USD/CAD is extremely overvalued - BBH

As was widely expected, the Bank of Canada (BOC) slashed the policy rate 25bps to 3.00% yesterday. The BOC also announced two changes to its monetary policy implementation framework. These tweaks are technical and have no material monetary policy implications, BBH FX analysts report.

USD/CAD can move higher on risks of US/Canada trade war

"First, the BOC will end quantitative tightening and begin purchasing assets as part of normal balance sheet management in early March. Second, the BOC announced that the deposit rate will be set at a spread of 5bps below the policy rate (i.e.: 2.95%). The aim is to mitigate some of the upward pressure that has been seen on the overnight rate relative to the policy rate in recent months."

"More importantly, the BOC signaled it may pause easing while warning that US trade policy is a major source of uncertainty for Canada's economy: (i) BOC emphasized again that "the cumulative reduction in the policy rate since last June is substantial" but scrapped previous easing guidance. (ii) BOC still projects inflation to remain close to the 2% target over the projection horizon. (iii) BOC projects GDP growth to rise above potential output in 2025 and 2026."

"Nonetheless, markets expect the BOC to deliver more rate cuts. We agree. Interest rate futures imply almost 75bps of BOC cuts over the next 12 months that should see the policy rate bottom near 2.25%. This would be at the lower end of the BOC's neutral range estimate of 2.25% to 3.25%. While USD/CAD is extremely overvalued, the overshoot has more legs. FED/BOC policy trend, risk of all-out trade war between Canada and the US, and the Trump administration's focus on lowering energy prices support a higher USD/CAD."