Will the Canadian dollar's reaction to BOC cuts reveal future U.S. economic trends and market direction?
By:Ilya Spivak
The Bank of Canada (BOC) is expected to deliver the equivalent of three 25-basis-point (bps) rate cuts over its remaining two meetings in 2024. That breaks down to 50bps priced in for this week’s rate decision, followed by 25bps more in December. The outsized move follows a sharp drop in inflation amid an ongoing economic slump.
The headline consumer price index (CPI) measure of price growth fell to 1.6% year-on-year in September, the lowest since February 2021. Meanwhile, the latest purchasing managers index (PMI) data from S&P Global showed that economic activity shrank for a fourth consecutive month in September. The pace of contraction accelerated to boot.
This stands in stark contrast to what’s happening south of Canada’s border in the United States. Analog purchasing managers’ index (PMI) data shows the pace of economic activity growth jumped to a 12-month high in May and has hovered within a hair of that level for the subsequent four months.
The critical difference-maker seems to be the service sector, which is driving growth in the U.S., while manufacturing is struggling. The tables turn in Canada. Its services firms depend on domestic demand, which is anemic. Manufacturers enjoyed a U.S. goods-buying spree amid the COVID-19 outbreak, but that has stalled.
Canadian consumers’ appetites are cool because interest rate hikes to combat post-pandemic inflation hit them relatively harder. At nearly 102%, their household debt levels as a share of gross domestic product (GDP) are higher than in the U.S., the Eurozone, the U.K. and Japan.
Meanwhile, Canada’s government is stingier with offsetting fiscal policy. Its debt to gross domestic product (GDP) ratio fell to 104% in 2023, according to an estimate from the International Monetary Fund (IMF). That would be a fourth year of decline from a peak of 118% in 2020. By contrast, the ratio was down to 122% in the U.S. last year, from 126% three years before.
With that in mind, traders will be keen to see the BOC’s updated economic forecasts to gauge which way the two economies might recouple. U.S. strength may begin to spill over into Canada again as demand for goods rebounds closer to historical norms. It now appears to lag services by the most in nearly two decades.
On the other hand, Canada might make for a cautionary tale. The U.S. is yet to experience the brunt of the rate hike cycle. In fact, its firms have spent less—not more—on credit costs even as the Federal Reserve has hiked rates, cushioned by cheap money stored up during the pandemic. A jump in refinancing rates on this debt is fast-approaching.
The Canadian dollar may help decipher which way the markets lean after the BOC announcement. If it drops despite an already dovish outlook, that might speak to a grim view of external demand, which could be a warning about what awaits the U.S. downwind. Alternatively, a rise may be a nod to the return of joint prosperity.
Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak
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