Forex: USD/CAD: Scotiabank – Five criteria for Bank of Canada rate cut

on Jan 27, 2014
Updated: Oct 21, 2019

**, Monday 27 January:**

The Bank of Canada last week signalled its openness to rate cuts but analysts at Scotiabank think the market may be misquoting the odds of that event happening.
In a weekly note, Scotiabank’s vice-president of economics Derek Holt and Dov Zigler, financial market economist at the Toronto-based bank, outline what they believe are the five main pre-conditions for a rate cut by the BoC.

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First, the bank “needs to test its brought-forward theory of housing demand by seeing a weak Spring housing market”. The theory states that the resurgence in sales last Northern Hemisphere spring and summer was mainly an acceleration of future demand on concerns that mortgage rates would rise with the US moving away from easy-money policies. Canadian home sales have fallen for three straight months but Scotiabank’s economists note that volumes are historically light at this time of year and believe that the big test remains the coming Spring’s data, “when Canada comes out of hibernation”.

As they put it: “Cutting before the Spring housing market data runs the risk of looking either brilliant if housing stumbles or mistimed and likely to draw political heat if housing rips. Conservative central bank cultures don’t tend to like such politically charged binary risks.”
At that point, the BoC would be looking for further evidence that inflation has stalled below its target, as the second critical pre-condition for a rate cut. Even though headline inflation as measured by the Consumer Price Index inched up in December to 1.2 percent y/y from November’s 0.9 percent, Scotiabank isn’t very hopeful of a trend, preferring to think that year-on-year CPI will slip back below one percent when the February figures are released after a brief spell above the lower band of the BoC’s target.

Although depreciation of the loonie is likely welcomed by the BoC at this point, Scotiabank notes that additional devaluation of the local dollar will potentially stoke inflation through import prices. In essence, “a further uncontrolled freefall in the currency would negate cut risk”, write Holt and Zigler.

Their fourth prerequisite for a cut is that the BoC will also want to see weak exports figures persisting before making the move.
Finally, the Scotiabank economists emphasize that “the BoC will also be mindful of the unfolding risks across emerging markets and the potential commodity implications such that its base case assumption of an improving global economy would perhaps also have to be disappointed”.
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The above chart shows the currently imputed market-assessed probabilities for rate cuts at each of the upcoming BoC meetings this year. As of 24 January, markets are assigning about a nine percent chance of a March cut, with the odds rocketing to 55 percent for a cut in October, seemingly the base case scenario for the markets.
Scotiabank’s economists think that by “June or July we’ll have a much firmer feel for whether the BoC is in cut mode” and conclude that “pricing is a bit light on June/July BoC cut risks and relatively heavy on September/October cut risks”.


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