CAD shouldn’t be a barrier to BoC hikes – Scotiabank

According to Derek Holt, VP & Head of Capital Markets Economics at Scotiabank, a key issue that has emerged concerning the BoC outlook is whether the Canadian dollar (CAD) is too strong to justify a hike in the context of the 5% appreciation in the CAD versus the USD since it began moving after May 4th.

Key quotes

“Obviously there are limits to tolerating exchange rate movements—and a risk to is that of sharply overshooting the arguments—but there are at least five reasons why one should not be so concerned about CAD movements to date—and arguably perhaps quite a bit further from here.”

“Inflation pass-through is what matters most

The level of USDCAD today versus a year ago has changed very little which may suggest no lasting effect of currency movements to date on core CPI.”

“CAD is still arguably at emergency levels of stimulus

The currency should be weaker given still-soft commodity prices, but if the worst effects of the commodity price plunge have worked through the economy, then CAD is still accommodative at the point when spare capacity is closed. Risks to trade should be evaluated in terms of net export volumes (net of imports) and the currency has been working favourably on net exports around present exchange rate levels.”

“It’s why the currency has appreciated that matters

The BoC has long moved away from its old ways of looking at good versus bad types of currency moves through approaches like “type 1 and type 2” forms of currency movements or the even older monetary conditions index that attempted to crudely weight the equivalence of rate and currency movements without exploring why currencies were moving. Abandoning these approaches was therefore done for good reasons, but the notion that why a currency moves should be considered is still generally valid.”

“The BoC does not look at currency risk just in terms of USDCAD

Going forward, if markets are wrong in doubting the Fed’s resolve to keep hiking, then that could limit further depreciation in CAD versus the USD. Further, it is not just how CAD relates to the USD that matters; it is also how it moves relative to a variety of other crosses in countries where several of the central banks are either guiding potential rate hikes (BoE), still hiking (Mexico) or approaching a more balanced outlook (ECB). In short, the BoC can have more comfort in hiking if other central banks are either stabilizing or moving with it on the bias going forward.”

“Broader financial conditions

The BoC stopped publishing its financial conditions index, but it is still a valid point to say that much more than just the currency affects broad financial market conditions. Bloomberg’s high yield debt index is at an all-time high. Investment grade corporate spreads are favourable. While the TSX has fallen this year, it remains close to where it was by mid-2014 before commodities fell and 28% higher than the trough in early 2016.”

“What, me worry? Nah

If it’s a worry, then Governor Poloz had several opportunities to flag it directly (unlikely, as the BoC may prefer a more opaque approach relative to, say, the RBA) or indirectly by adopting a more cautious tone, but he did not.”