Bank of Canada Governor Tiff Macklem

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there would be a number of reasons why this is the case. One is that the market does not believe that the Bank of Canada will pause. Another is that currency bulls might warm to the idea of a pause if this pause sets up a strong performance in Canadian asset prices, such as stocks and bonds. And a third argument is that other factors are driving the currency at the moment, like commodity prices.

“Whatever it is we do think that the disconnect between rate policy and the currency highlights the fact that the FX market puts too much faith in interest rate differentials as determinants of currency moves”, said Mr. Steve Barrow.

The first argument Mr. Steve Barrow mentioned, which is that the market does not believe in a pause from the BOC, could have some validity. After all, others facing a seemingly pretty similar economic situation, notably the US, seem far from pausing and may even have to step up the pace of monetary tightening again. In addition, post-BoC meeting economic data in Canada has been robust as we saw most clearly with the huge 150k rise in employment in January. The Bank of Canada might give the impression that it wants to “see through” any firm data but the FX market, for one, seems to be sceptical about this.

A second argument is that a rate pause from the Bank of Canada could prompt asset price outperformance, especially in bonds, and so suck in capital. This scenario clearly assumes that investors believe that the pause will persist, unlike the first explanation Mr. Steve Barrow offered.

A third alternative is that other factors are really driving the currency at the moment. For instance, Canada’s strong natural resource base might mean that the movement in energy prices is the key to why the Canadian dollar is performing well. However, this falls over on two counts. The first is that energy prices have not rallied so far this year and we can also point out that another resource-rich currency, the Norwegian krone, is the worst performing G10 currency this year.

But the argument Mr. Steve Barrow prefers is that interest rates are simply not the key driver for currencies that the market seems to think. Moreover, this view does not just relate to the movements in the Canadian dollar, but to all currencies all of the time. There’s excessive focus on interest rates, particularly policy rates, because central bank policy presents a huge amount of fodder for analysts, traders and investors to talk about.

In short, it is easy to talk about central bank policy and relate this to currencies when the actual reasons for currency movements might reflect factors that are often unknown, or somewhat less interesting to talk about.

This is how we feel about the relationship between currencies and interest rates. Rates are an ‘easy out’ to explain or try to predict currency movements but, very often the real reasons are very different. This is not to say that we know for sure why the Canadian dollar might be performing well this year except to say that interest rates may not be an important reason.

Generally speaking, we put more faith in the performance of asset prices as a currency determinant, especially when it comes to the performance of the US dollar. With asset prices looking pressurised at the moment, Mr. Steve Barrow thinks it more likely that the Canadian dollar will slide against the US dollar in the near-term but this should not detract from a better performance against other currencies.