The Bank of Canada (BoC) made a significant move on Wednesday, raising its overnight interest rate to a 22-year high of 4.75%. The decision was driven by concerns over an overheating economy and persistent high inflation. The central bank had been assessing the impact of previous rate hikes but concluded that its monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.

The Canadian economy has exhibited surprising strength in consumer spending, housing activity, and a tight labor market, signaling that excess demand is more persistent than initially anticipated. These factors led to the BoC's decision to increase interest rates, marking the fastest tightening cycle in the bank's history.

Following the rate hike, the Canadian dollar responded positively, appreciating by 0.4% against the US dollar. Money markets indicate a 60% chance of another rate hike in July, with further tightening already priced in for September. The market's reaction suggests expectations of continued monetary policy tightening by the BoC to address inflationary pressures.

The BoC's decision to raise interest rates was not entirely unexpected. However, the accompanying statement revealed the central bank's surprise and frustration with the reinvigoration of inflationary dynamics in the economy. The persistence of inflation despite previous rate hikes has raised concerns, prompting the BoC to take action.

In April, annual inflation accelerated to 4.4%, the first increase in 10 months. The BoC observed higher-than-expected prices for a wide range of goods and services, fueling concerns that inflation may not recede to the 2% target as rapidly as required. The central bank believes that further rate hikes are necessary to counter these inflationary pressures.

The impact of the interest rate hike on foreign exchange markets was notable. The Canadian dollar rallied, leading to a drop of a third of a percent in the US dollar to Canadian dollar exchange rate. Market expectations of future rate hikes are a driving force behind the Canadian dollar's strength.

Not only did the US dollar weaken against the Canadian dollar, but the pound also depreciated by 0.40% in the pound to Canadian dollar exchange rate. If the US dollar to Canadian dollar exchange rate reaches the projected level of 1.25, further depreciation of the pound against the Canadian dollar may occur.

The BoC's decision to raise interest rates reflects its commitment to combating inflationary pressures and achieving the 2% inflation target. The central bank will continue to assess economic indicators and inflationary dynamics to determine the need for additional rate hikes. The timing and extent of future rate increases will depend on factors such as inflation expectations, wage growth, and corporate pricing behavior.

Market participants and analysts anticipate further rate hikes in line with the BoC's goal of reducing demand and achieving the inflation target. The Canadian dollar's strength and the positive carry it offers make it an appealing option for investors. However, the ultimate impact of future rate hikes on both the domestic economy and foreign exchange markets remains to be seen, as it will depend on various economic factors and indicators.

As the BoC closely monitors economic developments, market participants eagerly await further updates and their potential implications for interest rates and the Canadian dollar.

Monfor Weekly Update

The recent agreement on the US debt ceiling has provided some relief to global markets, and investors are once again paying close attention to central bank monetary policies.

In light of a disappointing inflation report, it is widely anticipated that the Bank of England will raise interest rates by an additional 0.25% this month. Market expectations suggest that rates may peak around 5.35% in the second half of the year. However, the negative consequences of higher interest rates on the economy are causing significant concern. There is an increased risk of a recession and growth may fall below projected levels.

In the United States, there is a mixed sentiment among market participants regarding whether there will be one final rate hike. Inflation has proven to be persistent, leading to uncertainty about whether interest rates have already reached their peak. As a result, interest rate cuts have been postponed until early next year.

Despite inflation slowing to a lower-than-expected 6.1%, the European Central Bank remains relatively hawkish. However, the market has adjusted its expectations for rate hikes, with two more increases anticipated in the coming months.

Weaker growth data from China is currently impacting global risk sentiment across different asset classes.

Interest rate differentials are currently driving momentum in the foreign exchange markets. The Euro is weakening due to a softened rate outlook. The GBP/EUR pair continues to reach new year-to-date highs above the 1.1600 level, while the GBP/USD pair has made a strong recovery from recent lows and is now trading above 1.2500.

The Pound to New Zealand Dollar exchange rate continued its upward trend this week, reaching some of its highest levels since the beginning of the pandemic. However, there is now an increased risk of a correction in the exchange rate. This potential setback may become more likely in the coming days and weeks.

In the early part of the week, the New Zealand Dollar lost ground against most major currencies, including the Pound. However, the losses were not as significant as those observed after the Reserve Bank of New Zealand (RBNZ) interest rate decision last Wednesday.

Since the RBNZ's decision to raise its cash rate to 5.5% last Wednesday, the Kiwi Dollar has experienced losses. The central bank's updated forecasts indicate that the interest rate is likely to remain unchanged at its current level in the foreseeable future. Although this decision was in line with earlier forecasts, it was seen as 'dovish' compared to expectations that had increased following the government's announcement of increased investment spending and funding for post-disaster reconstruction in the recent annual budget.

For the week leading up to Wednesday, the New Zealand Dollar performed poorly compared to other advanced economy currencies, particularly against the U.S. Dollar and the strong Pound. In fact, the GBP/NZD exchange rate reached its highest levels since April 2020.

The rally in GBP/NZD was driven by the Office for National Statistics' data, which suggested that the decline in April's inflation may have been caused by previous drops in energy prices. The data also revealed an acceleration of inflation in the domestic sector of the economy. While overall inflation decreased from 10.1% to 8.7% last month, the core inflation rate, which is more significant, rose from 6.3% to 6.8%. Consequently, interest rate derivative markets indicated a high likelihood of the Bank of England (BoE) raising the Bank Rate from 4.5% to 5.5% this year.

However, this prospect poses a challenge for the Sterling, as the increased expectations for the Bank Rate could impact the UK economy. Mortgage rates are based on the market-implied rate rather than the actual Bank Rate. Therefore, households can expect to pay 5.5% or more when renewing fixed-rate mortgages, which is significantly higher than the average level of 0.1% to 0.75% seen over the past 15 years. This implies that monthly mortgage repayments could consume a substantial portion of some incomes.

Furthermore, there are concerns about the cooling labour market and projections that the UK economy will underperform many of its counterparts this year. Additionally, reports suggest that speculative traders have heavily invested in Sterling, making it vulnerable to profit-taking.

Monfor Weekly Update

The GBP to EUR exchange rate's upward momentum so far this year has faced significant resistance, hindering its progress in the latter half of May. However, the consolidation around the 1.15 level could see a breakthrough in either direction following the release of European inflation figures for April on Thursday.

Throughout last week, GBP remained relatively stable against the Euro.  GBP's advance faltered shortly after UK inflation figures for April were released, showing a smaller decline than expected.

The unexpected rise in UK Consumer Price Index (CPI) contributed to a sell-off in the bond market, which negatively impacted risk sentiment and weighed on Sterling. Michael Cahill, a G10 FX strategist at Goldman Sachs, noted that the substantial increase in UK CPI fuelled the selloff in government bonds, affecting GBP.

Derivative markets quickly adjusted to reflect a high probability of the BoE raising the Bank Rate to 5.5%, following the data released the previous week. The decline in April's inflation was attributed to earlier drops in energy prices. This was further supported by the core inflation rate, which rose from 6.2% to 6.8% as prices of domestically produced goods and services increased in various categories after the start of the financial year. Such price increases are precisely what the BoE has been attempting to prevent.

Rate expectations have steadily increased throughout the year, driven by official figures and private sector indicators suggesting greater resilience in the UK economy than initially anticipated. The BoE upgraded its forecasts this month, now projecting modest growth for 2023.

GBP/EUR is primarily focused on Europe's inflation figures this week, as UK economic data remains relatively limited. The likely outcome and market response are uncertain, especially if price pressures on the continent remain persistent.

Economists surveyed expect Europe's inflation rate to fall from 7% to 6.3% for April, with the core inflation rate edging lower from 5.6% to 5.5%.

Please note:  The news and information contained on this site should not be interpreted as advice or as a solicitation to offer to convert any currency or as a recommendation to trade.

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