Trade of the Week: Bank of Canada Rate Hike May Boost Canadian Dollar

Notice how the CAD has a year-to-date climb versus most of its G10 peers, except for safe haven currencies such as the Japanese Yen and the Swiss Franc.

Go further back to the end of 2020 and you’ll also find that the CAD is the sole G10 currency that has advanced against the greenback since.

Why has CAD been outperforming?

1. Oil’s surge

Canada is the world’s fourth-largest oil producer and has the world’s third-largest crude reserves. The oil and gas sector accounts for about 5% of the economy, with the commodity being Canada’s largest export.

In short, Canada is reliant on oil. Hence, oil prices have a major impact on the loonie.

Considering oil’s rip-roaring 13% surge so far in 2022 (adding to last year’s 50% climb) that has helped boost CAD’s allure

2. Higher yields

Yields are the calculation of earnings from an investment. And Canadian bonds are now offering higher yields than their counterparts in the US, Europe, and Japan. These higher yields suggest that investors would be more inclined to park their money in Canadian assets over those in other developed markets.

Such heightened demand also implies greater demand for the Canadian dollar, which in turn is offering support for the loonie.

3. Hawkish BoC outlook

Markets are giving a 72% chance that the Bank of Canada will raise interest rates on January 27th, which would mark its first since the pandemic. Inflation in December hit 4.8% which was its highest reading since 1991. Raising interest rates is a primary way that a central bank can help subdue consumer prices.

Note that markets are also forecasting six rate hikes by the BoC before 2022 is over. That is more than the Fed and the Bank of England, who are both expected to hike 4 times respectively this year.

Overall, such ‘hawkish’ expectations have been fueling CAD’s strength in recent months, while also offering the rationale for those higher yields mentioned earlier.

However, not everyone agrees that a BoC hike this week is a foregone conclusion.

Two-thirds of economists surveyed by Bloomberg think that the Bank of Canada’s Overnight Lending Rate will remain at 0.25% this month. In fact, last Tuesday, markets had priced in an 82% chance of a January rate hike, only to pare back such bets down to 72% at the time of writing (hence the recent recovery in USDCAD).

USD/CAD daily chart

In short, the BoC has to deliver on a hike this week to give USDCAD a chance of revisiting its 200-day simple moving average (SMA) as a key support level. That support region is also strengthened by the presence of the currency pair’s 50% Fibonacci retracement level from its June-December 2021 advance.

However, if the BoC disappoints some segments of the markets and keeps rates lower for a while more, that could see USDCAD testing its 50-day SMA for immediate resistance, with stronger resistance set to arrive around the 23.6% retracement line.

BoC vs. ECB to keep EURCAD’s downtrend intact

Compared against the likes of the European Central Bank, which remains far from raising its own interest rates, the BoC appears to be much further ahead in the path towards restoring policy settings to pre-pandemic levels

This diverging outlook has been a key driver of EURCAD’s downtrend over the course of 2021, aided further by the stellar gains in oil prices.

The unwinding of hawkish BoC bets has translated into a slight pullback for EURCAD in recent sessions, even as the pair recovers from oversold conditions after having broken below its lower Bollinger band and touching its lowest levels since April 2017.

Still, EURCAD is not expected to see significant gains in the weeks and months ahead, barring a dovish surprise out of the Bank of Canada this week.

EUR/CAD daily chart

As long as hawkish BoC expectations remain intact, depending on the mid-week meeting’s outcome, and with oil prices set to explore further upside, then the Canadian dollar could still see more gains against most of its G10 peers in the near future.

By Han Tan Chief Market Analyst at Exinity Group

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