With the Bank of Canada gearing up for its final interest rate decision of 2024, experts warn the flagging Canadian dollar could well have further to fall if the central bank delivers the sizeable cut that markets expect.
The Bank of Canada is widely expected to lower its benchmark interest rate, currently sitting at 3.75 per cent, in a fifth consecutive decision on Wednesday.
But how steeply the central bank cuts is still up for debate, with markets and many economists now arguing for a larger, 50-basis-point cut, matching the drop seen in October.
Money markets raised odds of an oversized step to 80 per cent after Friday’s November jobs report showed a larger-than-expected jump in the unemployment rate to 6.8 per cent last month.
The weak employment figures were enough for BMO to shift its own call for Wednesday’s rate decision, with economists at the bank now expecting a half-point cut rather than the typical 25 basis points. TD Bank is the lone big Canadian bank calling for a quarter-point cut this week.
But Friday’s jobs report also had a dampening effect on Canada’s dollar.
The Canadian dollar lost roughly half a cent compared to the American greenback on Friday, continuing what has been a dismal few months for the loonie.
As of late Monday, the loonie stood at around 70.5 cents to the U.S. dollar, around four cents lower than where it stood in late September. The Canadian currency is floating just above 4.5-year lows compared to its U.S. counterpart.
Among the factors experts have offered to explain the loonie’s decline are the re-election of Donald Trump and the president-elect’s protectionist trade policies.
But Nathan Janzen, assistant chief economist at RBC, points to a divergence in the policy rates between the Canadian and American central banks as the prevailing headwind for the loonie.
And he sees that gap widening in the months to come.
“That will tend to put downward pressure on the value of the Canadian dollar versus the U.S. dollar,” he told Global News.
The Bank of Canada has so far delivered 1.25 percentage points of interest rate cuts since kicking off its easing cycle in June, among the fastest and earliest rate cutters among central banks globally.
Get weekly money news
Get expert insights, Q&A on markets, housing, inflation, and personal finance information delivered to you every Saturday.
While the U.S. Federal Reserve made a splash with its first cut of half a percentage point in September, the central bank south of the border has already slowed its pace with a 25-basis-point drop last month.
The reason why the Bank of Canada has had to cut more sharply is because of more pronounced weakness in the Canadian economy, while the U.S. economic engine is holding firm, Janzen explains.
In addition to the soft November jobs report, recent data has shown the Canadian economy undershot the Bank of Canada’s expectations in the third quarter of the year. While price pressures have shown a bit of stickiness lately, that economic weakness is expected to keep providing disinflationary pressure across the Canadian economy.
“That does warrant a more aggressive Bank of Canada than the U.S. Federal Reserve in terms of additional rate cuts,” Janzen says.
A weak loonie has a slew of consequences for Canadians. Not only do Canadian travellers face more costly trips through the U.S. with their dollar not stretching as far as it used to, but at home, goods imported from the U.S. will be pricier for businesses.
Even BMO, which upped its call for a larger cut last week, warned in a note to clients on Friday that there are risks tied to the Canadian dollar from a 50-basis-point cut that “should not be ignored.”
Benjamin Reitzes, BMO’s director of Canadian rates and macro strategist, wrote that if the loonie were to be “hammered” by a steep rate cut, consumers would feel it quickly at the grocery store.
“Groceries, which are a particularly sensitive spot for Canadians, would see almost immediate pressure as winter drives increased imports of fresh food,” Reitzes wrote.
Because of the pressure on imports, a weak Canadian dollar can put some fuel into inflation — putting the Bank of Canada’s inflation-fighting progress at risk if the exchange rate continues to falter.
“The potential impact on inflation and inflation expectations should not be overlooked,” Reites wrote. “And, be warned, if C$ depreciation gains momentum, it might be hard to stop.”
Will a weak loonie hold back the Bank of Canada?
Bank of Canada governor Tiff Macklem has said in the past that, while the central bank sets monetary policy for the Canadian economy independent of other jurisdictions, there is a “limit” to how much policy rates can diverge from the U.S. Fed because of this relationship.
“We know that when the Canadian dollar gets weaker, the cost of imports rises, which can cause higher prices for consumers, which is at odds with the Bank of Canada’s policy goal,” Janzen says.
But Janzen does not expect the Bank of Canada will be cowed from delivering a larger, 50-basis-point cut on Wednesday amid fears for the loonie.
Out of the entire consumer spending basket, he says that only around 10 per cent of the typical Canadian’s expenses account for imported goods, excluding motor vehicles. The rest of that spending is largely based around services, including shelter.
Janzen says that with the remaining 90 per cent of the typical basket still facing significant disinflation from Canada’s cooling economy, the central bank will likely tolerate some uptick in pressure from the relatively small proportion of imported goods on Canadian budgets.
In other words, a weak loonie is not yet putting the Bank of Canada’s inflation-fighting mandate at risk, Janzen argues.
While markets have effectively priced in a 50-basis-point cut from the Bank of Canada on Wednesday, Janzen expects that the loonie will not fall much farther this week if the central bank delivers that expected drop.
But he also believes markets are underestimating how much more divergence is in the cards between the Bank of Canada and the U.S. Fed in the months to come, with the latter likely to halt its easing cycle earlier amid continued economic strength south of the border.
That means the loonie likely has further to fall in 2025, according to Janzen.
There’s a silver lining to the Bank of Canada’s earlier start in the easing cycle, which is that the forecast recovery could be closer on the horizon, he adds.
RBC sees the Canadian economy rebounding in the second half of 2025 as the lagged impacts of previous interest rate cuts start to deliver some relief to consumers and businesses. Janzen does note that ongoing “uncertainty” around U.S. trade policy is likely to have further implications for the exchange rate between the two currencies.
But once the Bank of Canada’s policy rate hits its neutral levels and the gap with the U.S. Fed’s rates stops widening, he sees better days ahead for the Canadian dollar.