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Canadian headline CPI fell 0.7 percentage points to 3.1% YoY at the start of the fourth quarter, in line with economist expectations.
This largely reflected lower gasoline prices (-7.8% YoY).On a monthly basis, headline CPI rose just 0.1% in October following a 0.1% contraction in September, with the monthly increase driven primarily by travel tours and property taxes and other special charges. As a result, all-items CPI actually fell -0.1% MoM on a seasonally adjusted basis. Meanwhile, CPI ex food and energy, the traditional measure of core inflation, rose 0.5% MoM, although again this largely reflected stronger shelter inflation.
While the headline data was constructive, what markets really care about, however, is the Bank of Canada’s preferred measures of core inflation. Here, the average 3-month moving annualised rates of core-trim and core-median fell below 3% for the first time since March 2021, suggesting core inflation pressures have cooled and narrowed further heading into Q4. In fact, if the current pace of underlying core price growth is sustained in November, these same measures would fall to 1.91%, below the BoC’s 2% target for headline inflation. In conjunction with data showing slack building within the labour market and growth data suggesting the economy is in a shallow recession, October’s constructive inflation report has completely undermined the BoC’s hawkish bias.
This is yet another confirmatory point for our view that the BoC, having led the Fed during the hiking cycle, will once again be the pace setter in rates markets next year, with a cut in the overnight rate likely as early as April under our base case.
BoC’s preferred measures of inflation drop below the 3.5-4% range that has held all year and that forced the Bank into resuming its hiking cycle back in Q2
While the BoC’s measures of underlying inflation are illustrative of the overall price pressures within the Canadian economy, it is worth noting that the details of October’s CPI report were also soft. Goods prices remained in contraction at -0.8% MoM having fallen -0.3% in September, while most of the 0.9% increase in services inflation stemmed from shelter (+0.856%). In fact, the only sub-component that exhibited concerning strength for the BoC was recreation, which increased 1.1% month-on-month, although we expect this to moderate in the coming months as demand conditions weaken further and labour market pressures ease.
Given the narrowing and softening in price pressures in the Canadian economy, we think the BoC will likely lead the DM easing cycle in 2024, with a rate cut occurring as early as April under our base case. While the macro data to hand suggest a rate cut could take place as early as the first quarter, we expect Governing Council members will want to be certain that inflation is converging back to 2% on a sustained basis before easing policy having wrongly pre-empted the inflation outlook back in Q2. Although earlier policy easing is a prominent risk to our base case.
Markets have been slowly aligning with our view on the BoC’s policy path in recent weeks, with the implied probability of a rate cut in April rising to 74% at present. This has seen the Canadian dollar lag the G10 rally amid the softer dollar environment as BoC easing expectations have broadly moved in lockstep with the Fed’s.
We expect this dynamic to persist in the coming weeks and note risks are actually tilted to the upside for USDCAD even if the dollar continues to weaken on a broad basis as markets further align with our view that monetary policy is set to be looser in Canada than the US in 2024. The release of Q3 and September’s GDP data at the end of the month stands out as the main catalyst for such a move given the data is likely to confirm the Canadian economy entered a technical recession in the third quarter.
Upside risks for USDCAD are presented ahead of that in the form of stronger US activity data and this afternoon’s Fall budget. While we expect the budget to be a dull event for markets, there is a risk fiscal policymakers fall into the trap of loosening policy to combat low growth and narrow their polling deficit amidst the more favourable inflation and rate environment, although we believe this would trigger an adverse in Canadian assets. In terms of levels, we think USDCAD could re-test its year-to-date high of 1.39 by year-end, while we expect a breach of 1.40 in 24Q1 on the basis that the Canadian economy tips into a more sinister recession over the winter months.
CAD has underperformed on G10 crosses this month, a dynamic we expect to persist
Author:
Simon Harvey, Head of FX Analysis