Diverging outlook on interest rates could support USD/CAD

USD/CAD remains in a short and medium-term uptrend despite the negative spillover effect from Oil prices.

The reason for this is the diverging outlook on the future path of interest rates in the US and Canada. Interest rates are a key FX driver because global capital tends to flow to where interest rates are higher all other things being equal. 

This has supported the US Dollar most recently during its early April rally and provided a bullish backwind for USD/CAD. 

Interest rates in Canada are expected to fall in the summer amid declining inflation and slower growth but the reverse is increasingly the case in the US. 

In the US stronger macroeconomic data, persistently high inflation and a tight labor market are seen as factors likely to keep interest rates comparatively higher for longer. 

From expecting three 0.25% rate cuts in 2024 at the start of the year when inflation was tracking lower, the Federal Reserve is now indicating it may only cut twice or perhaps once. Some Federal Reserve officials are even signaling that the central bank should keep interest rates at their present level until more evidence of inflation coming down is available. 

Market based indicators of the number of rate cuts have also changed radically with odds now showing the most likely month for the Fed to implement a first rate cut is September, when previously expectations had been zeroed in on June. 

The situation in Canada is very different. There, inflation is still tracking lower and the probability of the Bank of Canada (BoC) cutting interest rates by 0.25% in June stands at 70%, according to analysts at Brown Brothers Harriman. 

Indeed, on Tuesday, BoC governor Tiff Macklem stated, “there’s some downward momentum in underlying inflation.” 

Canadian Consumer Price Index (CPI) data backs this up. Whilst headline inflation crept higher in March – to 2.9% from 2.8% it remains below the BoC's 3.0% target. In addition, the main drivers were rising gasoline prices and the rising US mortgage rates used by many Canadian property owners, according to Tradingeconomics.com. 

Both the core-trim and core-median measures of the Consumer Price Index (CPI), however, showed signs of easing – to 3.1% (the lowest since June 2021) and 2.8% (matching the July 2021 low), respectively – according to BBH.