• Canadian CPI could further strengthen

• Bank of Canada prioritizes inflation over growth

• Loonie could show temporary reaction

BoC sees no rate cuts in sight

The Bank of Canada (BoC) kept interest rates unchanged at 5.0% earlier this month, making investors think that the tightening cycle has probably run its course.

While futures markets expect interest rates to remain stable for the next year, a few investors believe that the central bank could either increase or decrease borrowing costs during that period.

Bank of Canada governor Tiff Macklem argued against the case of rate cuts, saying that even if the 2.0% midpoint inflation target is achieved, interest rates will not return to the historic lows observed after the 2008 financial crisis. Moreover, he accompanied the pause in interest rates with a hawkish message that additional rate hikes will remain on the table as the fight against inflation is still in progress. Hence, it might be too early to consider rate cuts for now.

Inflation might extend its rebound in August

Following a rebound in the US headline CPI today, a similar outcome could be possible in Canada given the rising oil prices. Gas prices could follow suit, challenging indebted households at a time when the economy is stagnating. A falling housing investment, which was led by a drop in construction, and a decrease in exports and household spending were behind the stagnation in the second quarter. In addition, although jobs growth was relatively stronger in August, the Canadian labor market has been overall too volatile for more than a year now, showing no clear trend.

Choosing between growth and inflation 

The BoC governor defines recession as a condition with a large unemployment rate and a substantial drop in output, which is not the condition of the economy at the moment. Therefore, choosing between inflation or growth, the central bank will probably prioritize the former again during its next policy meeting in October, although compared to other major central banks, the BoC is relatively closer to its target range of 1-3%. Perhaps a slowing economy might be considered part of the inflation treatment.

How will the loonie react?

As regards the market reaction, a US-like positive surprise in Canadian CPI readings could temporarily boost the loonie. Futures markets are currently pricing in steady rates with 80% probability for October’s policy meeting and unless the data beats estimates by a large margin, investors may not change their projections. Besides, there will be another CPI and employment release before its next gathering, suggesting that investors may wait for more evidence before adjusting their rate forecasts. If Canada’s 10-year government bond yield faces a temporary increase as the US bond experienced after the US CPI release, the loonie may post only short-lived gains.

From a technical perspective USD/CAD is still standing resilient around the 23.6% Fibonacci retracement of the latest upleg at 1.3550 for the second day. Hence, although Tuesday’s close below the 20-day simple moving average (SMA) raised downside risks, the bears will have to breach that floor to drive towards the 1.3500 round level. The 200-day SMA could be another important pivot point at 1.3460.

Alternatively, if CPI readings miss expectations, boosting the pair above the 20-day SMA at 1.3575, some consolidation could develop near the 1.3640 resistance zone. Then, the pair will attempt to push above the 1.3700 area with scope to reach the 2020 descending trendline.