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Economists Warn of Potential Decline in Canadian Dollar Amidst Diverging Interest Rates

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Amidst speculation of potential interest rate cuts by the Bank of Canada (BoC), economists caution that the Canadian dollar (CAD) could face significant downward pressure compared to the U.S. dollar (USD), especially if the Federal Reserve maintains a different trajectory.

Following remarks by BoC Governor Tiff Macklem indicating the possibility of a rate cut at the upcoming June meeting, the loonie experienced a notable decline against the USD. This trend, compounded by a robust American currency and the likelihood of a cautious Federal Reserve, suggests a challenging environment for the CAD.

Derek Holt, Vice President of Capital Markets Economics at Bank of Nova Scotia, underscores the interconnectedness between Canadian and U.S. monetary policies, highlighting the limited independence of the BoC from the Federal Reserve.

The CAD’s performance has been lackluster in 2024, experiencing a four percent decline since mid-December, despite a surge in oil prices. Economists Stefane Marion and Kyle Dahms from National Bank predict further depreciation of the loonie, with projections reaching as low as 70 cents USD by the fourth quarter.

The recent rise in U.S. inflation, surpassing analyst expectations, has tempered predictions of rate cuts by the Federal Reserve, further exacerbating the pressure on the BoC to take aggressive measures.

Benjamin Reitzes, Canadian Rates and Macro Strategist at BMO Capital Markets, outlines the challenges faced by the BoC in navigating diverging interest rates, emphasizing the risk of importing inflation through currency differentials.

While the BoC may opt for rate cuts independently, there are limits to how far policy rates can diverge before adverse effects on the currency become untenable. Royce Mendes, Managing Director at Desjardins Group, predicts a potential spread of up to 112.5 basis points between BoC and Fed rates during the easing cycle.

Market sentiment indicates a 50/50 chance of a June rate cut by the BoC, with expectations of only two additional cuts throughout the year. However, long-term concerns persist regarding Canada’s inflation and affordability challenges, which could further weigh on the loonie.

Jean-Francois Tardif, Founder and Portfolio Manager at Timelo Investment Management, warns of the potential for the loonie to depreciate significantly over time, citing expensive housing and economic disparities with the U.S. as contributing factors.

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