Synopsis:

Bank of America forecasts a ceiling on the potential rally of USD/CAD, despite imminent monetary policy divergence, citing inflation risks and structural financial concerns within Canada that could limit the pair’s upward movement.

Key Points:

• Monetary Policy Divergence: BofA expects the Bank of Canada (BoC) to begin its rate cutting cycle in the summer, while anticipating the first Federal Reserve rate cut towards the end of the year. This policy divergence is recognized by many investors, potentially influencing USD/CAD dynamics.

• Impact of CAD Weakness: A sharp sell-off in the CAD following the BoC’s rate cuts could lead to significant inflationary pressures within Canada. BofA estimates that for every significant rise in USD/CAD, there could be an additional 15 basis points added to Canadian CPI. A surge to 1.45 in USD/CAD could increase Canada’s CPI by a full percentage point.

• Market Reaction and Ceiling on Rally: The potential inflationary impact and structural portfolio outflows due to a weaker CAD may concern FX markets, thereby imposing a ceiling on how much USD/CAD can rally. This is in contrast to other currency pairs where similar dynamics may not be as pronounced.

• Relative Position of CAD: Compared to other major developed country currencies, the CAD is in a more favorable position, making it a less preferred option for those holding a bullish USD view.

• Bank of Canada’s Potential Interventions: While the current risk of FX intervention by the BoC is low, the bank has a history of intervening in the FX and repo markets. Such measures could be considered if USD/CAD movements threaten economic stability.

• Outlook and Forecasts: BofA maintains a downward forecast path for USD/CAD, expecting it to revisit the 200-day SMA of 1.35 by the end of the year. However, the long-term forecast for 2025 has been adjusted from 1.30 to 1.32 due to diverging terminal policy rates between the Fed and BoC.

Conclusion:

While the impending divergence in monetary policies between the U.S. and Canada suggests potential for a USD/CAD rally, BofA advises caution, highlighting structural and inflationary risks that could cap significant gains.