Interest rate differential and housing market dynamics driving CAD weakness

This report provides a fundamental analysis of the Canadian dollar (CAD), examining the key factors influencing its recent performance and potential trajectory over the next five weeks. The report covers fiscal policy, economic conditions, monetary policy, and relevant geopolitical and market themes, concluding with a synthesis of these factors and their implications for CAD forex traders.

Fiscal policy

Canada's fiscal policy is currently focused on addressing the housing crisis and supporting economic growth through investments in clean energy and innovation. The government's budget 2024 outlines a plan to build more affordable homes, make life more affordable for Canadians, and grow the economy in a way that benefits everyone.

Over the past five months, the government has implemented several fiscal measures aimed at stimulating the economy and addressing social challenges. These include:

The Affordable Housing and Groceries Act, which aims to make it less expensive to build new homes and enhance competition in the grocery sector.

The Canada Dental Care Plan, which provides dental coverage for uninsured Canadians.

Investments in clean energy and innovation, including major economic investment tax credits for clean technology and clean electricity.

In the next five weeks, the government is expected to continue implementing its fiscal plan, with a focus on delivering the remaining major economic investment tax credits and advancing its housing strategy.

The impact of fiscal policy on economic growth, economic indicators, monetary policy, and financial markets is significant.

The government's fiscal plan is expected to support economic growth through investments in infrastructure, clean energy, and innovation. However, the effectiveness of these measures will depend on factors such as the global economic outlook and the pace of private sector investment.

Fiscal policy can influence economic indicators such as employment, inflation, and trade. For example, the government's housing strategy could contribute to lower rent inflation if successful in increasing housing supply.

Economics

Canada's economic situation is characterised by moderating growth, easing inflation, and a tight labour market. The economy has been slowing in response to the Bank of Canada's interest rate hikes, but it has so far avoided a recession.

Economic growth

Canada's economic growth has slowed in recent months, but it remains positive. The Canadian economy expanded by 0.4% in the first quarter of 2024, accelerating from a flat reading in the previous period. However, this growth fell short of market expectations of a 2.2% increase.

Private sector forecasters expect GDP growth to remain moderate in the coming months, with Trading Economics projecting a 0.4% expansion in the second quarter of 2024. For forex traders, this suggests that the CAD is unlikely to receive significant support from strong economic growth data in the near term.

Labour

Canada's labour market remains tight, with low unemployment and solid wage growth. The employment in Canada rose by 90.4K in April 2024, the most in 15 months, and the unemployment rate held steady at 6.1%. Average hourly wages increased by 4.7% year-over-year in April.

While the labour market remains strong, there are signs that it is beginning to cool. Job vacancies have declined in recent months, and the unemployment rate is expected to rise slightly in the coming quarters. For forex traders, this suggests that the CAD may face some downward pressure from a softening labour market.

Price changes

Inflation in Canada has eased in recent months, but it remains above the Bank of Canada's 2% target. The annual inflation rate in Canada eased to 2.7% in April of 2024 from 2.9% in the earlier month.

Private sector forecasters expect inflation to continue to ease in the coming months, with Trading Economics projecting a 2.5% rate in the second quarter of 2024. For forex traders, this suggests that the CAD is unlikely to receive significant support from high inflation data in the near term.

Trade

Canada's trade balance has been volatile in recent months, affected by fluctuations in commodity prices and global demand. Canada recorded a trade deficit of CAD 2.3 billion in March of 2024, contrasting with a surplus of CAD 0.5 billion in February.

The outlook for Canada's trade balance is uncertain, with global economic conditions and commodity prices expected to remain volatile. For forex traders, this suggests that the CAD may be susceptible to swings in sentiment related to global trade developments.

Monetary policy

The Bank of Canada (BoC) began its rate-cutting cycle in June 2024, decreasing its key interest rate by 25 basis points to 4.75%. This move was widely anticipated and reflected ongoing disinflation and softer economic growth in Canada. The central bank signalled that more rate cuts are to be delivered should inflation continue to slow as expected.

The BoC's monetary policy has influenced and could continue to influence economic growth, economic indicators, and financial markets.

The BoC's interest rate hikes have contributed to a slowdown in economic growth. However, the recent rate cut suggests that the BoC is now prioritising supporting economic activity.

The BoC's policy has also influenced economic indicators such as inflation and employment. The recent rate cut could contribute to higher inflation and a tighter labour market if it stimulates economic activity.

The BoC's monetary policy has a significant impact on financial markets, particularly the CAD exchange rate. The recent rate cut has weakened the CAD, and further rate cuts could lead to further CAD weakness.

Geopolitics and market themes

Several geopolitical situations, market-moving events, and market themes could influence the CAD.

Bank of Canada commences rate-cutting cycle.

Synopsis: The Bank of Canada (BoC) commenced its rate-cutting cycle, decreasing its key interest rate by 25 basis points to 4.75%.

Market impact: This move was widely anticipated but has nonetheless weakened the CAD as the interest rate differential between the US and Canada widens.

Conclusion

Over the next five weeks, the CAD is likely to face downward pressure from the widening interest rate differential between the US and Canada. The BoC's signal that more rate cuts are likely if inflation continues to ease suggests that this differential could widen further.

The Canadian housing market also poses a risk to the CAD. While the government is taking steps to address the housing crisis, the high level of household debt and the potential for a correction in the housing market could weigh on the CAD.

For CAD forex traders, it will be crucial to closely monitor the BoC's monetary policy decisions, US economic data, and developments in the Canadian housing market. The potential for further BoC rate cuts and continued USD strength suggests that CAD weakness may persist in the near term.