Concerns over the Omicron wave led the Bank of Canada to delay raising rates in January. Those worries appear to have been misplaced with the national economy running at full steam and inflation at its highest level in 30 years. A 25 basis point rate hike is our call for next week’s meeting despite geopolitical jitters, but that may not be enough to lift the loonie.
Tightening to start with a movement of 25 basis points
Even after Russia invaded Ukraine, financial markets are fully pricing in a 25 basis point rate hike from the Bank of Canada (BoC), with speculation growing that this could prove to be a move. by 50 basis points next Wednesday. To us, 50 basis points seems unlikely given the global caution prompted by the Russian military assault on Ukraine, but there are certainly strong domestic arguments for a sustained tightening of monetary policy starting with a move of 25 basis points.
In January, the Bank of Canada admitted it was close to deciding whether to raise interest rates, but the uncertain economic impact of the Omicron variant held it back. They said this would “weigh on activity in the first quarter”, but suspected it would be “less severe than previous waves” of Covid and that economic growth would “rebound and remain robust over the projection horizon”.
The actual economic impact is expected to be marginal, with the number of Covid cases plummeting since the start of the year, while business and sentiment surveys have improved. The BoC has already admitted that the “economic slowdown” has now been “absorbed” and that “the labor market has tightened considerably”. In addition, inflation continues to climb and now stands at 5.1% for the headline CPI, the fastest rate in over 30 years.
Deputy Governor Tim Lane, speaking just over a week ago, warned that the Bank was “aware” of the risk that inflation could prove more persistent again. This, in turn, could require the BoC to be both “agile and, if necessary, forceful” in adjusting monetary policy “to deal with whatever situation arises.”
We continue to seek six total interest rate increases from the Bank of Canada this year
Given the increase in commodity prices in response to Russia’s military intervention, this will indeed be positive for the Canadian economy, which should further stimulate investment in this key sector. As a result, we continue to seek six total interest rate increases from the BoC this year, and three more in 2023. This would leave the policy rate at 2.5% by the end of next year, a level that he was last of all back in October 2008.
Source: Refinitiv, ING
FX: the 25 basis point rise is not enough to push the loonie up
Markets have been increasingly speculating on the idea of a 50bp rate hike by the BoC over the past week, with the overnight index swap (OIS) market currently pricing an implied probability above 50%. As noted above, this is not a remote possibility, but we expect a more cautious 25bps upside. Therefore, we expect some weakness in the Canadian dollar (CAD) following the Bank of Canada announcement, which could however be moderated by a hawkish forward message, which should cement market expectations another five to six increases by the end of the year.
The domestic drivers of most major currencies are currently playing a very secondary role as the Russia-Ukraine conflict continues to send shockwaves through all asset classes. The CAD is exposed to conflict via its high beta to global risk sentiment, but soaring oil prices and limited direct implications for Canada (unlike European countries) mean the CAD can better weather the Ukraine crisis than some of its peers (such as the Swedish krona, the Norwegian krone, the euro or the pound).
Read the original analysis: Bank of Canada to raise rates by 25 basis points as domestic pressures mount