Above: File image of BoC Governor Macklem. Image © Bank of Canada, Reproduced Under CC Licensing.

The Canadian Dollar rallied after the Bank of Canada raised its policy interest rates by 25 basis points to 4.75% and signalled it felt further rate hikes were required.

The hike itself was not entirely unexpected, but the tone of the accompanying statement betrayed a central bank somewhat surprised and frustrated by a perceived reinvigoration of inflationary dynamics in the economy.

The Bank appears concerned that the impact of previous interest rate hikes is not having the required dampening effect on activity.

In the statement, the Bank noted Canada's economy was stronger than expected in the first quarter of 2023, that "consumption growth was surprisingly strong and broad-based" ... "demand for services continued to rebound" ... "excess demand in the economy looks to be more persistent than anticipated."

These are all inflationary developments and the Bank believes it has a cure: higher interest rates.

"There were plenty of reasons for the BoC to restart its tightening cycle today," says Josh Nye, Senior Economist at Royal Bank of Canada.

Above: GBP/CAD (top) and USD/CAD showing post-BoC action.

Canadian inflation rose in April to 4.4% in the first increase in 10 months, with the Bank observing prices for a broad range of goods and services coming in higher than expected and the Bank of Canada appears concerned inflation won't fall back to its 2.0% target as rapidly as required:

"With three-month measures of core inflation running in the 3½-4% range for several months and excess demand persisting, concerns have increased that CPI inflation could get stuck materially above the 2% target."

Regarding the outlook, the Bank suggests further rate hikes are likely if the data warrant.

"Governing Council will continue to assess the dynamics of core inflation and the outlook for CPI inflation. In particular, we will be evaluating whether the evolution of excess demand, inflation expectations, wage growth and corporate pricing behaviour are consistent with achieving the inflation target," said the statement.

"Our expectation has been that if the BoC was coming off the sidelines, they would intend to hike more than once—if 4.50% wasn’t restrictive enough it’s hard to think 4.75% is," says RBC's Nye. "The onus is clearly on that data to soften broadly to preclude another rate hike, and timing a slowdown has been challenging."

The Canadian Dollar's rise reflects the market's expectation for further rate hikes ahead.

"A quarter percentage point rate hike to 4.75% could potentially put levels below 1.33 in play for USD/CAD that have been out of the market since mid-February," says Joe Manimbo, Senior FX Analyst at Convera.

Following the decision the U.S. Dollar to Canadian Dollar exchange rate (USDCAD) dropped a third of a percent to 1.3350.

"The attractive risk-adjusted carry can keep CAD in investors' favour for longer," says Francesco Pesole, FX Strategist at ING Bank. "Fresh BoC tightening means that USD/CAD may trade closer to 1.25 than 1.30 by year-end."

The Pound to Canadian Dollar exchange rate (GBPCAD) fell 0.40% to 1.6666, a move to USD/CAD 1.25 (as per the above forecast), all being equal, implies further GBP/CAD is in store.