Caught off guard by dollar spike

How come the loonie shot so high when everybody expected the rate hike?

The Bank of Canada raised interest rates by 25 basis points Wednesday in a move widely expected by investors.

But some were caught off guard by the significant spike in the loonie that followed, pushing it close to the US79-cent mark.

While the Canadian dollar’s recent strength (up more than five per cent in the past month) has been attributed to expectations for higher interest rates, it was thought that much of the rally had already run its course. After all, the BoC carefully laid the groundwork for its first rate hike since 2010, telegraphing to the market that it planned to remove 50 bps of cuts made after oil prices plunged in 2015.

But in contrast to pre-decision remarks from Governor Stephen Poloz and his deputies, the hike was not positioned as a reversal of one of those two rate cuts, according to Avery Shenfeld, chief economist at CIBC World Markets. “The market seemed to interpret that as implying that the bank is planning on more than one further hike this year,” Shenfeld said.

The hawkish tone sent the Canadian dollar higher, as bond yields also spiked. The loonie appreciated by about a full penny at one point, and the two-year Canada bond yield jumped by six to seven basis points.

Shenfeld believes the BoC has left itself some breathing room in terms of the next rate hike. Instead of moving in September, the economist noted that it could wait until October to allow time for inflation to show through. This would also help prevent the Canadian dollar from appreciating too quickly if the U.S. Federal Reserve doesn’t hike rates in September.

The BoC’s decision to tighten monetary policy was supported by the central bank’s confidence that above-potential growth will absorb excess capacity in the economy.

The central bank also raised its real GDP growth forecast for 2017 to 2.8 per cent (from 2.6 per cent), and for 2018 to two per cent (from 1.9 per cent).

“The reason for the 2017 upgrade was not just the stunning Q1, but also a solid follow-up with Q2 and Q3 pegged at three per cent and two per cent respectively,” economists at National Bank Financial said in a research note.

While the central bank expects a solid follow-up to the strong first half, does that mean it will raise rates again at the next meeting? The inflation outlook makes that unclear, as the BoC acknowledged some risk to its twoper-cent inflation forecast for 2018.

“The slowdown in inflation of some advanced economies (including Canada) may be due to ‘common factors’ such as downward trend in inflation expectations, which would call for a cautious approach in policy normalization,” National Bank Financial said. “At this point, we still think there is another rate hike slated for this year.”

Jimmy Jean, senior economist at Desjardins Group, is confident the central bank will hike rates again in October, then pause until well into 2018. “The pause will be made in the spirit of engineering very gradual normalization process,” he said in a report.