Bank of Canada Could Force Canadian Dollar Losses (USD/CAD Rally)

The Bank of Canada is virtually guaranteed to leave interest rates unchanged at its upcoming meeting, but the Canadian Dollar may nonetheless see volatility on the official statement.

In their decision to cut interest rates to 0.25 percent, Bank of Canada officials made it surprisingly clear that rates would remain unchanged through the second quarter of 2010. The Bank made it plainly obvious that they were attempting to set a ceiling on more medium-term interest rates, and a virtual guarantee of persistently low target rates led to a commensurate correction in Canadian Dollar money market rates.

Given such exceptional clarity on interest rates, what else could the Bank of Canada possibly do to move markets? Quite simply: Quantitative Easing.

Deputy BoC Governor John Murray recently published an article in which he outlines the justification, the mechanics, and the relative success rates of “Unconventional” monetary policy measures—strongly hinting that the Bank of Canada needed to look beyond interest rates to continue boosting money supply. Murray establishes target rates of 0.25-0.50 percent as the “Effective Lower Bound” of interest rates and explicitly highlights three mechanisms that banks may use beyond interest rates. (His statement is available here)

  1. [B]“Conditional statements about the future path of policy rates”[/B]: This quite clearly makes reference to the Bank of Canada’s recent announcement that explicitly says the central bank will leave rates unchanged until Q2, 2010.

  2. [B] “Quantitative Easing”[/B]: The key buzzword for any major central bank, Quantitative Easing involves a central bank’s purchase of private or public debt that expands its monetary base.

  3. [B]“Credit Easing”[/B]: A mechanism in which the central bank purchases private debt in especially distressed credit markets—also expanding its monetary base.

The BoC has clearly used the first mechanism and quite clearly reserves the right to use the next two, but why should we believe that they are likely to do so?

He goes on to highlight the “Four Guiding Principles” behind these unconventional measures, and explicitly says, ”Any decision to use them necessarily involves some risk and uncertainty. To deal with these challenges, the [B]Bank of Canada [/B]has identified four key principles that would guide its actions whenever these
unconventional measures are employed.” This is clearly not a guarantee that the Bank of Canada will use Credit or Quantitative Easing as a tool in its monetary policy arsenal, but we would argue it greatly increases the odds of such an announcement. The key question remains as to the timing of any such announcement.

Given such explicit commentary by its Deputy Governor, there is a reasonable chance that the BoC may choose its upcoming meeting as the appropriate time to announce QE or CE measures. This will be especially important for currency traders—especially if the announcement produces a similar reaction as did the Fed’s Quantitative Easing decision.

With the US Dollar/Canadian Dollar exchange rate at such exceptionally oversold levels, we could easily envision a strong USD/CAD rally on any such Quantitative or Credit Easing announcements. It is somewhat unclear whether we can see the opposite—a Canadian Dollar rally on the lack of such announcement. Yet we would argue that it may only be a matter of time before the Bank of Canada joins the Fed and aggressively expands its monetary base.
[B][I]Written by David Rodríguez, Quantitative Strategist for [/I][/B]