The U.S. Federal Reserve created market volatility with their meeting on December 18th and the subsequent press conference. The statement from Chairman Jerome Powell that upset the apple cart was his response to the last question of his press conference.
Chair Powell was asked if he could rule out a rate hike (increase in the Federal Reserve’s overnight lending rate) in 2025. His response, “You don’t rule things completely in or out in this world” was enough to send stock markets lower by approximately 3% within a few hours.
However, Powell then went on to say, “That doesn’t appear to be a likely outcome. I think we’re at 4.3%, that’s meaningfully restrictive and I think it’s a well-calibrated rate for us to continue to make progress on inflation while keeping a strong labor market.”
Stock markets tend to shoot first and ask questions later, which is why the market initially focused on the first sentence of his response.
Stock markets (led by the U.S.) enjoyed a very good year which made the market more susceptible to a sharp sell-off in response to the potential for interest rates to increase in 2025 rather than continue their downward trajectory. Lower interest rates were ‘priced-into’ stock markets and stocks like lower interest rates because lower rates increase the present value of the future cash flow generated by publicly traded companies.
Ultimately, the direction of interest rates will be determined by the path of inflation in 2025. As this week’s chart highlights, inflation is declining faster in Canada than the U.S.
Canadian headline inflation (year over year CPI) is shown in red and U.S. inflation is shown in blue. The band that most central banks target for inflation is highlighted in light grey (1-3%). Notice that Canadian inflation at 2% is running 60 basis points below that of the U.S. at 2.6% currently. This difference in inflation is being predominantly driven by strength in the U.S. economy relative to the Canadian economy.
You may have also noticed the Canadian dollar trading at multi-year lows as we approach 2025. The link between weakness in the Canadian dollar and inflation is interest rates. Interest rate differentials (difference between interest rates of different countries) are the main driver of currency rates.
In this case, the U.S. dollar has substantially appreciated relative to the Canadian dollar because interest rates are higher in the U.S. Additionally, the market expects interest rates in the U.S. to remain above interest rates in Canada due to the relative strength of U.S. economy.
Everything else being equal, lower inflation allows for lower interest rates as the primary mandate of central banks is to control inflation. The political chaos and void of leadership in Ottawa are contributing factors to recent Canadian dollar weakness, however, it will be the path of inflation and interest rates that ultimately determines the path of the Canadian dollar for 2025.
I hope everyone had a merry Christmas and wishing all my readers a happy, healthy and prosperous 2025!
Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca
