GBP/CAD buoyed as BoC eschews rate rise But warns of higher borrowing costs aheadSuggests QE unwind to begin in near futureGBP/CAD bid & finding support near 1.6960

Above: BoC Governor Macklem. Image © Bank of Canada, Reproduced Under CC Licensing.

The Pound to Canadian Dollar exchange rate rallied in the midweek session after drawing a bid from the market when the Bank of Canada (BoC) passed up an opportunity to lift its cash rate but also warned that borrowing costs are likely to begin rising during the months ahead.

Sterling recovered the 1.70 handle and USD/CAD rallied back above 1.26 on Wednesday after the BoC left its cash rate unchanged at 0.25% in a move that was in line with economists’ expectations but which may have surprised parts of the financial markets.

Pricing in the overnight indexed swap market had implied there was some probability of a surprise decision to lift the benchmark and potentially explains the subsequent increases in USD/CAD and GBP/CAD.

“The CAD understandably knee-jerked lower following the pass on a hike. The reaction however, has been reasonably contained given that the market had largely priced in a hike for this meeting,” says Mazen Issa, a senior FX strategist at TD Securities.

“We will hold onto our GBPCAD shorts for now but hold a bias to lighten up in the coming days,” Issa and colleagues told clients following the decision.

Above: GBP/CAD shown at 15-minute intervals alongside USD/CAD.

Reference rates at publication:

GBP to CAD spot: 1.7027High street bank rates (indicative): 1.6425 - 1.6544Payment specialist rates (indicative: 1.6868 - 1.6936Find out about specialist rates and service, hereSet up an exchange rate alert, hereWhile Canada’s main interest rate was left on hold the BoC warned that accelerating inflation is likely to mean borrowing costs have to rise over the coming months if the bank is to ensure that consumer price growth returns to the 2% target during the years ahead.

“Looking ahead, the Governing Council expects interest rates will need to increase, with the timing and pace of those increases guided by the Bank’s commitment to achieving the 2% inflation target,” the BoC said in its statement.

Canadian inflation rose to almost five percent in December and was projected by the BoC on Wednesday to remain near that level throughout the first half of the year before declining steadily thereafter.

Governmental responses to the coronavirus have disrupted international supply chains across the world, leading to materials and goods shortages while raising prices across the board and lifting inflation in many parts of the globe.

These factors and a robust recovery in the domestic labour market have lifted pay rates for workers, which is a potentially effective recipe for further increases in overall inflation.

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“We see the Bank hiking in March if better news on the virus arrives in time, as the first move of a 75-100 bp tightening this year, and a total of 150 bps of hikes in 2022-23,” says Avery Shenfeld, chief economist at CIBC Capital Markets, in a note to clients following the BoC’s announcement.

The BoC also suggested on Wednesday that once its cash rate is lifted, it could begin to steadily reduce the bank's holdings of Canadian government bonds acquired as part of its quantitative easing programme, which would potentially be an upside risk to bond yields and the Canadian Dollar.

Canada's cash rate was cut from 1.75% in January 2020 and to 0.25% by March that year but financial market prices have recently implied that investors are wagering heavily on the benchmark being lifted to 1.25% or more before the curtain closes on 2022.

“We expect the first interest rate now to come at the March 2nd policy meeting. The BoC acknowledged overall “economic slack [is] now absorbed” and that “the labour market has tightened significantly”. This is clearly evident,” says Francesco Pesole, a strategist at ING.

“We continue to see the BoC tightening cycle as a positive factor for CAD in 2022, although external factors will play a big role too in directing the currency from now on. Assuming oil prices remain resilient and the global risk sentiment picture stabilises after the recent jitters, we think USD/CAD can stay on a downtrend for the rest of the year and hit 1.22 in 4Q22,” Pesole and colleagues also said.

Above: Pound to Canadian Dollar rate shown at daily intervals alongside USD/CAD.