📝 Policy Divergence Pressuring Canadian Dollar: RBC

The BoC has kept pace with (and even led) the Fed this tightening cycle, with markets pricing similar terminal policy rates for much of this year. But expectations began to diverge in the past month amid differing trends in inflation and jobs data, and following the Fed's surprisingly hawkish dot plot in September. The fed funds rate is now seen peaking nearly 50 bps above the BoC's overnight rate. That would be well within histori-cal patterns—the Fed hiked an additional 50 to 100 bps in each of the past three tighten-ing cycles.

Canada-US bond spreads have tightened significantly with more attractive yields in the US contributing to a weaker Canadian dollar against the greenback. Indeed, the Canadian dollar fell below the 76 US cent mark in September for the first time since 2020 and continued to sink from there, dropping to 73 cents by the end of the month. It remains the case—as we pointed out last month—that the Canadian dollar is up against all other G 10 currencies year-to-date. So while the Canadian dollar is down more than 7% this year relative to the US dollar, it's only 2% lower on a trade weighted basis. A weaker currency represents an easing in financial conditions—supporting exports and lifting import prices and inflation—which the BoC might see conflicting with its objec-tives to tighten policy and slow growth and inflation.

We continue to assume the BoC will dial back the pace of rate hikes with a 50 by increase later this month. But the Fed's hawkisluiess and the currency's weakness keep a 75 by increase on the table, and any upside surprise in key inflation and inflation expectations data between now and October 26th could tip the scales in favour of a larger move. - RBC