Loonie under pressure, but for how long?

In Canada, the policy rate will be lowered for the third time in half a year tomorrow. The Canadian dollar is under considerable pressure as a result. However, this may change later this year if other central banks follow suit with interest rate cuts.

The Canadian dollar has been taking quite a beating lately. In the past two years, the currency has lost almost 13% of its value against the euro. Initially, this downward trend was closely tied to falling oil prices. In the summer of 2022, a barrel of Brent oil was trading for over $100. Now, that same barrel fetches around $75. After Saudi Arabia and Russia, Canada is the world's third-largest oil exporter. When oil prices drop, it often has a significant impact on the value of the Canadian dollar. However, there have been other factors at play with the loonie, as the currency is also known, in recent times.

Economy could use a boost
The Bank of Canada is on the verge of lowering the policy rate by 25 basis points to provide some breathing room for the economy. A lower interest rate makes it attractive for businesses and consumers to borrow money for investments or spending. The economy could use this push. Unemployment has risen from less than 5% in the summer of 2022 to 6.4% in July. This is quite different from the United States, where unemployment is just over 4%. One major difference is that the Bank of Canada (BoC) has more room to stimulate the economy. With inflation at 2.5%, it falls within the target range of 1% to 3%.

Interest rate difference is felt
The BoC has been taking advantage of this room. If the rate is cut by 0.25% during the policy meeting, it will be the third reduction in half a year. This is in stark contrast to the European Central Bank (ECB), which has only made one rate move this year. Financial markets in the United States have been waiting for the first rate cut since 2020 for months. This difference is clearly felt in currency markets. Despite the slowdown in the decline of oil prices, the loonie remains under pressure. The lower interest rate makes it less attractive for parties to hold assets in this currency.

Focus shifts
Whether the pressure on the Canadian dollar continues in the coming months largely depends on how the BoC explains its interest rate decision. If there are hints of more rate cuts in the coming quarters, the loonie will take another step back. However, if the central bank takes a more cautious approach, attention will shift to the Federal Reserve and the ECB. Particularly in Europe, the central bank seems more inclined to boost the moderately performing economy rather than wait for more evidence of declining inflation. It is possible that interest rates on our continent may follow in Canada's footsteps.

Joost Derks

Joost Derks is a currency specialist at iBanFirst with over twenty years of experience in the foreign exchange market. This column reflects his personal opinion and is not intended as professional (investment) advice.

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