USD/CAD Set for Further Surge Amid BOC Rate Cut and US Trade Tensions

The Bank of Canada (BOC) made headlines yesterday by reducing its policy rate by 25 basis points, bringing it to 3.00%. This move was in line with widespread market expectations, though there were additional tweaks to the BOC’s monetary policy framework that have drawn attention. These changes are largely technical, but they signal important shifts that could affect the Canadian dollar’s performance against the U.S. dollar.

BOC’s Policy Adjustments: Balancing Act Between Easing and Growth

The BOC announced two key policy modifications that will impact its future monetary strategy. First, the bank will halt its quantitative tightening program and begin asset purchases in early March, marking a shift in how it manages its balance sheet. Second, the deposit rate will now be set at 5bps below the policy rate, a technical move aimed at alleviating upward pressure on the overnight rate relative to the policy rate in recent months. While these changes don’t dramatically alter the overall monetary policy stance, they do reflect a more dovish approach.

Despite these adjustments, the BOC emphasized that it may pause its rate cuts in the near future, especially with ongoing uncertainties in the global trade environment. The central bank warned that U.S. trade policy remains a significant risk to Canada’s economy, pointing to potential disruptions stemming from evolving U.S.-Canada relations.

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Economic Outlook: Moderated Growth, Inflation Control

In terms of economic forecasts, the BOC remains cautiously optimistic. The central bank anticipates GDP growth will rise above potential output in 2025 and 2026, supporting the case for a gradual return to higher growth rates. However, inflation is expected to remain near the 2% target over the projection horizon, which gives the BOC some flexibility in its policy decisions.

While the BOC’s decision to reduce the policy rate over the past few months has been substantial, the central bank dropped its earlier guidance on further easing. This signals that the BOC may hold off on further cuts for now, depending on how the economic landscape develops.

USD/CAD: Overvalued, but Still Room to Grow

Despite these shifts, market expectations are leaning toward more rate cuts from the BOC in the near term. Futures markets are pricing in almost 75bps of rate cuts over the next 12 months, which could bring the policy rate closer to 2.25%. This would place the rate at the lower end of the BOC’s neutral range, which is estimated between 2.25% and 3.25%.

BBH FX analysts believe that the current USD/CAD exchange rate is “extremely overvalued,” but they see room for further upside. The overshoot, they argue, could persist due to several factors:

1. Interest Rate Differentials: The divergent monetary policy paths of the U.S. Federal Reserve and the Bank of Canada will continue to drive the USD/CAD exchange rate higher. The Fed is unlikely to cut rates significantly in the short term, which gives the U.S. dollar an advantage over the Canadian dollar.
2. Trade Tensions: The possibility of an all-out trade war between the U.S. and Canada could create additional volatility in the exchange rate. With the Trump administration’s continued focus on lowering energy prices and renegotiating trade deals, there is a heightened risk of economic disruptions that could negatively affect the Canadian economy.
3. Global Risk Appetite: The broader global economic landscape, including geopolitical tensions and uncertainty surrounding global trade, is expected to influence investor behavior. A flight to safety could see the U.S. dollar appreciate further, putting additional pressure on the Canadian dollar.

Conclusion: A Risk-Filled Outlook for the CAD

In conclusion, while the Canadian dollar may appear overvalued at current levels, various economic and geopolitical factors suggest that the USD/CAD exchange rate could continue to rise. The BOC’s cautious approach to rate cuts, combined with ongoing trade uncertainties with the U.S., creates a challenging environment for the Canadian dollar. As a result, traders and investors may find that the current market dynamics provide more room for the USD to strengthen relative to the CAD, especially if the U.S. and Canada find themselves in a prolonged trade conflict.