will also have an impact on CAD's reaction. If Macklem sees ongoing growth and tighter Fed policy over the border, the local currency would rise in anticipation of a copycat aggressive monetary policy approach from the BOC moving forward. However, if he sees inflation as hamstringing America and monetary policy, the BOC would not want to be significantly more aggressive than its peer in Washington. 

Final thoughts

The BOC is set to raise rates to 1% and probably signal a more aggressive policy given high inflation and employment. However, this could be the peak. If the world slows down due to Russia's war or China's covid issues, the loonie could rise now, but fall in the coming months if the bank is forced to climb down.