Loonie at risk of bigger drop as focus shifts to Bank of Canada

Canada’s dollar is at risk of extending its decline if the nation’s central bank confirms that policy rates there have basically topped out even as persistent inflation concerns put upward pressure on short-end yields in the U.S. 

With the U.S. currency resurgent in the past month, it could take a more-hawkish-than-expected message from Bank of Canada boss Tiff Macklem on Wednesday to really put a floor under the sliding loonie. That’s even more the case after U.S. central bank chief Jerome Powell used an appearance before Congress Tuesday to hammer home a hawkish message that bolstered the greenback. 

Swaps pricing for the Bank of Canada right now shows that one more hike at some point within the next few months is probable, but for the next couple of meetings at least they’re pointing to a pause. In contrast, markets linked to the Federal Reserve indicate another percentage-point of tightening from here.

The Canadian currency has fallen more than 3 per cent from its February peak and was trading around $1.375 per dollar on Tuesday. Nevertheless, its decline over the past month has been less dramatic than for commodity-related peers such as the Norwegian krone, the New Zealand dollar and the Australian dollar, which could provide scope for catchup. On the U.S. side of the equation, meanwhile, bets that the Federal Reserve will need to take its benchmark higher and stay there longer have solidified in recent weeks, widening the U.S.-Canadian differential.

“Central bank divergence is now the key driver of FX pairs,” said Bipan Rai, a currency strategist at Canadian Imperial Bank of Commerce. And in his view that puts the Canadian dollar, along with the Australian dollar, at risk because of their respective central banks.

Brad Bechtel, a New York-based foreign-exchange strategist at Jefferies, reckons the dollar-loonie pair could once again test 1.39, although the trajectory of the US currency is of key importance as to whether it can get there. He favors betting on a decline in the loonie versus its U.S. and Mexican peers, but is more upbeat about its prospects against the euro and yen.

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Market positioning on the Canadian currency appears to have grown more bearish since January when policy makers in Ottawa said they will likely halt further hikes following a series of tightening moves that’s seen their benchmark climb to 4.5 per cent from its longstanding low of 0.25 per cent in early 2022.

Open interest in Canadian dollar futures has jumped to levels last seen in 2021. Combined with the marked depreciation of the currency, that suggests the accumulation of a larger short position. Commodity Futures Trading Commission data ordinarily provides a lens into positioning also, but that is currently lagged by around a month due to problems with the data, so the view is somewhat murky there.

Meanwhile, both Canada and the U.S. will report on the state of their labor markets on Friday, giving potential hints for further policy moves.

In the view of CIBC’s Rai, strong numbers on U.S. job openings and employment this week have the potential to push the U.S.-Canadian dollar pair to somwehere between 1.38 and 1.40.

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