By Michael O’Neill

There are a couple of certainties in life, but the Fed knowing interest rate direction isn’t one of them. Fed Chair Jerome Powell said as much in his post-FOMC meeting press conference on May 1 and again yesterday in Amsterdam. He said, “I would say my confidence is not as high as it was, having seen the readings in the first three months of the year.”

Mixed Producer Price Index Data

The Producer Price Index failed to impress him. He claimed the data was mixed because although PPI rose by more than expected, the previous month’s results were revised lower. He reiterated that he did not expect the Fed’s next move to be a rate hike, but it was more than likely rates would remain unchanged for longer than previously expected.

Underwhelming CPI Data

Then came the Consumer Price Index data on May 15. It was rather underwhelming, but you wouldn’t know it from the bond and equity market reactions. The 10-year US Treasury yield plunged to 4.34% from a pre-data peak of 4.449%, while the S&P 500 index jumped 0.58%.

Market Reactions to CPI

Consumer prices increased 0.3% in April, compared to the 0.4% rise in March. Core-CPI, which excludes volatile food and energy prices, rose by 0.3%, matching expectations but down from 0.4% in March. Year-over-year, Core-CPI increased by 3.6%, slightly lower than the previous 3.8%. Traders were encouraged by the results, and according to the CME FedWatch tool, futures traders have a 70% probability that the first rate cut will occur at the September 18 meeting. They have been wrong all year, and Mr. Powell’s recent comments suggest that they are still wrong.

Bank of Canada Rate Cut Hints

North of the border, Bank of Canada Governor Tiff Macklem may be muttering curses of his own. The BoC Governor has dropped broad hints that he will be cutting rates as early as June. Canadian banking economists are projecting a total of 75 bp rate cuts by the end of the year.

Implications for the Loonie

Assuming Mr. Powell is correct and US interest rates will remain unchanged for longer than previously anticipated, and Mr. Macklem follows the Canadian bank forecasting lead and cuts rates by 75 bps, it will be seriously bad news for the loonie. The 10-year Canadian/US interest rate differential would widen to -150 bps in favor of the US and sink the Canadian dollar.

US Economy Resilience

The Fed can afford to leave rates unchanged. The US economy may not be booming anymore, but it is still chugging along at a healthy pace. The Atlanta Fed’s EconomyNow app forecast Q2 GDP at 3.8% following the PPI and CPI reports (it dropped from 4.2% on May 8), while S&P Global is forecasting GDP growth of 2.5% in 2024. The Bank of Canada is not similarly blessed. The Canadian government is forecasting just 0.7% GDP growth in 2024, which supports an easier BoC monetary policy.

Impact on Canadian Importers

Lower interest rates will have borrowers grinning from ear to ear while importers would be crying into their scotch, assuming they could still afford a bottle. It is easy to understand why. Canada imported $277.04 billion worth of goods in 2023, of which 10% or $28.17 billion was food. Other major imports include vehicles, machinery (including computers), and refined petroleum (gasoline, diesel). A sharply weaker Canadian dollar means importers have to spend significantly more money on the same volume of goods, making it likely that they would pass the added costs on to the consumer. That’s also called inflation, and inflation has perplexed policymakers since even before Covid.

Government Spending and Fiscal Discipline

The federal government is not making life any easier for the BoC Governing Council. The Trudeau government increased government spending while showing zero financial discipline. A prime example is the Kinder Morgan pipeline project. It had an initial cost of $3.4 billion, but after a blizzard of regulatory barriers and Indigenous protests, the Canadian government took ownership for a mere $4.7 billion in 2018. The government demonstrated its shrewd fiscal management skills by finally finishing the project in April 2024, leaving taxpayers on the hook for $34.4 billion.

Comparing Economies

The Canadian economy is a basket case compared to its southern neighbor. It’s not hard to see why. The U.S. economy is significantly larger than Canada’s, with a GDP over $25 trillion compared to Canada’s $2 trillion. This larger scale provides more opportunities for investment, innovation, and consumption. The sheer size of the U.S. economy allows it to absorb shocks better and recover more quickly from economic downturns. The American economy is far more diversified, including technology, finance, healthcare, manufacturing, and energy. The American labor market is deemed to be more flexible, while the US also has a larger and younger population base.

Downside Risk for the Canadian Dollar

All of the above suggests that the risk to the Canadian dollar is heavily skewed to the downside. Mr Powell may not be confident in the US inflation outlook, but it is BoC Governor Tiff Macklem’s rate cutting actions that may have him saying “Oh 💩