By Michael O’Neill
The Bank of Canada (BoC), the Federal Reserve (Fed), and the European Central Bank(ECB) are not even close to being a holy trinity. However, there are three of them, and this trio is singing from the same song-sheet. The chorus is “Low, low interest rates, until some faraway future date.”
The low interest rate theme was on full display this week. The ECB reaffirmed their commitment to negative, zero and near-zero interest rates on Thursday. They said “The Governing Council expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%.
That statement followed the BoC’s decision on Wednesday, which had a similar message. “The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.”
The Fed is the 800lb gorilla in the room. The G-10 central bankers like to talk about their independence, but when the Fed is flatulent, they are all odoriferous. The proof is in the G-10 actions during the 2008 Financial crisis and most recently their responses to the COVID-19 pandemic in March. Fed Chair Jerome Powell poured liquidity into financial markets, and his counterparts in the G-10 followed suit.
The Fed left interest rates unchanged at its July 29 meeting. They said, “The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The three bankers blame low inflation for the need to keep interest rates at record low levels. They are also worried about persistently low inflation levels in their jurisdictions.
Jerome Powell addressed the low inflation concern in a speech August 27.
He said “If inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down.
He has a plan to remedy the situation.
He said “To prevent this outcome and the adverse dynamics that could ensue, we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
That differs from the current goal of “symmetric 2%. “It is defined as the requirement for the Fed to respond if inflation is above or below 2%.
Coincidently, the ECB and BoC are also conducting monetary policy reviews. Even though the three central banks employ close to one thousand economists, many of whom hold doctorate degrees, they appear to be arriving at the same conclusion. If you can’t get inflation to the desired level, change how the level is calculated.
The Bank of Canada is harmonizing with the Fed and ECB, but FX traders don’t care. USDCAD direction is closely tied to broad US dollar sentiment. Domestic economic reports are largely ignored. Weak data is blamed on the impact of coronavirus measures, while strong reports get dismissed because the results are skewed by the pandemic.
US dollar sentiment is what drives CAD direction, particularly EURUSD price action. The chart below highlights the correlation between CAD, EUR, AUD and USDX. CAD is the blue line.
Source: Saxo Bank
Massive Federal and Provincial budget deficits barely raise an eyebrow. Last week, the Congressional Budget Office forecast a US budget deficit of $3.3 trillion by the end of 2020. Canada’s budget deficit pales in comparison. It jumped from $25 billion in February to a forecast for a $343.0 billion deficit by the end of the year. FX markets just yawn, as the G-10 governments have similar issues.
USDCAD may track EURUSD moves, but the moves appear to favour Canadian dollar losses rather than gains.
That may be due to a couple of factors, the first being the decimation of the Canadian oil industry. The currency has not recovered from Saudi Arabia’s price war. Even worse, the Federal government plans a series of measures to end Canada’s reliance on fossil fuels. Those measures will come to light in two weeks when Prime Minister Trudeau delivers the Throne speech. He is rumoured to be announcing major new social spending and climate measures.
Another Canadian dollar negative is President Trump.
He is not a fan of the Prime Minister, but he is a fan of tariffs. Trump imposed tariffs on Canadian aluminum and is also threatening levies on softwood lumber and lobsters.
Those concerns help explain why the Canadian dollar is the worst-performing major G-10 currency since February. The holy trinity’s determination to keep interest rates “very low for an extended time”, isn’t helping.
The following chart highlights the Canadian dollar’s underperformance.