Financial markets and forecasters are betting that the Bank of Canada will cut interest rates sharply again this week. As the Bank of Canada prepares for its final interest rate decision in 2024, experts warn that if the central bank significantly cuts interest rates as expected by the market, the weak Canadian dollar is likely to further decline.

The market generally expects the Bank of Canada to lower its benchmark interest rate for the fifth consecutive time on Wednesday (currently 3.75%).

However, the extent of the central bank's interest rate cut is still debatable, and the market and many economists currently advocate expanding the rate cut to 50 basis points, which is equivalent to the decline in October.

The November employment report released last Friday showed that the unemployment rate jumped to 6.8% last month, exceeding expectations, and the money market has increased the possibility of a significant interest rate hike of up to 80%.

The weak employment data is enough to make Bank of Montreal change its view on Wednesday's interest rate decision. The bank's economists currently expect a 50 basis point rate cut instead of the usual 25 basis points. TD Bank is the only large Canadian bank to claim a 25 basis point interest rate cut this week.

Last Friday's employment report also had a restraining effect on the Canadian dollar.

Last Friday, the Canadian dollar fell by about 0.5 cents against the US dollar, continuing the slump of the Canadian dollar for several months.

Unexpectedly high unemployment rate, further depreciation of the Canadian dollar

As of Monday evening, the exchange rate of the Canadian dollar to the US dollar was about 70.5 cents, which is about 4 cents lower than the level at the end of September. Compared to the US dollar, the exchange rate of the Canadian dollar fluctuates above a 4.5 year low.

The factors proposed by experts to explain the decline of the Canadian dollar include Trump's re-election and protectionist trade policies.

However, Nathan Janzen, Assistant Chief Economist at the Royal Bank of Canada (RBC), pointed out that the difference in policy rates between the Canadian and US central banks is the main unfavorable factor for the Canadian dollar.

He believes that this gap will continue to widen in the coming months. He told reporters, "This will put downward pressure on the value of the Canadian dollar/US dollar

The story of two economies

Since the start of its easing cycle in June, the Bank of Canada has cut interest rates by 1.25 percentage points, making it one of the fastest and earliest central banks in the world to do so.

Although the Federal Reserve's first 0.5 percentage point rate cut in September caused a sensation, the central bank has slowed down the pace of rate cuts, cutting 25 basis points last month.

Janzen explained that the reason why the Bank of Canada had to cut interest rates more significantly was because the weakness of the Canadian economy was more apparent, while the engine of the US economy was strong.

In addition to the weak November employment report, recent data shows that the Canadian economy fell below the Bank of Canada's expectations in the third quarter of this year. Although price pressure has recently shown some stickiness, it is expected that economic weakness will continue to bring anti inflationary pressure to the entire Canadian economy.

Janzen said, "This indeed proves that the Bank of Canada is more aggressive than the Federal Reserve in further interest rate cuts

The weak Canadian dollar will have a series of consequences for Canadians. Canadian tourists traveling in the United States not only face higher costs because their dollars are not as abundant as before, but also because imported goods from the United States are more expensive for businesses within Canada.

Even Montreal Bank (BMO), which raised its expectations for a 50 basis point rate cut last week, warned in a report to clients on Friday that the risks posed by the 50 basis point cut to the Canadian dollar should not be ignored.

Benjamin Reitzes, the head of interest rates and macro strategist at BMO Canada, wrote that if the Canadian dollar is hit by a significant rate cut, consumers will soon feel it in grocery stores.

Reitzes wrote, "For Canadians, grocery is a particularly sensitive area, and with the increase in winter fresh food imports, grocery will almost immediately face pressure

Due to import pressures, the weak Canadian dollar may exacerbate inflation - if the exchange rate continues to decline, the Bank of Canada's efforts to combat inflation will face risks.

The potential impact on inflation and inflation expectations should not be ignored, and if the depreciation of the Canadian dollar strengthens, it may be difficult to stop, "Reites said

Will the weak Canadian dollar hinder the actions of the Bank of Canada?

Tiff Macklem, Governor of the Bank of Canada, has previously stated that although the central bank independently formulates monetary policy for the Canadian economy from other jurisdictions, there are "limitations" to the difference between policy rates and the Federal Reserve due to this relationship.

Janzen said, "We know that when the Canadian dollar weakens, import costs will rise, which may lead to an increase in consumer prices, which is inconsistent with the policy objectives of the Bank of Canada

But Janzen expects that the Bank of Canada will not further cut interest rates by 50 basis points on Wednesday due to concerns about the Canadian dollar.

He stated that in the entire consumer spending basket, imported goods account for only about 10% of the typical Canadian's expenditure, excluding cars. The remaining expenses are mainly based on services, including housing.

Janzen stated that due to the cooling of the Canadian economy, the remaining 90% of currencies in a typical currency basket still face severe anti inflation, and the Bank of Canada may tolerate an increase in pressure from the relatively small proportion of imported goods in the Canadian budget.

In other words, the weak Canadian dollar has not yet endangered the Bank of Canada's mission to combat inflation.

Although the market has actually digested the news of the Bank of Canada cutting interest rates by 50 basis points on Wednesday, Janzen expects that if the Bank of Canada cuts interest rates as expected, the Canadian dollar will not fall too much further this week.

But he also believes that the market underestimates the extent of the divergence between the Bank of Canada and the Federal Reserve in the coming months, and that the Fed may end its easing cycle prematurely as the US economy continues to strengthen.

Janzen stated that this means the Canadian dollar may further decline in 2025.

He added that there is also a glimmer of hope for the Bank of Canada to start its easing cycle earlier, which is that the expected recovery may be closer to us.

Royal Bank of Canada believes that as the delayed impact of previous interest rate cuts begins to provide some relief to consumers and businesses, the Canadian economy will rebound in the second half of 2025. Janzen did point out that the ongoing "uncertainty" surrounding US trade policy may have further impacts on the exchange rate between the two currencies. But once the policy interest rate of the Bank of Canada reaches a neutral level and the interest rate gap with the Federal Reserve stops widening, he believes the outlook for the Canadian dollar will improve.