• BoC will announce its interest rate decision on Wednesday, September 7.
• Markets expect BoC to raise its policy rate by 75 bps.
• CAD needs a hawkish surprise to outperform USD.

The Bank of Canada (BoC) is widely expected to hike its policy rate by 75 basis points (bps) to 3.25% from 2.50% following its September policy meeting.

In July, the BoC surprised markets with a 100 bps rate hike and acknowledged in its policy statement that it had underestimated inflation since the spring of 2021 mainly because of global factors. Furthermore, the bank noted that its intention to front-load rate increases was due to broadening and persistent inflation.

While commenting on the policy outlook in the ensuing press conference, "our aim is to get rates to the top-end or slightly above neutral range quickly,” BoC Governor Tiff Macklem said. According to the BoC’s policy statement, the neutral range is between 2% and 3%.

In the meantime, Statistics Canada reported on August 16 that inflation in Canada, as measured by the Consumer Price Index (CPI), declined to 7.6% on a yearly basis in July from 8.1% in June.

Hawkish scenario

In case the BoC goes against the market expectation again and delivers another 100 bps rate hike, this could trigger a significant reaction and provide a boost to the Canadian dollar. In that scenario, the CAD should easily outperform the euro and the Japanese yen due to the policy divergence between the respective central banks. Against the USD, CAD’s gains could remain limited with investors awaiting the August inflation data from the US before deciding whether to price in a 75 bps Fed rate hike later in the month. It’s worth noting, however, that even if the BoC decides to raise its policy rate by 100 bps, it could refrain from committing to such aggressive rate hikes in the future. Since there will not be a press conference this time around, the language in the policy statement will be scrutinized by investors.

Neutral scenario

The BoC could opt for a 75 bps hike, as expected, and say in its policy statement that it will adopt a data-dependent approach moving forward while reiterating its commitment to bring inflation back to its 2% target. Such a rate increase would lift the policy rate “slightly above” the upper limit of its neutral range. A neutral tone could make it difficult for the loonie to stay resilient against its American counterpart.

Dovish scenario

If the bank raises the policy rate by 50 bps, the CAD is likely to face heavy selling pressure. The BoC could acknowledge the slowdown in economic activity alongside softening price pressures and tilt toward a more conservative policy stance. The latest data from Canada revealed that Real Gross Domestic Product (GDP) expanded at an annualized rate of 3.3% in the second quarter. This print followed the 3.1% growth recorded in the first quarter and missed the market expectation of 4.5%.

Among the three different scenarios listed above, the dovish is the least likely one. Major central banks remain focused on bringing down inflation at the expense of growth and the BoC is unlikely to react to a single CPI print. Meanwhile, markets are pricing in a terminal rate of nearly 4%. Hence, a 50 bps rate hike would be a very big dovish surprise even if it’s enough to lift the policy rate to the upper limit of the neutral range.